There’s a finance strategy that says it’s wise for you to have at least one years’ worth of cash on hand. That way if your investments decline significantly, like they did with the COVID-19 crisis, then you can take money from your cash account and let your investments recover. While this sounds good in theory, is it really a good idea? Today you’ll find out!
Please note that I am not talking about your emergency fund here. You should definitely have an appropriate level of emergency fund to protect against unforeseen circumstances. Instead, what I am talking about is your investment strategy.
In professional circles, this strategy is known as a bucket strategy. It’s one where you always keep at least one or two years worth of cash in your investment portfolio, while the remainder is invested more aggressively. The purpose, as stated before, is to tap into the cash portion of your portfolio when your other investments go south. However, when looking at the research, this strategy actually harms you more than it helps you. There are two primary reasons for this.
First, you experience what is known as cash drag. Essentially, having a large amount of cash in your portfolio prevents you from making stock market-like returns. This is significant since the stock market goes up 75% of the time. As such, the odds are not in your favor to keep money in cash.
Second, a properly diversified portfolio would include high quality bonds, which serves as the conservative part of your portfolio. The bonds are intended to be your safety net if your stock investments decline. Generally speaking, bonds go up when your investments suffer significant declines. The research shows that having an appropriate stock/bond mix is superior to a stock/cash mix.
While it may sound great to have a portion of your portfolio in cash to protect against COVID-19 type recessions, it can actually do more harm than good. Instead have a properly diversified portfolio of stocks and bonds which is already designed to help you weather any storms that come your way!
I’d love to know if you’ve found this content helpful. Also, let me know if you’ve used a bucket strategy and how it’s worked for you. Please comment below.
CERTIFIED FINANCIAL PLANNER™