Cash is dull. Having money sitting in your account doing nothing can be boring to watch, especially when compared to equities. In the current interest rate environment, cash returns are also lacking.
But boring can be useful. Cash might not provide investors with high returns, but it does offer optionality, and you can’t put a price on that.
The benefits of cash in a portfolio
The coronavirus pandemic of 2020 has been one of the best case studies of why cash is always necessary.
Millions of people around the world have lost their jobs because of the crisis. Equity values have fallen, and private as well as public companies have collapsed into bankruptcy.
Granted, some companies have seen a dramatic improvement in trading performance, but on average, businesses and individuals are struggling.
Very few people saw the crisis coming. Even if you’d been sufficiently aware of world events in December 2019 to recognise the initial virus outbreak in China, it’s unlikely you’ve anticipated the impact the episode would have gone on to have on the global economy.
That’s why cash is a vital part of a personal financial strategy. It provides protects against uncertainty and a cushion against the unknown.
Even at 0% interest rates, these benefits remain. In the most extreme example, it is impossible to put a price on being able to keep your home in an economic downturn.
From an investment perspective, an investor who had cash to buy the S&P 500 at the March low, would have achieved a more than 50% return by early September. Most investors would comfortably accept seven years of 1% per annum cash returns for this quick, sharp profit.
Alternatively, an investor who’d been fully invested at the onset of 2020, and then lost their job in the pandemic might have had to sell at a loss. This would be a dire outcome for the sake of a few extra percentage points of return.
So, cash may be dull, but it is valuable in a different way.
Personal finance gurus and wealth managers advise holding around three months worth of expenses in cash at any time, to cover any unforeseen drop off in income. The pandemic has shown that this is far too optimistic.
Six months may be a more realistic target.
The same time, investors may want to allocate a certain percentage of their portfolio to high-quality bonds or cash. This would provide an extra layer of protection.
Following this strategy would sacrifice returns. However, it’s vital to remember that investing is a marathon, not a sprint. Having a plan in place to survive the downturns is just as important as finding the right investments in the first place.