Should You Hold Cash in Your Portfolio?
Experienced investors will almost always have a balance in cash and/or cash equivalents (like 90-day treasury bills or other money market investments) as part of a well-diversified investment portfolio.
On a day-to-day basis, holding cash or cash equivalents can provide some form of relief should unforeseen expenses arise. From an investment perspective, viewing cash as part of your asset allocation allows you to hold a defensive cash position and enables swift offensive portfolio purchases, relative to investment market movements.
Benefits of Holding Cash or Cash Equivalents
The absolute minimum cash or cash equivalents you should hold is enough to cover three to six months of expenses in case there is an unexpected emergency that interrupts your earnings and/or cash flow.
This allows you to get through the emergency without having to liquidate investments at an inopportune time which could trigger excess taxes or investment losses.
Defensive Portfolio Position
During a market downturn, a position in cash or cash equivalents provides a cushion as it will maintain its value while other portfolio asset classes may lose value.
Offensive Portfolio Position
Holding cash or cash equivalents in your portfolio provides liquidity for future opportunities. It will allow you to take advantage of market and/or individual security downturns by enabling you to purchase securities at the best time, i.e. when prices are lower.
Decreased Portfolio Volatility
While holding cash or cash equivalents in a portfolio may reduce returns in a rising market it can also help to limit losses in a declining market. Therefore, a portfolio allocation to cash or cash equivalents serves to decrease the overall volatility or risk exposure of your portfolio through a whole market cycle.
Cash or cash equivalent holdings can allow you to rebalance your portfolio between other asset classes such as bonds and equities without having to sell investments in the outperforming asset class to purchase investments in the underperforming asset class.
Downsides of Holding Cash or Cash Equivalents
Low-Interest Rate Environment
Holding cash or cash equivalents during a period of low-interest rates and higher market returns will have a negative effect on total portfolio returns – however, the opposite will be true when markets are declining.
Lower Returns (Cash Drag)
Cash and cash equivalents are considered to be almost risk-free, but long-term returns do not keep up with those of equities, bonds, and real estate.
How Much Cash Should You Hold
Warren Buffet has commented that “Cash is like oxygen – everyone needs it and takes it for granted when it’s abundant, but in an emergency, it’s the only thing that matters.”
How much you should hold in cash or cash equivalents will change as your needs and lifestyle evolve. There is no general rule on how much you should hold beyond what is necessary for an emergency fund.
It is important to consider cash and cash equivalents when establishing your investment plan. An optimal allocation to cash or cash equivalents depends on your individual financial goals and needs, time horizon, risk tolerance, and investment strategy. Consulting with a financial professional will provide personalized guidance specific to your circumstances.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.