According to the Wall Street Journal, cash was the best performing asset class in 2018. However, many investors shy away from cash investments, such as Treasury bills, money market funds and savings accounts. Given their modest returns in recent years, that is not surprising. But, cash does play an integral role in a well-diversified portfolio, particularly as interest rates increase.
For starters, the low volatility and liquidity of cash investments provides stability in the event of a significant or prolonged market downturn. This is especially important if the length of time before you need to utilize your portfolio is relatively short. Needs and life goals can dictate such timing. Driving factors such as nearing retirement, college tuition for a child and a new car are just a few examples. Each individual circumstance is unique and it is important to create an approach that works for you.
Some investors view cash as a drag on their portfolio's overall returns, but the opposite can also be true. When you have a cash cushion, you can allocate other funds to riskier investments that possibly offer significant growth potential over the long term. With sufficient cash on hand, you will not need to use long term investments for short term cash needs, and sufficient cash makes it easier to stay the course rather than sell these assets in a panic during turbulent times. Keep in mind that asset sales have tax implications. Unintended consequences can result if there is a failure to plan.
Cash offers other advantages, including:
- Lower Downside
Because cash investments have little downside risk, they help to mitigate a portfolio's overall volatility. In the event of a market downturn, a portfolio with significant cash investments generally declines less than one without such investments.
Cash offers diversity, which can be critical to a healthy investment portfolio. Different asset classes (for example, stocks, bonds and real estate) tend not to move in tandem with each other. Cash investments are good diversifiers because they typically have relatively low correlations with other types of assets.
Keeping cash under your mattress is usually a bad idea because its value erodes over time as inflation drains its purchasing power. Cash investments; however, earn interest and their interest rates tend to change quickly as market rates and inflation shift. Short-term money markets are currently yielding around 2%.
Certain cash investments, such as deposit accounts and CDs, enjoy the added protection of FDIC insurance on balances up to $250,000.
Holding cash gives you the opportunity to purchase assets at attractive prices without having to sell to raise cash during times of distress.
How much of your portfolio should be invested in cash? There is not one correct answer to this question because an appropriate cash position is dictated by such factors as your financial situation, time horizon and risk tolerance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.