Cash is a 'temporary parking space': Are you holding too much of it? Wells Fargo weighs in
(Kitco News) Cash can play an important role in an investment portfolio, but it does not work long-term, said Wells Fargo.
"Cash can be a temporary parking place for funds awaiting investment, but over long periods of time, inflation can erode its purchasing power," said Wells Fargo investment strategy analyst Michael Taylor. "We believe cash and cash alternatives have a place in a portfolio."
The answer to how much cash is best to hold gets very complicated, especially during periods of fear and uncertainty.
Wells Fargo suggested putting aside three to six months of living expenses in an emergency fund. But when it comes to the rest of it, the time horizon is key when keeping cash on hand, Taylor wrote on Monday.
"Investors should hold enough cash to meet short-term liquidity needs to avoid selling assets at inopportune times … We believe that investors holding too much cash could miss latest market recovery potential and may hinder long-term performance," he said.
Wells Fargo's research pointed out that investors tend to hold more cash than the recommended amount. This is a bad thing because the biggest downside of cash is its eroding value.
"The value of cash can erode over time due to the effects of inflation. Although inflation may be low today, that may change in the future. Riskier assets, such as stocks, have the ability to outpace inflation, but they do come with an increase in volatility," Taylor noted. "Cash investor has been losing ground since the early 2000s."
Many investors turned to cash in March when stocks tumbled on coronavirus-related shutdowns. However, Wells Fargo highlighted that those who chose to keep cash around for longer lost out.
"If we consider the recent selloff triggered by the coronavirus and lockdowns, an investor who remained invested outperformed one who did not participate. Based on our analysis, a portfolio that increased cash holdings to 15% during the recent bear market (March through mid-August 2020) underperformed one that remained at only 3% cash by roughly 7% over the recovery period," Taylor described. "A portfolio that redistributed half its equity allocation to cash over the same period underperformed one with 3% cash by 15%."
When explaining why investors turn to cash, Kitco Metals global trading director Peter Hug described the phenomenon as a natural impulse in times of crisis.
"When you start to get nervous, the natural reaction is to take some money off the table and park it into cash," Hug said back in September.
Cash gives investors significant advantages, he added, noting the increased ability to enter the market at a lower level or additional cash reserves if everything starts to sell off even more.
This is also why Wells Fargo suggested that the best way to use cash is as "a temporary parking place" for funds that are just waiting to be invested.
"When an investor has a large sum of cash from the sale of a house or from an inheritance, we do not recommend rushing to invest it. Instead, for portfolios with cash holdings above our suggested allocation, we encourage investors to consider investing it thoughtfully and ease into the market," Taylor said.
One piece of advice is to use dollar-cost averaging, which is a process of investing cash overtime by playing on market fluctuations.
"Dollar-cost averaging overlooks day-to-day market fluctuations that make it difficult to pinpoint the optimal time to invest. Instead of investing a lump sum into the markets, a fixed dollar amount is invested regularly over a period of time," Taylor explained.