Cash: The Least Sexy Part Of Your Portfolio

Other than keeping a rainy day emergency fund in cash equal to about six months of your take home pay, there are a handful of reasons why you might put a stash of cash in your investment portfolio. One would be if you pay attention to the oft-cited principle (the "Rule of 100") that the percentage of stocks and bonds in your portfolio should be equal to the difference of 100 minus your age, with the rest in cash. For example, the theory goes, if you are 35 years old, you should have 65% of your portfolio in stocks and bonds, and 35% in cash (not including the rainy day fund). That is a little too conservative for my taste, but the point is that the older you are, the less time you have to recover from a downslide. Conversely, the younger you are, the more chances you can afford to take, and the more chances you should take. When you are young you have more recovery time from a bear market. The Rule of 100 is especially valid if you start your serious savings during a run of good years, i.e., a bull market, because that kind of market enables you to build up a cushion; a few bad years won't wipe you out. Whether you are young or old, some of your investment picture will include cash.

A second reason for a cash fund, not too much unlike the first, is that you may be running up against a milestone event for which you've been saving, such as a college education for your child, or a graduate degree or retirement date for yourself. If you have been saving for junior's post high school education for the last eighteen years, you don't want that money to disappear right before he goes off to his freshman year at State U. You might be more frisky, investment-wise, when he's in the primary grades, but you should reign it in a little (by allocating more to cash or other safe investments) as he becomes a high school upperclassman.

A third reason for the cash stash might be that you simply have a low tolerance for risk. You just can't get a good night's sleep knowing that the money you have in the market could evaporate in quick order, sometimes due to unforseeable events like economic problems in a small European country (say, Greece, for example) or the bankruptcy of a formerly solid company (like Lehman Brothers). There is nothing wrong with having a low risk tolerance. There are more folks who do than those who admit it. And, those who maintained a high cash position during the most recent recessions looked like geniuses compared to the market players; the former had peace of mind and they did not lose as much moola .

A fourth reason for keeping cash might be that you are holding onto it until you see an investment opportunity for which you can plunk in your dough when the time is right. When shareholders dump some stock, they don't always turn around and immediately reinvest the sales proceeds in some other venture. They might wait for a better opportunity to come along, and in the meantime they keep the proceeds in cash.

The main reason that the typical investor, Mr. Smith, has cash as a definite percentage of his portfolio is that he is hedging his bets. Let's say, for the sake of discussion, that Mr. Jones has all of his money in stocks. If the market goes up he will profit more than Mr. Smith who only had 80% of his money in the market. But if the market goes down, Mr. Jones will lose more than Mr. Smith. I think the trade-off for Mr. Smith is smart. He is not greedy, but by hedging his bet he has a little more peace of mind and can still enjoy the upside, albeit to a lesser degree than Mr. Jones. Yes, this example is a little over-simplified, but it illustrates that cash plays a key role in the investment strategy of the average worker/saver.

If you are convinced that not all of your serious savings should be invested in stocks and bonds, but instead a portion should be allocated to cash, what is the best strategy for doing so? One ploy you might consider is laddering CDs. That will be the topic of my next post.