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How to use cash in an ASX share portfolio for maximum returns

using cash in asx share portfolio represented by one hundred dollar notes flying freely through the air
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How can you use cash in an ASX share portfolio for maximum returns?

It’s a tricky question. Cash is a useful asset to hold, but it is not a productive one. Especially in this era of near-zero interest rates. See, cash sits in the bank and slowly loses its purchasing power over time because of inflation. With interest rates at near-zero around the world, the bank won’t likely be paying you a substantial (let alone inflation-beating) interest rate in compensation, as was the case in days of yore.

And yet, cash is every investor’s best friend in times of market turmoil. When volatility hots the share market, suddenly everyone wants to ‘be in cash’, regardless of the prices of the shares they own. Thus, you will typically see some ASX investors sell their shares at a loss during a market crash.

But is that how most investors should use cash?

No, in my opinion. See, cash is a tool, not a long-term safe haven. Sure, having your capital in cash during a market crash might technically ‘save you’ a loss. But unless you use that cash prudently and expeditiously in the said crash, you’ll probably find ‘switching to cash’ a deleterious action to take.

In my view, the best way to use cash in managing your ASX share portfolio is as an insurance policy. Let me explain.

Cash as insurance

The market goes up, most of the time. Over the past 10 years, the S&P/ASX 200 Index (ASX: XJO) was down in only 3 out of those 10 years. Thus, I think most investors should have most of their capital invested in shares all of the time, provided those shares are top notch.

A cash position can also be maintained, as an insurance policy. I call it insurance because (like all insurances), it will cost you returns if nothing goes wrong. But if there is a market crash, you can use this cash ‘insurance’ to buy even more shares of your favourite companies for far cheaper prices. This is the strategy I personally had in place at the time of the March share market crash, and having a 10% to 30% cash position served me very well.

If markets go up, you have 70% to 90% of your portfolio sitting in that tailwind. If there’s a crash, you have some cash to deploy. You win either way.

So rather than trying to ‘sell out at the top’ and ‘buy back in at the bottom’ (a strategy that rarely works well, in my view), I would suggest using your cash as insurance, with a set proportion (perhaps 10% to 30%) allocated based on the risks you see in the current market. That way, instead of relying on luck, you are making your own luck.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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