Turbulent times cause many investors to cling to cash. But excessive exposure to this asset class brings its own risks.
Diversifying across major asset classes—stocks, bonds, commodities, and cash—is the foundation of what is called asset allocation.But perhaps no other asset class elicits such mixed feeling amongst investors as cash.In bull markets, cash is shunned as a headwind to potential growth. In bear markets, cash is an anchor few want to let go of.
Having a better understanding of the role cash plays in your financial allocation and its relationship to stocks and bonds is a critical step to meeting your financial goals.
Here are some key considerations:
- Within your overall financial program, cash plays an important role. A cash reserve provides you and your family with a measure of stability in the event of an emergency, and a cash allocation within your investment portfolio gives you the flexibility to pursue attractive investment opportunities when they arise.
- However, cash is not intended to be the primary holding within your investment portfolio. Your ability to reach your financial objectives will most likely be restrained if you depend on cash’s low returns—unless you significantly increase your contributions to make up for the lack of growth potential.
- In times of inflation, having some exposure to commodities may help bolster your portfolio when other asset classes come under pressure.
- During deflationary environments, government bonds or municipal bonds may provide additional benefits in lieu of cash.
As we all sit and wait for a potential default on Greece’s sovereign debt and at the same time consider trading out of stocks, we have to be aware of rate-of-return potential for cash-type assets. These are challenging times for investors needing to generate income. Bank-type money, that is money markets accounts and saving accounts, are paying below 1%. I don’t know about you, but that’s not going to get the job done for me.
Those with larger amounts of cash may want to consider owning bonds in order to increase their interest payments. After you decide to invest in bonds, you then need to decide what kinds of bond investments are right for you. Most people don’t realise it, but the bond market offers investors a lot more choices than the stock market.
Depending on your goals, your tax situation, and your risk tolerance, you can choose from municipal bonds, treasuries, corporate bonds, mortgage-backed or asset-backed securities, and international bonds. Within each broad bond market sector you will find securities with different issuers, credit ratings, coupon rates, maturities, yields, and other features. Each one offers its own balance of risk and reward. Work with a qualified financial professional to assess your current situation and what the proper mix of stocks, bonds, and cash should be for you. Good luck.
Doug Lockwood, CFP®, is a partner at Harbor Lights Financial Group, a full service wealth-management team that has been dedicated to assisting clients in the accumulation and preservation of their wealth for over eighteen years. He was recently named one of America’s Top 100 Financial Advisors by Registered Rep Magazine (August 2010) based on assets under management. Doug Lockwood is a registered representative with and securities offered and advisory services through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. For more information, go to www.hlfg.com.