When stocks and bonds experience negative performance, as they have this year, many investors become interested in cash. Indeed, some will repeat the mantra, “cash is king.” This has certainly been the case this year as nominal yields have been increasing to levels we haven’t seen in years. But, as with any financial decision, it is important to understand the benefits and dangers of any change in strategy before we act.
The Benefits of Cash
The greatest benefit of cash comes when we view and utilize it for short-term needs such as paying monthly expenses, buying a car, or funding an upcoming vacation. Whether the cash is set aside in our checking account or an emergency savings account, it’s not about the yield but the accessibility and dependability of the US dollar.
An allocation to cash for upcoming (or unexpected) expenses reduces the risk of having to sell stocks or bonds that are down in value to pay your bills. Cash is of greatest benefit when it is used to pay for upcoming expenses, saved in an emergency fund for unexpected expenses, and as part of an investment strategy with stocks, bonds, and other investment assets.
The Dangers of Cash
The greatest dangers of cash are when we utilize it as an investment (or parking spot) within a long-term investment portfolio. While cash offers a positive nominal yield, it almost always produces a negative real return (interest rate less inflation rate). Due to its negative real return, cash is not a sustainable long-term investment strategy.
Some investors are tempted to use cash as a “parking spot” when experiencing losses in their investments. While moving to cash will remove the immediate risk of short-term loss, and likely provide instant emotional relief, it introduces significantly more risk to future returns. Since cash is not a sustainable long-term investment strategy, the investor must guess when to get back in.
Let’s say the market goes up 15% from the bottom. Is it now “safe” to get back in? What about 20%, or 30%? What if the market goes up, the investor re-enters the market, and it goes down again? Does the investor move back to cash? And at what point would the investor realize the train has left the station (bull market) and the investor is not on board?
You get the point. Going to cash in an investment portfolio provides temporary emotional relief and stops the short-term bleeding, but introduces significantly more risk as the investor has become a speculator – trying to figure out when to get back in and how long to stay.