Portfolio Tips: Why You Should Hold Cash

Source: Thinkstock

Source: Thinkstock

The whole point of investing is to generate returns by buying assets that will appreciate in value over time. Cash is antithetical to this notion of investing. If you hold cash you aren’t going to generate any returns, especially in this low interest rate environment. In fact with inflation holding cash realistically generates negative real returns, meaning that if you hold cash for an extended period of time then it will likely lose value.

Nevertheless I think holding cash in your portfolio is a really good idea. Or if you use margin, then having access to cash (i.e. not being fully invested) is a really good idea. This is the case no matter how much conviction you have in your investment ideas.

So if you think that your investment ideas will generate outstanding returns why not fully invest in them?

There are two basic reasons. The first is that as smart as we like to think we are we are all fallible as investors. This means that we are going to make mistakes — some assets that we buy that we believe will rise in value will inevitably fall in value. If you are fully invested then you feel all of the pain of your investment going down. But if you have some cash, your losses will be less severe.

Second, even if you are right about the fundamentals of your investments, you will not always get the timing correct. After all just because a $20 per share stock is worth $50 per share doesn’t mean that it can’t go to $10 per share first. In fact, if you have a large portfolio of stocks then chances are extremely high that a couple of your investments will go down. If you don’t hold any cash then you simply have to ride this out. But if you do hold cash you can add to your positions.

Thus, when you hold cash you are effectively betting that this cash will be a superior investment to your chosen investments, at least for a short period of time. This bet will almost certainly pay off if you have a ten-stock portfolio. If just one of those stocks falls by 50 percent in value then your cash rises by 100 percent in value relative to that stock. You have a gain insofar as you can buy twice as much of that stock now that it is half the price, and yet you don’t have to pay taxes on the “gain.”

How much cash you should hold depends on a lot of factors. First, if you hold a portfolio of highly volatile stocks then you should probably hold more cash than someone who holds a “widows and orphans” collection of low beta dividend paying stocks.

Second, if your stocks have been performing really well then you should hold more cash. As stocks rise they become less enticing. While market sentiment may improve the reasons you bought a stock are probably less compelling unless a company’s situation has changed. For instance if you think that a stock is worth $50 per share and you’ve held it as it has risen from $25 per share to $45 per share then if you sell some you aren’t missing that much upside, and profit taking by others could drive the stock lower.

Third, if you have a portfolio with a set amount of money in it, as opposed to a portfolio to which you dedicate some or all of your regular income, then you should hold more cash. When you anticipate that you will have money coming into your portfolio, it’s not that big a deal if you only have a little bit of cash because if an opportunity arises to buy a stock you like inexpensively then you will be able to buy it once you deposit more money into your brokerage account. You don’t have this luxury if you don’t add money to your portfolio, and so you want to make sure that you are prepared for market volatility and the opportunities that it presents.

Holding cash is an essential part of any investment strategy. When you prepare your portfolio you need to ask yourself how much cash you should hold and under what conditions you will deploy some of it. Doing so might be frustrating, especially if your stocks are rising. But your stocks won’t always rise, and when they fall, you will be very happy that you have cash.

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