'Cash is trash' is a common phrase in the world of investing.
Many people will tell you that cash has no place at all in your portfolio. If you want to get rich then you've got to be invested in shares or property. You've got to be fully invested in these markets at all times to make it big.
I couldn't agree less. This is a dangerous mindset that has cost investors dearly over the years. The truth is cash isn't trash it's an investor's best friend.
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Cash isn't just for a rainy day fund
Obviously, before you even start investing, it makes sense to build up a cash fund to cover emergencies.
For example, you might lose your job and need some money to get by as you look for another one. Unexpected household and car repairs can also cost a lot of money. An emergency fund equivalent to around six months' living expenses is a good idea.
But what about the role of cash in investing?
The first rule of investing is not to lose money. Having a chunk of your portfolio in cash at all times can help it survive the ups and downs of the investment markets. To see how this can work, you need only look back to the wild times of 2008.
In times of extreme panic, there is a dash for cash. Assets that are supposed to spread and reduce investment risks tend to move in the same direction. We saw this in 2008 when the value of shares, many types of bonds and gold all went down together. Anyone who kept a decent allocation of cash in their portfolio before the panic, lost far less money than those who were fully invested.
It also helps you to sleep slightly better too by adding some stability to your portfolio. Wild swings in the value of your portfolio can be very unsettling. By having cash, which doesn't move around much, your portfolio should be less volatile and therefore less likely to panic you into doing something stupid.
Cash gives you options
Even better, those who held cash were able to buy assets that had fallen in price. This allowed them to make money as the markets recovered in 2009. If you are fully invested all the time you cannot do this. You have to ride the ups and downs of the market.
It's always worth remembering that if an asset loses half its value it needs to double just to get back to where you were. Holding cash means that at least part of your portfolio doesn't face that risk.
Sure, your portfolio won't do as well in raging bull markets, but the lower losses suffered in falling markets, and the opportunity to buy cheap assets after markets have fallen, gives you a good chance of getting reasonable long-term returns.
Cash is a hedge against falling prices but what about inflation?
Deflation - or falling prices - is generally bad for assets such as shares or gold. Bonds tend to do well and so does cash. This is because the real value of cash goes up as the pound in your pocket can buy more goods and services at lower prices.
Given that one of the aims of investing is to increase the purchasing power of your money, cash can be a good choice if you think prices are going to fall.
But surely cash is a bad asset to hold if prices are going up? Here the real' value of cash its purchasing power - goes down. Surely it would be much better to own shares, property and gold?
Well, interestingly, the track record of cash during times of inflation might not be as bad as people commonly believe.
Take the 1970s when the cost of living went up at an average annual rate of 13% per year. The real returns on cash were as good as the real returns on shares, despite the latter being seen as a good inflation hedge.
| -2.3% | -4.1% | -2.3% |
| Source: Barclays Equity Gilt Study 2012 |
Why was this? It's because inflation led to rising interest rates (as central banks tried to tackle inflation). As rates went up, so did the returns on bank and building society accounts. These increasing rates actually did a good job of preserving the real' value of cash without the rollercoaster ride of owning shares. Whether this happens in the future, of course, remains to be seen.
The case for cash in today's markets
The powers that be (in this case governments and central banks) want you to think that cash is trash. That's why interest rates on cash are very low or non-existent. They want you to take your money out of cash and risk your savings in things such as shares, bonds or property instead.
But what are you getting in return? The answer is not much. The dividend yield on the UK stock market (FTSE All-Share index) is 3.5%, a basket of corporate bonds yields 3.3% and ten-year government bonds yield 1.9%.
Falling company profits and rising interest rates could mean that investors are taking a lot of risk for not much in return. Having a chunk of your portfolio in cash may give you even less return, but you are not likely to lose much either and you will have the opportunity to buy assets more cheaply if and when a big sell-off comes.
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