When it comes to a properly diversified, long-term investment portfolio, what portion of your account should be held in plain old cash? In this article, we will refer to ‘cash’ as any short-term investment that has little chance of price appreciation and (currently) pays a low rate of interest. For example, a money-market or Treasury bill fund. As for a long-term investment portfolio, we are speaking of a retirement account, funds that will not be needed for 5 to 10 years.
Before we begin our discussion, let’s briefly go over what investment components are essential in a long-term portfolio. A well-diversified long-term investment portfolio will generally hold several different asset classes. The largest portion should be in stocks, both domestic and international, as stocks are the driving engine behind long-term returns. Bonds should be the second biggest part of your long-term investment plan as bonds often provide a cushion when stocks decline. 3 other assets classes should also be part of your investment portfolio as they provide great diversification and oftentimes little correlation to stock and bond returns: real estate, commodities and alternative investments. Keep in mind that these last 3 products should comprise no more than 20% for even the most aggressive of investors.
How about cash? Why would one want to even hold an asset class that at present time offers such paltry returns? For example, cash earns little to nothing these days—and can lose value over time as inflation erodes its purchasing power. Most cash deposits earn close to zero interest, which is even lower than the subdued rate of inflation that the government reports. Compare that to the 2% dividends that big stocks in the U.S. typically pay each year, and holding cash may look like a foolish proposition. It can also be argued that cash does little to diversify risk, because it does not zig when other investments zag, and vice verca (treasury bonds and gold tend to move in opposite directions as stocks).
With all these negative attributes, should cash still be an integral part of the portfolio pie?
The answer is: Yes. Holding a small portion of your basket of investments in cash provides two very important benefits.
First, it provides ammunition during a market decline to buy more of a depressed security, whether that be stocks or bonds (more often stocks). Cash gives you this flexibility, that is, the ability to pounce on investment opportunities as they arise.
The second benefit of holding cash is to avoid huge market downtowns, as cash has essentially no risk. As the old adage goes, “Sometimes the best investments are the ones you don’t make”, that is when things are bad, holding cash can make you look like an investment genius. The Oracle of Omaha, Warren Buffet, is currently sitting on roughly $100 billion at this point in time in his Berkshire Hathaway portfolio.
So given the huge stock market run-up over the past several years where US equity markets have had their second-longest bull run in history and the impending explosion in the bond market has yet to occur, how much cash should be prudent for an investor to hold? As always, one has to consider their goals, time horizon and risk tolerance. 10% to even 15% at writing looks like a fair amount for a growth-orientated investor with a long-term horizon.
This doesn’t mean that you should have 10% to 15% sitting idly in cash. If you are holding mainly mutual funds in your portfolio, be sure to see how much of an equity fund is holding in cash to calculate this figure. For example, some more ‘defensive’ US large-cap equity funds are already holding high levels of cash as of writing: Take the Yackman Focused Fund (ticker: YAFFX). This fund is holding 23.42% of its portfolio in cash. As such, if you hold 20% of your portfolio in large-cap US equities using this fund, you are already holding 4.68% of your investments in cash.
In conclusion, don’t be stymied by today’s abysmal cash returns. Holding a small portion of your long-term investment portfolio in cash serves two purposes: It gives you ammunition to take advantage of buying opportunities when markets decline and cash also provides no volatility risk when markets drop precipitously. I try not to make market predictions, but keep in mind that we’re in the throes of one of the longest bull markets in history and looking back in time, long market uptrends tend not to end well. As such, maintaining a higher weight in cash today (in the 10% to 20% range) might prove to be the best investing decision you can make given today’s lofty market values.