The issue of cash holdings generates debate between investors and operators. While some consider it an essential component of a well-planned investment strategy, others believe that it is not necessary to maintain cash within an investment portfolio.
Assess the Role of Cash
Before we go into the issue of cash in the context of an investment strategy, it is essential to assess its role in terms of personal financial planning. It is usually recommended to have the cash available to finance immediate personal expenses. For people who may face sudden expenses in areas such as health or other emergencies, it is advisable to plan and keep funds available in the form of liquid cash.
The point is that one should be prepared for unforeseen expenses without the need to liquidate investments to finance urgent needs as a backup plan. Having an emergency fund can be very valuable and also allows us to plan investments in the medium and long term.
In case the money from the emergency fund is part of our portfolio, this represents a minimum amount that must necessarily be kept in cash. It can even be safe to deposit that money into a different account to avoid confusion or giving way to temptation and risking the money in the market.
Loss of Purchasing Power
As for cash as part of an investment strategy, it is important to keep in mind that having that involves a cost in terms of lost returns. Today the interest rates that are paid on the cash are practically close to zero, although the inflation is also considerably low. Hence, this money in majority of the cases is losing value against the increase in cost of living.
Surplus Cash has an Opportunity Cost
Not only this, assuming we get positive returns on our long-term investments, the money that is not invested in the market is not playing a role in these gains. The cash not only loses value against inflation, but also has an opportunity cost by not participating in the profits available in the market.
Cash Provides Flexibility
On the other hand, cash also provides flexibility and a chance to take advantage of opportunities that may arise. For example, if an asset falls in price much lower than expected, the investor may need cash to buy or increase positions without having to liquidate other holdings.
For someone who knows how to use resources strategically, cash can be a tool to maximize long-term returns even if this implies that in certain market contexts where prices rise continually cash in the account would imply lower returns.
Reduces Portfolio Volatility
In addition, cash functions as a tool to reduce portfolio volatility. The higher the percentage of cash, the lower the volatility of our capital as a function of market fluctuations. At present, given that both bonds and stocks have made huge gains over the past six years, many investors prefer to keep a sizable cash balance to protect themselves from possible price adjustments in the medium term.
Short-term Traders Use of Cash
Short-term traders on the other hand are of a different view. They usually buy assets they think that are going to rise over the next few days with well-defined stop levels to close positions in case prices move against the position. In these cases, cash plays a residual role i.e. the liquidity balance is defined in terms of the short-term market context and the price outlook of the different assets.
In short, keeping cash in the account always has a cost, especially in bull market contexts. However, this does not mean that it should not be kept effective as part of the investment strategy. Conversely, cash can be enormously valuable in terms of seizing opportunities and reducing volatility when making smart strategic decisions.