Cash can be handy to have on hand. Whether it's to take advantage of a sudden investment opportunity, have ready for the unexpected, or just to park some in a savings account or term deposit to lower the overall risk profile of your portfolio, even if the interest rate is not what you expect to earn on the balance of your portfolio.
However, even for the conservative money manager the extended period of ultra low interest rates we have endured has made cash a difficult asset to justify, particularly as returns across many portfolios have been impacted as we have navigated a number of years of heightened volatility in many asset classes.
But it is that volatility and accompanying uncertainty that has made the security of cash appealing for many, particularly for those approaching or in retirement. If you’re re-thinking the balance of cash in your investment portfolio, start with these tips.
The risk of market exposure
Whether you’re investing for short term goals (like a holiday or renovation), or long-term wealth creation, low cash rates and ongoing market turmoil mean it’s never been more important to diversify the mix of investments in your portfolio to smooth out long term returns.
As you build your wealth, it is wise to add different asset classes to your portfolio. Volatility in the markets can have a disproportionate impact on a larger undiversified portfolio. The shorter your investment goal’s timeframe, the less time you have to make up any loss – a market correction could wipe out years of growth.
Fixed income and liquidity
When planning your portfolio it's important to consider the life cycle of new investments. You may purchase shares in a building company to take advantage of an infrastructure building boom you have identified, but what if that company does not get to participate in the programs? Will it still meet your growth expectations, and how long will you hold it to achieve the goals you have set?
Also, if you have to sell your shares quickly to meet other commitments, how will that impact your wealth if you have to take a loss?
Holding a range of assets from term deposits to corporate and high-yield bonds, property, equities or commodities provides you with more revenue streams and options to manage your cash flow.
By choosing assets that also react to different market drivers you can smooth out returns over the long term. For instance, a portfolio of just shares will drop dramatically if the sharemarket drops dramatically. A portfolio split between bonds and equities will perform differently, as bonds are largely uncorrelated to the forces driving the sharemarket. Each new asset class brings it's own positives and negatives, so it's about finding the balance that provides the growth you require as well as the income streams and a framework that meets your risk tolerance.
As you get closer to retirement, this can also help you scale back on work, pay for travel plans or a child’s wedding. Depending on your goals, a guaranteed return and regular income through interest may become more important than rapid wealth growth.
So how much cash is enough?
To work out the right amount of cash for your portfolio, add up any expected ‘big expenses’ for the next two years if you are close to retirement. If retirement is still some way off, just put aside enough to cover all your loan repayments for one year as a safety net in case of a market downturn or job loss. Of course, you can hold more of your portfolio in cash if your risk appetite is low.
A smart investment portfolio will have some exposure to growth investments, as well as defensive strategies. This gives you the potential for more predictable long term growth and income streams.
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