Should cash be part of your portfolio?
One of the lowest risk investment options available is investing in cash, generally via a bank or term deposit. Yet investors frequently disagree about how much to invest in this asset class and whether to invest in cash at all.
The value of cash cannot fluctuate like the value of shares or bonds does, which means your capital is virtually guaranteed. But because cash is low risk, it also offers lower potential rewards than riskier asset classes. The return on a cash investment is the interest payments alone. Currently, interest rates are at all-time lows, so potential returns are limited.
Every investor will need to weigh the individual risks and benefits of holding cash, given their personal financial situation. Even experts, however, can 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 choose to 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 portfolio?
Should you invest in cash for the long term?
Interest rates are currently at record lows, meaning cash is offering minimal returns. Inflation also erodes the value of cash and diminishes its buying power over time. Many investors view cash as a largely stagnant investment.
For this reason, it is generally not advisable to hold large quantities of cash for the long term. However, if you’re going to need the money in the short term, you might choose an investment class with more capital stability, such as cash.
Motley Fool analysts recommend not having money invested in the share market if you might need it in the next three years. It can be more beneficial to hold cash. But if your time horizon extends beyond that, chances are you can make better returns by investing in shares.
Your investment time horizon and risk profile are key factors in deciding how much of your portfolio to allocate to cash. A time horizon of at least three to five years is recommended when investing in riskier assets such as shares. This is because the value of shares fluctuates with the market, and a more extended investment period will give you time to ride out these fluctuations.
Keep cash for emergencies
However, cash plays a vital part in investing – outside its role as an asset class – as it can provide a buffer to protect your investments. Unexpected expenses will inevitably arise, requiring funds to meet them. By keeping some cash 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.
A stash of cash for emergencies can also help you mentally separate your investments from your day-to-day finances. Because you know you have cash available 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. This will help build your portfolio over time while allowing you to take advantage of market dips.
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.
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.
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 cash are at all-time lows, meaning it is not currently providing attractive long-term returns. 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 plays an essential role in building your portfolio and enabling it to grow. Cash provides both a buffer to protect your portfolio and a reserve from which to add to your portfolio. So, whether you include cash in your portfolio or not, your cash holdings can help shape it.
Last updated 20 April 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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