Daily Gains Letter

How Holding Cash in Your Portfolio Could Mean Opportunities for You When Others Run for the Exit

By for Daily Gains Letter |

interest ratesWhile talking to a friend of mine about general economics and the current market conditions, discussing topics such as where the stock market is headed next since it has gone up significantly and what these low interest rates mean in the long run, he opened the debate to an interesting front: how much cash should an investor have in their portfolio? Is cash any good to hold for investors who are in the market for the long term, saving for their retirement?

One of the most basic strategies to manage a portfolio is to invest the funds into different asset classes, which is referred to as “asset allocation.” The reason for asset allocation is that if one asset class (i.e. stocks) declines in value, the other class (those with a negative correlation to stocks), can rise and minimize the losses. Most often, investors who are saving for retirement allocate their portfolio to stocks and bonds completely—because they tend to have a negative correlation—and not hold any cash at all.

To say the least, investors who hold cash in their portfolio can benefit significantly, and may be able to earn a higher rate of return compared to those who don’t. But before going into further detail, how much cash should the portfolio of an investor actually have?

To assess how much cash an investor should have in their portfolio, they need to look at certain factors, such as how long they are planning to invest and if they need any funds in the short term.

Going back to the discussion with my friend, he, for example, plans to invest for the next 25 years down the road and doesn’t plan to withdraw any funds. He thinks holding 5%–10% of his portfolio in cash is more than enough for him.

The percentage of cash in a portfolio may differ from person to person; it is dependent on their time horizon and what they are investing for. However, every investor can benefit from holding cash.

Consider this: suppose your portfolio was fully invested in stocks prior to the broad market sell-off in late 2008 and early 2009? As a result of this, your entire portfolio would decline—even if you held stronger companies.

Now, if your portfolio had cash, you could act quickly, because some of the well-known names on the key stock indices were trading for very low prices. With cash in your portfolio, you could have purchased those companies and healed the losses you may have accumulated. Cash in a portfolio provides an opportunity to buy strong companies at fairly low prices.

With all this said, there are arguments against cash, such as that it doesn’t provide a portfolio with any return and that it’s simply money rotting away due to inflation.

I agree that cash doesn’t earn any interest or provide any return, and that, if held in a portfolio over the long term, it will be impacted by inflation. However, what’s certain about the markets is that they fluctuate; so in times when there are buying opportunities, investors can go out and buy, rather than suffer and see their portfolio decline.

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