We discuss several reasons why you should keep some cash in your investment portfolio. While it may like a drag, it can be the best asset to own in turbulent times.
- Benefits of having Cash in our Portfolio
- How much Cash we should keep in our Portfolio
Before we start talking about the benefits of having a percentage of your investment portfolio in cash, I want to clarify that I do not want you to confuse having cash in the portfolio you’re your personal emergency fund.
Your emergency fund is there to cover your expenses in case something unexpected happens, such as a job loss. How large the emergency fund is will depend on many variables: your personal circumstances, monthly expenses, and tolerance level in difficult situations.
Regardless of that, in this post we will refer to having cash as part of our investment portfolio. That money does not need to be in your brokerage account. It can be in a bank deposit, or where it is accessible to us if we need access to it.
Another important caveat is that when we talk about having cash in the portfolio, we mean hard currencies, such as US Dollars, Euros, and similar alternatives. High-yielding emerging market currencies should not be considered in the same category.
The Price of having Cash in our Portfolio
Before discussing the benefits of having cash in our investment portfolio, we must be aware that this also has a cost. Cash is one of the assets with the worst long-term returns.
Its nominal return is similar to short-term interest rates. And while short-term interest rates can be high at times, history shows that they tend to be lower than the inflation rate and much lower than the returns we can achieve with other types of investments.
As a result, the cost of having cash in our portfolio is, on the one hand, the difference between short-term rates and inflation, and, on the other hand, the difference between those rates and returns from other asset classes. The latter would be an opportunity cost.
Benefits of having Cash in our Portfolio
There are two main benefits of having cash in our investment portfolio: optionality and diversification. They can be extremely powerful:
The best way to look at cash is as an option. Options give us the right to buy or sell an asset in the future at a predetermined price. For this reason, options rise in value when the price of that asset rises or falls, depending on whether they give us the right to buy or sell.
Obviously, options come at a price. The potential to profit from movements in the market is something valuable. And the value of the option gradually decreases over time, as the option approaches its expiration date.
Although cash has no expiration date and can be used at any time in the future, we have already discussed that it does have a price too. Cash is gradually losing value. But if there are big drops in the market, the value of cash, like that of an option, is going to skyrocket.
Therein lies the appeal of having cash: it will allow us to benefit from a market crash. In a crash, high quality assets go on sale and we are in a position to deploy our cash to snap them up, thereby being able to achieve high returns later on.
For example, in March 2020 we saw the S&P 500 go all the way down to 2,300 points, the German DAX at 8,000 points, gold at $1,450 per ounce and silver below $12 per ounce. We could have only taken advantage of it by having cash ready to deploy.
As you can see, cash is an option. An option that allows you to benefit from market crashes.
The second big benefit of having cash in your portfolio is the power of diversification. If, for example, you have 10% of your portfolio in cash, you can decide to have 5% in US Dollars and the other 5% in other currencies, such as Euros or Yen.
Diversifying into different currencies is important if you have a sizeable portfolio and a significant percentage of it is in cash.
Some of the most interesting currencies, apart from the US Dollar, are the Euro, the Swiss Franc and the Japanese Yen. Do not get fooled by other “strong” currencies such as the British Pound, the Australian Dollar or the Norwegian Krone. In most scenarios that lead to a crash, these currencies get weaker against the US Dollar.
Having part of your cash in currencies that tend to strengthen in times of financial stress will allow you to have even more purchasing power ready to deploy when that happens.
How much Cash we should keep in our Portfolio
So, the question arises: how much cash exactly should we have in our investment portfolio? The answer is by no means scientific.
In my opinion, the larger your portfolio, the higher percentage you should have in cash. This is because if the size of your portfolio is $5,000 and you are investing $1,000 more every month, your new contributions represent a considerable percentage of your portfolio. If there is a 30% crash, the new contributions will be the dry powder you can use to acquire cheap assets.
On the other hand, if you already have a portfolio worth $500,000, are contributing $2,000 per month to it and there is a 30% crash, it is important to have dry powder to cushion the drop and be able to take advantage of that crash.
Approximate Cash Allocations
As an indication, and not as a recommendation, these are approximate percentages of your portfolio that you can keep in cash, depending on how large that portfolio is:
- Less than $10,000: at those levels I would be fully invested. You will benefit from an eventual crash with the new contributions you make.
- Between $10,000 and $50,000: at those levels I would have 5-10% of the portfolio in cash.
- More than $50,000: at this level you could have 10% in cash. You do not need more if you have a significant percentage of your portfolio in gold.
- More than $250,000: once you reach higher levels, you could consider having 10-15% of your portfolio in cash, especially if the portfolio is large relative to your regular income. It would also be beneficial to have allocation to gold and long-term bonds.
As you can see, having some cash in your investment portfolio is important. While that comes at a cost, it will allow you to benefit from poor market performance, diversify the risk of your investments and even interpret a market crash for what it can be: very good news for your future.
The important thing when it comes to investing is not to suffer major blows. The goal should be to achieve strong and steady returns. Especially when your portfolio is large enough, you should never take too much risk.
If you want to learn how to build a diversified portfolio in a very simple manner, check out the following link:
Build a Diversified Portfolio with ETFs
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