UPFINA's Mission: The pursuit of truth in finance and economics to form an unbiased view of current events in order to understand human action, its causes and effects. Read about us and our mission here.
Reading Time: 4 minutes
There is lots of incredible analysis when it comes to finance and economics. However, a lot of it overlooks the simplest detail that is vital for any financial portfolio. While we cannot give you information that is specific to your circumstance, cash serves a critical role in any portfolio. It is often argued that cash cannot be a viable “investment” because it doesn’t offer any return. But this analysis overlooks the optionality that cash provides to any portfolio, at any time. Every segment of your wealth is important, and that includes first and foremost cash because it allows you to make decisions that other investors with no cash allocation do not have the opportunity of making.
Cash In An Investment Portfolio
In an investment portfolio your cash position should vary. This is cash that is outside of your savings, emergency fund, and daily expenses. The amount of cash you have as part of your investment portfolio should either depend on the business cycle or the amount of opportunities you see in the market. Specifically, if you are a long only investor who likes to buy undervalued securities and hold them for a year or more, you want to increase your cash position when the business cycle is near its end such as when the yield curve has inverted. Cash doesn’t provide much returns in a highly liquid money market account, but it provides you optionality. It’s worth foregoing a small amount of opportunity cost when waiting for a decline in stocks because you’ll get the opportunity to buy the decline at reduced valuations. The more money you have in cash before a bear market, the easier it will be to be aggressive while others are panicking as we discussed in What To Do In A Selloff? Conversely, having a small cash position in your account after equites have fallen in a bear market would make most sense if you have already taken advantage of discounted valuations. The more valuations fall the less reasons you need to invest. For example, if stocks are down a hypothetical 20%, you’ll need to see improving data to be fully invested. However, if there is a decline of say more than 40%, based on the historical average decline during bear markets, it’s relatively less risky to buy the index regardless of cyclical improvement.
If you are a shrewd asset manager who has a portfolio that acts nothing like the market, you’ll raise cash if you can’t find anything to buy. Being patient is a psychological advantage because it will give you more conviction in your investments than if you bought a security just because of “fear of missing out.” If you made the latter decision, you’ll have instant regret if the investment loses money which might cause you to sell it at a bad time. Closing a position to make yourself feel better is a terrible choice. If you can’t manage your emotions, you should put your money in passive strategies. Not everyone can actively manage their money pursuing risky strategies with high payoff potential.
Cash Allocation For Lifestyle Planning
We looked at the cash in a portfolio, but that’s not the only cash you have. Everyone needs liquidity for paying daily expenses, emergency funds and savings account. The key here is to worry about meeting your own goals instead of following others. Everyone has different expenses meaning you can’t copy anyone else’s decisions. For example, if you have $2,000 in your checking account every month, you don’t want to liquidate that and put your expenses on a credit card to chase a hot stock or popular trade. The trade can lose money and credit card debt has extremely high interest rates.
Another example of lifestyle planning where you would want to avoid the basic financial template is if you are saving for a big expense such a house. Even if you are young and you are saving for a house in the intermediate term, which is less than 5 years, it’s best to take a conservative approach with the money you need for a down payment. This goes against the general advice to take risk when you’re young. If you are saving for a house, you need to make plans years ahead of time to be in a good financial position to do so. You’ll want to avoid big draw-downs in this part of your assets because you don’t want a bear market to affect your life choices. A recession could weaken the housing market, so you’ll want to act at that point since this improves affordability and the buyer’s negotiating power. Here is an in-depth review of this debate on investing in stocks versus renting or buying a home.
Saving for a house using a conservative approach gives you a glimpse of what life will be like when you own a home. Firstly, it will teach you how to budget. Secondly, it shows you the opportunity cost you are foregoing by owning a home. For example, a safe investment portfolio could earn a hypothetical 3% per year while an aggressive one could earn 8% per year. In the same sense, your stock portfolio will likely go up more than the value of your house during your ownership period. The point we’re making is to be conservative and recognize owning a home isn’t a good investment from a return stand point. The reason you own a home is to live in it. If the house does appreciate in value, you’ll be in great shape. The key is to not to rely on that capital gain when budgeting.
Is Your Cash Diversified?
Just like its a good idea to be diversified in your investments, the way you hold cash should also be diversified, whether its amongst different banks or in different types of bank accounts. The FDIC insures deposits up to $250,000, which makes certificates of deposit, commonly known as CDs as well as checking and savings accounts, a relatively safe form of investment as long as you are under the insured threshold. The worst case scenario is inflation is higher than the interest rate on a fixed CD where you are required to hold your money for a specified period of time, hurting your purchasing power. It’s notable that not all of the money you are saving for an intermediate term purchase needs to be tied up in a CD. You can diversify with other products such as a high yield savings account. Each account type has pros and cons, for instance the biggest negatives on CDs are they lock your money for a fixed timeframe, which is reflected in the higher rate of return to compensate you for the opportunity cost of holding your cash in the CD.
Have comments? Join the conversation on Twitter.