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Why Cash Should Be Part of Your Portfolio

Dryden Pence

Whenever markets drop, there is inevitably chatter about the need to move to cash, whether it's on television or in commentary pieces, which tends to imply that it's not already an important part of nearly every well-thought out investment portfolio.

Many, of course, already maintain cash and cash equivalents (i.e., U.S. Treasury bills, certificates of deposit, commercial paper and money market mutual funds) as a buffer against volatility. As they should.

[Read: Let Volatility Lead to Opportunity.]

But there are reasons to have cash beyond limiting risk. Indeed, large cash positions can also allow investors to, in the words of Warren Buffett, "Be greedy when others are fearful." To figure out how, first look at the current market environment.

A Summer of Volatility

Trade, interest rates and international tensions are testing global markets.

The United States economy has enjoyed 10 years of near continuous growth, while over the same time global gross domestic product has experienced a similar upward trend, save for a brief let up from 2014 to 2015. Nevertheless, in recent months an assortment of intertwined challenges have taken center stage.

An intensifying trade spat with China, along with struggling German and British economies, caused U.S. Treasury prices to spike earlier this summer, which prompted a yield-curve inversion and the Federal Reserve to cut interest rates.

Meanwhile, if the recent Group of Seven meeting in France demonstrated anything, it's that the wealthiest countries on earth are increasingly at odds concerning a host of important issues, further clouding an already uneasy global picture.

All this contributed to an uptick in market volatility around the world during the latter half of August, adding to the notion that an international economic slowdown loomed around the corner. And while stocks have mostly stabilized since, some continue to harbor recessionary fears. That sense of dread is likely unwarranted, however, especially in the U.S., where consumer spending, small business and employment data remain strong.

How Much Cash Should an Investor Have?

Again, every investor should have cash or cash equivalents in their portfolio, but the breakdown will depend on their long-term goals and individual circumstances.

Typically, this asset class -- and, yes, that's exactly what it is, just like stocks, fixed income and real estate -- should make up at least 2 to 5%.

[See: 8 Things to Remember When Reviewing Your 401(k).]

In the current environment, where only a few tweets could spur another round of volatility, it could make sense to ramp up that ratio. That's because declines could create opportunities for investors with cash on hand to go discount hunting.

Market dislocations can be short lived. Maintaining "dry powder" that can be deployed at a moment's notice makes it far easier to take swift action without having to unload preferred holdings in order to create liquidity.

Watch for Domestic Opportunities

Investors should take advantage of the volatility, not be a victim of it.

To find opportunities to both insulate yourself against the ongoing trade war and to appreciate how cash can help capture value, think about companies that generate most of their profits inside the U.S., including PayPal Holdings (ticker: PYPL), Amazon.com ( AMZN) and Walt Disney Co. ( DIS). Despite being huge, global brands, these firms still rely overwhelmingly on U.S. consumers, providing them good cover from potential trade-related fallout.

At the same time, broader market volatility could pare their valuations, particularly because they are included within many prominent exchange-traded funds, or ETFs, something that would cause them to tumble in value along with other equities during temporary market selloffs. At those points, investors armed with cash will be well-positioned, able to gobble up these stocks -- and others like them whose underlying fundamentals remain strong -- at a discount.

Cash Is Not a Magic Bullet

Very few things in life are absolute, and that goes for the merits of moving into cash. No doubt, it's a strategy that can make a lot of sense when markets are more unpredictable than normal, and as explained above, not just because it can help to ward off losses.

[See: 5 Reasons a Market Crash Is the Perfect Time to Buy.]

Even so, investors should be mindful that while financial markets in the long term do rise more than they fall, prolonged downturns do happen, despite what the last decade would suggest. Therefore, although bargain hunting can lead to potential rewards, there are significant risks associated with trying to use cash positions to pick up seemingly strong companies at reduced prices during times of hyper-volatility.

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