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Should you keep cash in your portfolio?

Should you keep cash in your portfolio?

Cash is king or cash is trash. That sums up the two points of view on whether you should keep a cushion of cash in your investment portfolio. As with pretty much everything in investing, there are pros and cons to both positions. But when you sort through all of the reasons to keep cash in your portfolio or kick it to the curb, it looks wise to keep at least some cash on your books.

Financial advisers, though, are pretty much split down the middle when it comes to keeping cash in your portfolio along with stocks and bonds. The big knock on cash—and it is a big one—is that cash is sure to be a drag on your returns.

The problem with cash is that it earns nothing. It doesn’t pay dividends, and there’s essentially no chance of price appreciation. That means there is an opportunity cost to keeping cash in your portfolio, as opposed to holding more bonds or stocks, and those costs can really add up.

Take a boring blue-chip stock such as, say, Colgate-Palmolive. A decade ago, you could buy one share of Colgate for about 17 bucks. Cut to today, and that same share is worth $64. That’s a gain of 272 percent. So if you kept $10,000 in cash rather than buying shares of Colgate 10 years ago, you would have missed out on turning that cash into more than $37,000.

But it gets worse. Cash loses value over time because inflation erodes its purchasing power. Take something that cost $10,000 a decade ago. Today it would cost closer to $13,000. So though cash doesn’t offer a return, it generates a negative return. It’s actually and actively working against you.

Despite the serious shortcomings associated with having cash in your portfolio, we still recommend that you keep some in addition to your stocks and bonds. If you’re a passive investor, keeping cash on the sidelines doesn’t really apply to you. You’re just trying to match the market, which means you need all of your skin in the game. But if you want to be more aggressive and focus on growth, having some cash in your portfolio can help.

Read about where to stash your taxable cash.

To be clear: We’re not talking about savings. Most financial advisers say you should keep six months’ worth of expenses in an emergency fund. That cash should sit in something insured, like a CD or savings account. Advisers also suggest that you keep enough cash to pay for big upcoming expenses, such as college or a car. And it’s important to maintain a separate account for your emergency cash to make sure you don’t touch it.

What we are talking about here is the wisdom of keeping cash in your brokerage account as an asset-allocation decision. That might look something like this: Instead of the (very) general rule of thumb of putting 60 percent of your portfolio into stocks and 40 percent into bonds, you might split it by 60 percent to 35 percent, with the remaining 5 percent sitting in cash.

Just beware that if you hold that cash in a tax-deferred retirement account such as a 401(k) or an IRA, you generally can’t touch it before age 59½ without paying a 10 percent penalty.

There are two good reasons to have that cash ready to go. For one thing, it has essentially no risk. Though it does lose its purchasing power over time, your stocks or bonds might tank, but your cash sure won’t. In a market crash, that cash will actually help limit any losses in your portfolio.

But the best reason to keep cash is so that you can be opportunistic when the market tumbles. Remember, the idea is to buy low. Keep in mind that this is not the same thing as trying to time the market, which is impossible anyway.

Warren Buffett very publicly bought stocks during the last crash, but he didn’t try to time the bottom of the market. Indeed, when Buffett was buying, the benchmark Standard & Poor’s 500 Index still had a further 28 percent drop coming until it bottomed out.

Although Buffett did not always get the very best deal possible, he did end up with some big bargains nonetheless. The market fell significantly from where he began buying, but it’s worth a heck of a lot more today. Buffett benefited by buying low because he had the ability to do so.

It should be noted that if you have cash on hand, you don’t have to sell anything (and pay associated taxes, fees, and commissions) in order to take advantage of the next sell-off—and there certainly will be one.

On average, stocks return only 6.8 percent per year after inflation. Moreover, it’s extremely difficult to beat the market. That’s why active investors should keep, say, 3 to 5 percent of their portfolios in cash. That’s enough cash to take a decent-sized position—or add to an existing one—when you find a security on sale.

To have any hope of bettering those otherwise paltry returns, you have to be greedy when others are fearful. Like Warren Buffett, you have to buy low, and you can’t do that without cash.

This article also appeared in the January 2015 issue of Consumer Reports Money Adviser.

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