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If you’re re-thinking the balance of cash in your investment portfolio, start with these tips.
Most portfolios hold some cash. It can be useful to have some liquidity on hand to take advantage of sudden investment opportunities, or to quickly act on any adverse impacts on a portfolio, like a margin call.
It can also he handy to have some parked in a savings account or term deposit to lower the overall risk profile of your portfolio, even if the interest rate is not what you expect to earn on the balance of your portfolio.
The amount you decide to allocate to your investment portfolio should be separate to any funds you keep on hand for emergencies, and typically portfolio managers recommend a minimum allocation of 5%, although it will vary depending on your overall portfolio allocation to defensive vs risk assets and personal circumstances.
The macro environment will also impact cash allocations. In higher interest rate environments, cash can be an easy investment that can earn reasonable returns with minimal risk, but that can also lead to over-allocations to cash that could lower long term returns if not managed.
It would be counter-intuitive to think that in times of low interest rates allocations to cash would fall, and that generally is true. However, if it is mixed with market volatility and uncertainty, as we experienced during the COVID-19 pandemic, investors can also turn to cash as a safe haven asset, again leading to an over allocation.
Cash is also a more attractive asset for those approaching retirement and focused on preserving wealth, however, while holding some cash in a portfolio is considered prudent, too much cash can impact portfolio returns. If you’re re-thinking the balance of cash in your investment portfolio, start with these tips.
The risk of market exposure
Whether you’re investing for short term goals like a house deposit, or long-term wealth creation, it is always important to diversify the mix of investments in your portfolio to smooth out long term returns and manage risk within a portfolio.
As you build your wealth, it is wise to continue to add different asset classes to your portfolio. Volatility in markets can have a disproportionate impact on a larger undiversified portfolio. The shorter your investment goal’s timeframe, the less time you have to make up any loss – the impact of a share market correction on a portfolio overly focused on equities could wipe out years of growth.
Uncorrelated assets classes and liquidity
When planning your portfolio, it’s also important to consider the life cycle of investments. You may purchase shares in a building company to take advantage of an infrastructure building boom you have identified, but what if that company does not get to participate in the programs? Will it still meet your growth expectations, and how long will you hold it to achieve the goals you have set?
Also, if you have to sell your shares quickly to meet other commitments, how will that impact your wealth if you have to take a loss?
Holding a range of assets from term deposits to corporate and high-yield bonds, property, equities and commodities, provides you with more revenue streams and options to manage your cash flow. Of course, there are also other options like managed funds, ETF’s, foreign exchange, and increasing ease of access to private capital markets both in Australia and internationally. The options for the investor are broad and varied and provide different benefits and risks across the economic cycle.
By choosing assets that react to different market drivers you can smooth out returns over the long term. For instance, a portfolio of just shares will drop dramatically if the share market plunges. A portfolio split between bonds and equities will perform differently, as bonds are largely uncorrelated to the forces driving the share market.
Each new asset class brings its own positives and negatives, so it’s about finding the balance that provides the growth you require as well as the income streams and a framework that meets your risk tolerance.
As you get closer to retirement and depending on your goals, a guaranteed return and regular income through interest payments may become more important than rapid wealth growth. This does not mean channelling all your funds into cash but rather as you age increasing your allocations to income side investments, like bonds and select alternative investments.
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