Cash is King as the saying goes, but does this apply to your investing? Cash is one of the traditional asset classes, along with Stocks and Bonds. In this post, we will explain why cash is a useful asset to have in your investment portfolio and what you can expect to gain from it.
What is Cash?
When it comes to investing there are two types of cash: cash itself and cash equivalents. Investopedia defines cash as “legal tender – currency or coins – that can be used in exchange for goods, debt or services”. It defines cash equivalents as “investment securities that are meant for short term investing; they have high credit quality and are highly liquid”.
Cash and equivalents are the safest forms of investment and depending on your risk profile they may complement your investment returns. We all know what cash is, we use it every day, but does it really belong in your portfolio?
Cash as an Asset Class
For simplicity sake, we will refer to cash and equivalents as cash from now on. Although cash equivalents may have a slightly higher risk than cash itself, the risk is usually low enough to group them together. US Treasury Bills (see bonds) are a cash equivalent. They are not 100% risk-free as theoretically, the US government could default, but if that happens you will have more to worry about than your investment return.
Cash will most likely be the lowest risk asset you own in your portfolio. As such, it can offer some protection from market fluctuations. As it will offer a low return, cash is not an asset that will offer attractive long-term gains. Cash may be a useful diversification tool, particularly for investors who actively manage their assets. They may see some benefits from re-allocating from stocks to cash during market bubbles.
As we know, low risk tends to equate to low reward. With that in mind, what purpose does cash have in your portfolio?
The Benefits of Cash
Firstly, cash offers a safety net. Cash itself cannot return less than you invest. If you put €1,000 in a bank account, you will get €1,000 from that bank account whenever you need it. Although the value of your cash may have dwindled (due to inflation), the principal amount will have remained the same. Cash is the only asset that doesn’t pose any capital risk. As discussed above, cash equivalents may have a small capital risk but it is usually insignificant.
Secondly, and perhaps more importantly, cash offers an investor the opportunity to increase their riskier holdings during market downturns. If you have 5 – 10% of your portfolio in cash, you will have the opportunity to buy stocks or bonds at any time you wish. this is used to great effect during recessions. Although your overall portfolio may have lost significant value, the value of the cash portion will not have changed. You can use this cash to purchase additional stocks or bonds at reduced prices, allowing you to reap greater rewards when the market rebounds.
Thirdly, cash can offer an important buffer to protect against life’s events. As it is readily accessible, it can be taken out and used to pay unforeseen tax bills, repair bills or whatever bills you may encounter. As a rule, we would advise against using the money you may need in the near future for investments, but nobody is perfect and unforeseen events happen. If and when they do happen, having some assets in cash will ensure you do not need to liquidate any stock or bond positions.
Should you Hold Cash?
Yes, in our opinion it is a sensible move to have some of your assets in cash for the reasons outlined above. Your overall risk attitude and personal circumstances will determine how much cash you should have on hand. The most important benefit of cash is the flexibility it offers and even having a small amount set aside will make you less prone to adverse events.
As always with investing, do your research to determine what the right level of cash is for you.
The Stoic Trader