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Cash isn’t an afterthought, something that remains when all the other asset allocation decisions are made. Even experienced investors can wind up with too much or too little cash—balance and diligence is key.

Investors often have a conflicted relationship with cash. In down markets, there is a temptation to flee to cash even though you may run the risk of losing out on attractive investment opportunities. In bull markets, the reverse is true: Cash may fall to negligible levels as investors seek to be fully invested. And there are times when an investor’s cash position is considered an afterthought.

Cash is an essential part of a comprehensive financial plan — it’s not an afterthought, something that remains when all the other asset allocation decisions are made.

The roles of cash in a financial plan

Cash performs essential functions in a well-designed portfolio: With a cash reserve in place, you can:

  • Deal with the unexpected. Cash or cash equivalent investments, such as money market funds, are highly liquid and can be easily accessed. Cash provides a cushion for financial reversals, such as unexpected expenses, a reduction in income or loss of a job. If an emergency strikes and there’s no cash reserve in place, you may need to sell assets at an inopportune time or take on debt.

A chart then appears on screen titled, "Growth of $2 Million Over Trailing 10-Years – As of March 31, 2020." The chart reveals upward trajectories of over a 10-year period for four primary categories: 10% Equity / 90% Conservative Fixed notated by a red line, Fixed Income – Conservative noted by a grey line, Inflation notated by a dark grey line, and Money Market/Savings Account which is referenced by a dark blue line. On the y-axis of the chart are measurements in millions of dollars, spanning upward from $1.8 million to $2.8 million. The x-axis includes month and year listings in six month increments, starting with March 2010 and September 2010, running every six months up through March 2020.

The red 10% Equity / 90% Conservative Fixed line runs upward with volatility at an approximate 40 degree angle from $2 million starting in March 2010, to just over $2.7 million dollars in March 2020.

The Fixed Income-Conservative line noted in light grey runs upward with minor volatility at an approximately 25 degree angle. At the September 2018 mark on the x-axis, the line ascends upward at a 50 degree angle, where the line ends at just less than the $2.5 million mark.

The dark grey Inflation line trends upward at a 20 degree clip with volatility. The line begins in the bottom left corner at $2.0 million in March 2010, trending upward as mentioned up to end at approximately $2.37 million in March 2020.

The dark blue line noting Money Market and Savings Accounts closely follows the $2.0 million line on the graph until the September 2015 mark. At that point the line sees a slight incline at an approximately 5 degree angle, which then ascends to a 20 degree angle by September 2018. The line ultimately ends in March of 2020 at a value of approximately $2.13 million.

  • Take advantage of new opportunities. One of the most significant benefits of holding cash is that it allows you to take advantage of attractive investment opportunities when they surface. Separate from the cash you keep in your emergency fund, an opportunity cash reserve gives you the flexibility to make new investments in assets at reasonable prices when the time is right — without having to sell or reduce an existing position.
  • Improve downside protection in challenging markets. Defensive assets such as cash have low or negative correlations with equities, an especially attractive feature when equity markets decline. While all defensive assets have this characteristic, cash offers the additional quality of price stability: Even though other defensive asset classes may be highly liquid, they can still experience price volatility. Because of its stability, cash can serve as an anchor for your portfolio during challenging times: When markets are unsettled, and other investors are panicking, having a cash reserve can provide you with greater peace of mind.

The challenge of finding the optimal cash level

Cash plays an undeniably important part in your financial plan, but there are drawbacks to having too much cash in your portfolio. While it is the safest and most liquid asset you can hold, cash offers the lowest return of the major asset categories. And even though inflation is at historically low levels today, there is always the risk that rising price levels can erode cash positions over time.

It’s crucial, then, to find the best mix of cash and other assets in your portfolio, a task that can be more difficult to do than it seems. First of all, your needs and situation are unique to you — there is no simple algorithm that can give you the "correct" answer. Your circumstances evolve, and financial market conditions change, making it a necessity to regularly revisit your asset allocations.

Some investors choose a self-directed approach to investing and portfolio management. However, it doesn’t take long for portfolios to deviate from intended asset allocations due to changing market conditions. This can make it challenging to keep cash at target levels as time passes—a compounded problem if the investor has multiple investment accounts. Also, self-directed investors may develop portfolios that are "barbelled," with investments in short- and long-term assets. As a result, they forsake opportunities in intermediate-term investments and have a less-than-optimal portfolio from risk-return and liquidity perspectives.

Fear of loss can cause investors to defer decision-making and hold too much cash in their portfolios: They try to pick the right time to put cash to work and wait for a significant pullback. However, when prices do drop, they may still hesitate because they are worried that the market might fall even more.

As a result, even experienced investors can wind up with portfolios that have too much or too little cash, which can cost them in the long run.

A chart titled, "2020 Year-to-Date Performance," then appears on the page. This chart features four lines representing the same primary categories as the prior graph: 10% Equity / 90% Conservative Fixed notated by a red line, Fixed Income – Conservative noted by a grey line, Inflation notated by a dark grey line, and Money Market/Savings Account which is referenced by a dark blue line. . On the y-axis of the chart there are percentage listings ranging from -4.0% ascending up to 5.0%, with 0% placed in the very middle of this axis. The x-axis includes month and year listings that track progress by week. The graph begins in December 2019, then progresses into January 2020 for four entries, given the number of weeks in January. This occurs running up through the fourth week in April 2020.

The red line notating 10% Equity / 90% Conservative Fixed begins at the 0.0% mark and progresses upward at an approximately 35 degree angle with volatility up to the February 2020 mark on the x-axis. The line then sees a sharp drop, followed by a dramatic increase at an approximately 75 degree angle up to the third week entry for March 2020. At this point the red line plateaus at the 4.4% increase mark and dives downward dramatically reaching the -3.1% at the trough. The line sees a slight increase at the forth week in March of 2020, levels off briefly, then sees a dramatic increase upward at an approximately 75 degree angle, leading to a positive 1.1% mark at the end of March 2020. The line then decreases slightly before leveling off at the 0.7% mark into the first entry for April 2020. The red line then sees an increase at a 50 degree angle trajectory with notable volatility up through the last entry in April which ends at a 3.9% mark.

The light grey Conservative Fixed Income line begins at the 0.0% mark in December 2019, before seeing an increase at a 20 degree angle with volatility up through the fourth week in February. At this point the light grey line juts upward at an approximate 45 degree angle with volatility reaching the 2.9% mark at the second entry in March on the x-axis. This line then decreases notably at a downward 45 degree angle with volatility before leveling off at the 1.0% mark. Starting at the mark between the fourth and fifth entry for March 2020, the grey line increases again at a 45 degree angle with volatility until reaching the right side of the chart, ending at approximately 3.1%.

The dark grey inflation line begins at 0.0% in December 2019 and stays level at that mark through January. Starting at the first entry for February 2020, the line juts upward slightly to approximately 0.5% before leveling off up through the first entry for March 2020 on the x-axis. The line again, juts upward slightly to 0.7% before leveling again up through the first entry for April 2020. At the April 2020 mark on the x-axis, the inflation line decreases slightly to the 0.5% mark, then remains stable up through April of 2020.

The dark blue line reflecting Savings Accounts and Money Market Accounts begins at 0.0% in December 2019 and stays level at that mark through January. Starting at the first entry for February 2020, the line juts upward slightly to approximately 0.2% before leveling off up through the first entry for March 2020 on the x-axis. The line again, juts upward slightly to approximately 0.35% before leveling again up through the first entry for April 2020. At the first April 2020 mark on the x-axis, the Savings Account / Money Market line increases slightly again to the 0.5% mark, then remains stable up through April of 2020.

A table appears on screen titled, "Return Statistics – Trailing 20-Years." The table features four columns with the following titles running left to right: Investment, Return, Worst 12-Month Return, and Max Drawdown. In the Investment row, there are four categories spanning the rows below: 10% Equity / 90% Conservative Fixed, Conservative Fixed Income, Inflation, and Savings Account / Money Market.

In the 10% Equity / 90% Conservative Fixed row, the data lists a 5.2% return, -1.6% Worst 12-Month Return, and a max drawdown of -7.5%. In the Conservative Fixed Income row, there is a 3.8% return listed, a -0.5% worst 12-month return, and a -2.7% max drawdown. In the inflation row, there is a 2.1% return listed, a -1.4% worst 12-month return, and a -4.4% max drawdown. In the Savings Account / Money Market row, a 1.6% return is listed, with a 0.0% worst 12-month return, and a 0.0% max drawdown.

Incorporating cash into your wealth plan

An experienced investment advisor can help you determine the right amount of cash to hold in your portfolio as part of your overall financial plan. An advisor works with you to create a customized, disciplined asset allocation plan to grow assets, optimize tax strategies, generate income as needed and maintain your desired level of risk. The result is a diversified portfolio across a range of asset classes, including cash and other defensive assets.

With the advice and expertise that your advisor provides, you can avoid overreacting to short-term events and remain focused on your long-term plan. An advisor can integrate investment advice into your comprehensive wealth management strategy and schedule regular reviews to keep your portfolio aligned with your objectives, including your cash allocations.

For more information, please contact your Key Private Bank Advisor.

Publish Date: June 18, 2020.

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not give legal advice.

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