Most investors hardly talk about the role of cash in their investing strategy. That is not surprising since most people who spend time thinking of their investments dream about how large their portfolios will grow. Stocks hold the promise of becoming doubles, triples, 10-baggers, or even 100-baggers if you hold them long enough.
But cash does not have the same prospects, at least not at current interest rates. Investing cash at 1% right now, it will take you 72 years just to double your money. That does not mean however that there is no use to cash in one’s portfolio. No matter how aggressive you are in pursuing maximum returns, holding some cash can be a smart move. Here are some of the reasons why.
- Cash makes market volatility easier to handle
Most investors understand psychologically that volatility is a feature of the stock market. Yet, many investors do not have the risk tolerance to handle a 30% drop within a month and are prone to react emotionally and panic-sell at exactly the wrong time, just like they did a few months ago.
But the same investors may be able to deal with a 15% decline just fine. Holding 50% of your portfolio outside of stocks, either in a pure cash investment like a savings account or in a relatively short-term fixed investment such a money market fund, would have helped to cushion a 30% drop in stocks into a less violent 15% decline for the total value of your investment portfolio.
This is the stabilising value of cash in an investment portfolio. It can give you peace of mind to hold on to your stocks when you most need it. By staying invested, many investors have now recovered much of their losses in their portfolios.
- Cash lets you strike when the iron is hot.
Perhaps the greatest benefit of keeping cash in your portfolio is that cash allows you to be opportunistic during turbulent times. Even if you are comfortable with the risks involved in being fully invested in stocks, choosing to hold some cashback gives you the chance to capitalise on unexpected declines in the stock market.
Again, let us take the recent Covid-19 bear market as an example. The stock market sold off across the board as investors were indiscriminate in their selling. Very few individual stocks offered shelter from the storm as fear permeated the market. Even the strongest companies were beaten down.
If you had cash to invest at the lows and bought stocks with it, you would have probably seen some handsome returns by now with the market recovery. If you did not have cash, then sure, your portfolio would have also bounced back — but you would have missed out on acquiring shares at bargain prices. Cash is indeed most handy in challenging circumstances.
- Cash lets you leave your stock portfolio alone.
At its core, investing is about reaching your financial goals. And at some point, you would need to sell your stocks to finance those goals – perhaps it is to buy a house, to send your kids to college or to take that long wait around the world trip. As value investors, our secret to reaching those goals is to find good companies and hold these positions tenaciously over time to yield multiples of our original investment. Selling your stocks prematurely to raise cash could put a huge dent to those financial dreams.
Sometimes, you know exactly when you are going to need cash and how much you want. Other times, you cannot predict when you need the cash. The Covid-19 pandemic is an extreme example of just how unpredictable personal finances can be. As countries and economies went into lockdown, millions of people suddenly faced the prospect of wage cuts or even worse job losses. Those who had saved up 3 to 6 months’ worth of expenses in an emergency fund would now be in a more secure position, and they would have avoided having to consider selling their shares when the stock market plunged in March.
Just to be clear, you are investing for the long term. The longer you are invested, the longer your money can compound in value and the longer you have to rebound from any downturns. But as life can be unpredictable, having spare cash already available reduces the risk of doing harm to your stock portfolio. The last thing that you want to do is to sell at the bottom of the bear market.
Put Cash on Your Side
Certainly, cash will never become a focal point of one’s investment portfolio. Unlike stocks, it is not sexy, and it will never grow very much. But cash is still a vital component of your investing strategy and is critical for your long-term investing success. As cash cushions portfolio losses in a sell-off; cash can also boost portfolio returns when shares are purchased cheaply. Hence, it is best to have cash in your corner.