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The Role of Cash in an Investment Portfolio

Stephen Morgan
February 9, 2022

Cash may seem like the least exciting type of investment, but it plays an important role in most well-balanced investment portfolios. Understanding its function, potential drawbacks and other key factors can help investors see how cash may best fit into their financial plans.

 

The Role of Cash in an Investment Portfolio

 

What do we mean by cash?

In general, when we’re discussing investments, cash doesn’t refer to physical dollars but to cash equivalents. While there are several cash equivalent solutions, one of the most common is a money market fund. These funds ideally yield some interest, but are primarily managed to maintain a stable net asset value. In other words, if nothing goes disastrously wrong, the funds are managed so that if you buy a share for $1, you’ll get $1 back when you sell. Between buying and selling there may be small value fluctuations, and you may collect or reinvest interest.

 

What are the advantages to holding cash?

In terms of investing, there are three primary reasons to hold cash in a portfolio.

  1. Cash can help control volatility in a portfolio. While bonds may also help balance risk, cash may be a better hedge in a rising interest rate environment. In that scenario, bonds are more likely to decline in value, while cash values shouldn’t change. Having this stability may provide some investors with a sense of confidence in times of market upheaval and may prevent some people from selling assets at the wrong time. This may be particularly helpful for someone in the withdrawal phase of retirement, potentially allowing them to avoid taking a distribution if the market is down.
  1. Cash may let investors take advantage of attractive stock market opportunities. For instance, having cash available may allow someone to purchase stocks at discounted rates during a market decline. This means the investor wouldn’t have to sell other assets to make the purchase. Plus, cash liquidity may allow the investor to act quickly when opportunities arise.
  1. Cash may be helpful from a logistics perspective. For instance, imagine an investor sells one asset to purchase another, but the gain from the sale is less than the cost of the new purchase. Cash could be used to make up the difference. Similarly, if an investor wants to purchase a new asset before the sale of an existing asset is final, they could use cash to complete the purchase first. The proceeds from the sale could then be used to replenish the person’s cash fund.

 

What are the drawbacks to holding cash?

The primary downside to cash is that it has limited growth potential. But in the current environment, with inflation running high, there is another disadvantage: A dollar doesn’t buy as much as it used to, so investors lose purchasing power by holding cash.

In addition, with interest rates so low over the past several years, the investor holding cash at near 0% potentially loses out on gains that might be earned if the money were invested elsewhere. In fact, that’s a main reason we’ve seen cash levels in investment portfolios decline in the last several years compared to a decade or two ago.

 

How much cash should be in a portfolio?

There is no specific amount of cash that’s right for every investment portfolio. Different people have different financial needs, goals and risk tolerance, and those will contribute to determining how much cash to hold.

For example, someone who has a higher risk tolerance may feel comfortable holding less cash than someone with a lower risk tolerance. A person with multiple income sources may need less reserve, and therefore less available cash, than someone with one income source. And a person living solely off investment distributions might have a more conservative investment strategy with a higher proportion of cash.

In general, a rising interest rate environment may indicate that it’s time to increase cash in a portfolio, while rising inflation may indicate it’s time to reduce cash holdings. When inflation and interest rates on cash-equivalent options start to converge, that may also signal that it’s time to hold more cash, since dollars are less likely to lose as much purchasing power and may gain some interest.

 

Find and keep a balance

Selecting the appropriate cash levels and options for your portfolio are individual decisions and something you should re-evaluate at least twice a year, if not quarterly. Your Hancock Whitney Financial Advisor can help you find the right balance for your personal situation and help you stay on track to your financial goals.

 

Talk to a Private Banker

 

The information, views, opinions, and positions expressed by the author(s), presenter(s), and/or presented in the article are those of the author or individual who made the statement and do not necessarily reflect the policies, views, opinions, and positions of Hancock Whitney Bank. Hancock Whitney makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented.

This information is general in nature and is provided for educational purposes only. Information provided and statements made should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Hancock Whitney Bank encourages you to consult a professional for advice applicable to your specific situation.

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