One of the least covered aspects of investing is how cash plays a role in your portfolio. The idea that cash is king has some truth to it. But it’s not without its risks either. In the end, it all depends on your investment strategy.
By cash, I mean money in savings accounts or money market accounts, and money market funds in a brokerage or retirement account. Lets be clear, this isn’t money you plan on spending next week, next month or next year. It’s not emergency or rainy day money either. That’s a separate topic altogether. This money is part of your investment strategy. Only it’s not invested because of the benefits cash offers.
Cash in a portfolio is a commonly discussed topic by the finance media. Fund managers are hounded about their cash allocation. Where their funds’ allocation sits in the near term. And what they plan on doing with that money. In this case, their performance is reliant on their short-term strategy and tied to their annual performance compared to the S&P 500.
As investors we don’t have that limitation. We can look as far out on our investment horizon as we want. Still, cash plays a similar role, just without the time constraints because it’s:
- Liquid – it doesn’t get any more liquid than cash
- Flexible – allows investors to take advantage of opportunities
- Stable – very defensive protecting investors from volatility and most risks
- Static – you know exactly how much is there, $20 today will be $20 tomorrow
This cash is part of your allocation strategy. Only it’s not invested…yet. Some might include T-bills, CDs, and other short-term investments. Others go so far as to claim it as a risk free asset. Which is far from the truth.
In reality cash protects you from permanent losses but opens you up to inflation risk. Simply, a dollar today buys less in the future. This needs to be weighed against other market risks.
There is opportunity costs as well. For example, over the past four years, any money sitting in cash would have missed a double in the S&P 500 and a nice return from bond funds too. Compare that to a negative real return in savings accounts or money market funds. How you use cash will depend on your investment strategy.
The purpose of an investment strategy is to grow your money while limiting losses. Both permanent loss and loss of purchasing power. Cash is just a tool used to limit permanent losses while you wait for the opportunity of higher returns.
Active investors build a portfolio strategy that is actively adjusted based on opportunities and specific events. Be it trading momentum, value investing or tactical allocation, cash gives you flexibility. In this instance, it’s really a tool for risk management.
Take value investing. A cash allocation limits your losses while you wait for an opportunity to present itself. Eventually, market volatility will present an opportunity that is undervalued. Where the risk of loss is so small and the return so high that sitting in cash makes no sense.
These active strategies require knowledge, discipline, and patience to wait for the right opportunity. This is why most investors focus on a passive strategy.
If the above is true for an active strategy, it’s nonexistent for the passive strategy. A passive allocation strategy tends toward a different approach based on ideals and convenience. It focuses on maintaining an asset allocation and rebalancing to limit permanent losses. Instead of waiting for opportunities. So cash doesn’t really play a role.
The idea of cash for the sake of cash, makes no sense in a passive strategy. If opportunities aren’t being sought out, any cash allocation will always be at risk of long-term opportunity costs and inflation risk. The only exception, when withdrawals are required, in retirement accounts. In this case, a plan should already be in place to limit capital losses.
What shouldn’t happen is too much cash in your portfolio. This never seems to work out well. Since cash is a terrible long-term investment. Yet it happens for any number of reasons.
Often, you see investors using cash as an excuse not to invest. Whether out of fear or other irrational reason. It’s understandable. Except, by fleeing to cash you are guaranteed to lose money.
Any good investment strategy is already built to protect your money. When you veer off course and sell out of fear, you put other areas of your portfolio at greater risk. So it shouldn’t be abandoned at the first sign of distress.
The best investment strategy is one built to fit you – your goals, your abilities, and behavior. Instead of one that fights you at every turn. If a cash allocation plays a role in that strategy, use it wisely. If not, remember, nobody gets rich sitting on their money. If you’re not spending it in the near future or looking for an opportunity, invest it already.