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Holding cash in your investment portfolio isn’t a wasted opportunity
While some investors may tell you that “cash is trash,” and that holding it may cause you to miss out on great investment opportunities, we’re here to explain why cash plays an essential role in your investment portfolio.
Cash: an important but oft-forgotten asset class
In fact, you can think of cash not just as the green slips of paper you use to buy things, or as a number in your checking account, but as an asset class unto itself! From this perspective, cash can serve a fundamental purpose in your overall investment portfolio by providing liquidity which is the degree to which an asset can be quickly bought or sold), reducing portfolio risk, and generating income. Having an appropriate amount of cash in your investment portfolios is a vital part of healthy portfolio management. At MoneyLion, our asset allocation models currently target a 2% allocation to cash.
1. Holding cash in your investment portfolio provides liquidity
Having cash in your investment portfolio helps make sure that your portfolio is sufficiently “liquid.” It would be best if you had enough liquidity in your portfolio to cover any investment fees and rebalance your portfolio as needed. Rebalancing involves periodically buying or selling investments in a portfolio to maintain an original target asset allocation. Investing isn’t a one-and-done activity. Choosing stocks, bonds, and other funds in the right proportions is a delicate balancing act. Once you’ve selected those asset allocations, it’s smart to periodically rebalance your investments to limit risk and possibly improve returns.
Another instance where having cash as part of your portfolio is important is if your investment account is subject to fees. It’s best to avoid being forced to sell stocks or bonds to be able to cover investment fees. Doing so could result in a taxable event or realized losses, which is when an asset is sold for a price lower than the original purchase price. Also, a short-term dip in the market could cause you not to have enough funds to make fee payments altogether.
2. Cash can provide a cushion for your investment portfolio
Cash sits in your investment portfolio, but it’s not invested in stocks, bonds, and other securities. Whereas the prices of stocks and bonds can experience swings each day, the value of cash held in your portfolio is relatively steady (not considering inflation). Thus, having a sufficient amount of cash can act as a cushion for your overall portfolio. Not only can cash retain its value, even if stock prices fall, but it may actually give you the option to buy stocks at a lower price.
3. Cash can offer low-risk returns
Finally, cash can generate small amounts of short-term income. Cash may be deposited into different instruments, like money market sweep funds within your investment account, that can earn interest with extremely low levels of risk. A money market sweep fund earns a small amount of interest for any uninvested available cash balance in your investment portfolio. Available cash is automatically swept daily into a sweep vehicle. When you’re ready to use the cash for trading or cash management activities, it’s automatically pulled from your funds. Like most low-risk investments, money market sweep funds tend to offer very little reward. It’s important to realize that although these types of accounts earn interest and have low risk, their returns may be small compared to other investments, like stocks, bonds, and exchange-traded fund (ETFs), or mutual funds.
Cash isn’t always king, but it’s still vital to your portfolio
Holding cash may not provide strong investment returns, but there are still many reasons to hold it in your portfolio. In fact, it’s good to think of cash as just another asset class – one that can balance the risks of other investments, generate small amounts of income, and help you achieve your financial goals.