We hear it all the time. Cash is king. And like a monarch, cash isn’t worth much if it just sits there doing nothing. No less an authority than the Oracle of Omaha himself, Warren Buffett, makes it a rule to keep enough cash on hand to seize potential investment opportunities and to serve as ballast in rougher market environments. As interest rates have risen over the past few years, cash and cash alternatives – including checking and savings accounts, Treasury bills, certificates of deposit, corporate commercial paper and money market mutual funds – have become viable sources of relative liquidity while offering a hedge against downturns.
So how much cash should you put to work? Here are a few myth-busting facts to help you find that cash sweet spot.
FALLACY: Cash drags on performance.
FACT: Cash’s performance may seem lackluster during rising markets, but its low risk/reward profile is intended to provide stable value during market declines. Under certain conditions, such as periods of rising interest rates or times of stock market turbulence, cash tends to do well relative to other asset classes. You don’t have to search too hard for ways to earn interest on your cash, even when the Federal Reserve changes its benchmark rate. Holding cash or cash alternatives is part of a well-allocated portfolio in which diversification of asset classes may offer different benefits in a variety of market environments. Your advisor can help you strike the right balance so you can deploy enough cash to gain the benefits without sacrificing in other areas of your financial plan.
FALLACY: Cash is for coffee and convenience stores.
FACT: It’s helpful to think of cash in two ways. Everyday spending and strategic cash for future needs. While the $20 bills in your wallet offer a convenient way to pay for everyday items, cash in your portfolio buys you time to think. Access to enough liquidity gives you flexibility during times of opportunity or uncertainty. You need confidence AND capital to opportunistically add fundamentally sound positions to your portfolio when the stock market is “on sale.” Cash allows you to do just that and help stay on track with your established financial plan.
FALLACY: Cash is for skeptics.
FACT: A right-sized cash cushion can actually be a sign of optimism. If market turbulence makes you skittish, increasing your allocation in cash might restore your confidence in your long-term financial plan. Plus, cash tends to do well as a “defensive asset” with low or negative correlation with equities.
Some investors may try to chase yield during unexpected market movements or low-interest rate environments. But when it comes to cash, access is very important. How much you hold depends on your risk tolerance and your investment objectives, but everyone can benefit from a cash cushion that can help stave off impulsive selling in shaky markets or help pay for unplanned expenses.
BONUS FACT: Cash is covered.
Cash holdings are generally protected under SIPC or FDIC coverage, but there’s a difference between the two. The Securities Investor Protection Corporation (SIPC) protects cash and investments in a brokerage account, in case the financial services firm folds or cannot conduct business, and cash or securities are missing. Its aim is to replace the value of the investment that was held with the broker/dealer, but it doesn’t protect against market loss. The Federal Deposit Insurance Corporation (FDIC) protects bank deposits, including interest, up to $250,000 per account holder, per account type, per bank. FDIC coverage does not cover stocks and bonds.
There’s a reason investing pros do not recommend stuffing the proverbial mattress with cash. Holding too much cash for too long could mean missing out on stronger performance from other asset classes or losing buying power to inflation. Ask your advisor to help you optimize your payable, on-demand cash so you gain low-risk, high-liquidity flexibility to help you make progress toward your long-term goals.
Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Asset allocation and diversification do not ensure a profit or protect against a loss. U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. Certificates of deposit offer FDIC insurance and a fixed rate of return. The market value of fixed income securities may be affected by several risks including interest rate risk, default or credit risk, and liquidity risk.
Sources: Investopedia; fdic.gov; sipc.org; reuters.com