Returns on cash investments
The market value of cash cannot fluctuate like the value of shares or bonds, which means your capital is virtually guaranteed. But because cash is low risk, it also offers lower potential returns than riskier asset classes. The returns on a cash investment are the interest payments. With interest rates on the rise, investors are taking a second look at this asset class.
Every investor must weigh the individual risks and benefits of holding cash, given their financial situation. Even experts, however, disagree about how much cash you should hold at any one time. Differing goals and attitudes towards risk can often explain these disagreements.
Risk-averse investors will naturally allocate more of their portfolio to lower-risk assets, such as cash. Those willing to take on greater risk will generally allocate more funds to higher-risk assets, such as shares.
Investment timelines play a role, too. Different asset classes can be more appropriate for longer and shorter time horizons. Differences in opinion about the future direction of investment markets can also have an impact. So, should cash be part of your investment portfolio?
Should you invest in cash for the long term?
Interest rates are rising from record lows, meaning cash offers higher returns than has been the case in the past few years. As a result, many are reconsidering its place in their investment strategy.
But inflation is also running high. Inflation erodes the value of money, diminishing its buying power over time. This means investing in a cash portfolio may not produce significant actual returns – even in a rising interest rate environment.
For this reason, holding large quantities of cash assets for the long term is generally not advised. However, if you need the money in the short term, it makes sense to choose an investment class with more capital stability and easier accessibility, such as cash.
Your investment time horizon and risk profile are key factors in deciding your liquid asset allocation. The value of shares fluctuates with the market, so a more extended investment period gives you more time to ride out these fluctuations.
Shares also carry liquidity risk. For example, micro-cap or speculative shares with low market capitalisations may take time to sell because they tend to attract fewer buyers and have fewer shares on issue. If a company goes into a trading halt, you will not be able to trade your shares until this is lifted.
In extreme cases, shares can also become illiquid if the markets seize in a crisis. Non-liquid assets can be difficult to sell. Cash, on the other hand, is a liquid investment.
A time horizon of at least three to five years is recommended for growth investments such as the stock market. Holding lower-risk cash may be more beneficial if you are likely to need your money during this period.
But if your time horizon extends beyond three to five years, chances are you can make a better return on investment (ROI) by choosing an option other than cash, such as shares or fixed-interest investments like bonds.
Keep cash for emergencies
Cash does play a vital part in investing – outside its role as an asset class – as it can provide a buffer to protect your investments. Unexpected expenses in life will inevitably arise, requiring funds to meet them. By keeping an emergency fund on hand, you will not be forced to exit investments early to meet an unexpected need for funds.
This is important as returns on investments are magnified when they compound over time. As billionaire investor Charlie Munger once said, "The first rule of compounding is never to interrupt it unnecessarily".
By separating a portion of your cash for emergency use, you provide a layer of protection to your portfolio. It is buffered in the event of an emergency as you will not be forced to call upon it immediately to meet financial obligations.
A stash of cash and cash equivalents for emergencies can also help you mentally separate your investments from your day-to-day finances. Because you know you have cash in your bank account if needed, you can afford to think long-term with your portfolio. This allows you to take advantage of opportunities that provide long-term rewards.
Buying the dip
Another compelling reason to keep some cash on hand is to enable you to top up your portfolio when suitable buying opportunities arise. Share prices are volatile, and the ASX moves with the economic cycle.
Down periods in the cycle can provide abundant buying opportunities for long-term investors seeking quality shares. Taking advantage of market dips can help build your portfolio over time.
While it is difficult for even experienced investors to time the market, long-term investors who buy the dip have the advantage of time on their side to accumulate returns.
It can take time for the market to recover from a downturn – it took the S&P/ASX 200 Index (ASX: XJO) 14 months to return to its pre-COVID levels from its March 2020 dip.
But investors who bought the dip would have made a return of 47% over that period. For this reason, many investors like to keep some cash on hand to take advantage of unexpected buying opportunities.
Not only can you buy the dip to add new investments to your portfolio, you can use this strategy for dollar-cost averaging purposes on existing stocks. This means buying more shares in a company you are already invested in for a lower price than you previously paid. This lowers the average price paid for all your company shares. This can improve your capital growth prospects and your dividend yields.
Pros and cons of liquid assets
Liquid assets such as cash play an essential role in providing a reserve you can draw on to avoid having to liquidate longer-term investments. Regardless of your investment objectives, you want to avoid having to make an investment decision due to a lack of liquid funds.
Warren Buffett always holds some cash. The way he sees it, cash is like oxygen – everyone takes it for granted when it is abundant, but if it disappears for a few moments, it is over. Having a liquid asset or cash equivalent available is an important contributor to personal financial stability.
Should cash be part of your portfolio?
The role that cash plays in your portfolio will depend on your investment timeline, goals, and risk profile. Returns on savings accounts are increasing but may struggle to keep pace with inflation. Nonetheless, cash is a low-risk asset that allows for capital preservation in the short term.
Whether or not you formally allocate a portion of your portfolio to cash, it does play an essential role in building a diversified portfolio and enabling capital growth. Cash provides both a buffer to protect your portfolio and a reserve from which to add to your portfolio.