When stock markets drop, it’s understandable to feel concerned. As a result, some people might feel inclined to move their money out of equities and bonds into cash.
However, there is a problem with that.
If you take money out of your investment portfolio and stick it under the mattress, it’s doing nothing for you. It only gives you an illusion of comfort.
Let’s imagine you want a cash buffer for the next three years, and you have a portfolio made up of 50:50 equities:bonds. (That ratio reflects the middle range of our clients – many have a 40:60 ratio which is less volatile.)
Zero cash buffer
You are fully invested, can draw income when you want, and Bob’s your uncle.
Bad cash buffer
You take three years of income as cash to sit on (boo!), and you have effectively reduced your overall asset allocation to equities.
Good cash buffer
You take three years of income as cash, and increase your allocation of equities, say to 60:40. This gives you a better chance of improved results, because equities have a higher expected return than both cash and bonds.
Have a look at this data compiled by Betafolio and Finalytiq* which shows the results of these three scenarios.
As you can see, a bad cash buffer is worse than having no buffer at all.
You might also be reassured to see the long-term trend and latest performance of a typical portfolio (this example is for 50:50 equities:bonds). The recent upward tick shows we’re currently in a V-shape recovery… however, we don’t have a crystal ball so we don’t know if it will turn into a W. All we can say is that, long-term, stock markets WILL rise.
What this means to you
If you decide to take a cash buffer, and you don’t increase your exposure to equities at the same time, you’ll be worse off than having no buffer at all.
We want you to be happy. So, if you want a cash buffer, of course you can have one. However, we don’t recommend you do it at the expense of having a portfolio that isn’t fully invested.
That means you need a GOOD buffer that’s made up of cash balanced by increased exposure to equities.
Let’s face it, we have no idea whether we are out of the woods yet. The best advice (backed by evidence) remains as always:
- Stick with the plan
- Stay diversified
- Choose funds with low-cost fees
- Ignore the media
- Wait for long-term results
If you found this article useful, you might also like:
- Where do you keep your cash?
- Investing in the markets. How risky is it, really?
- Creeping inflation is eroding your savings right now
*As you may remember, we partner with Betafolio who get their data from MorningStar.