Go to cash?

It’s panic time again. Markets are selling off, gold is plunging, and the hot money is rushing back to the “safety” of the U.S. dollar, driving bond yields to near record lows.

Unnerved readers are asking what they should do. Here’s an excerpt from an e-mail I received recently: “I am concerned about the impending Greek election and Italy, France, and Spain are also likely to be a huge problem. I have the majority of my portfolio in large caps from your recommendations but wonder if I should be mainly going to cash?” — Bruce M.

Selling everything and retreating to cash is the standard knee-jerk reaction in times such as these. If you get the timing exactly right, it can be a profitable strategy. The problem is that very few people ever do.

Here’s the usual scenario. After a period of strength, stock markets begin to trend down. Investors, who are sitting on profits, are a little uneasy but decide to wait a while to see if it is only a minor correction. The downward trend accelerates, fed by external economic, financial, political, or natural events. A bank collapses. A tsunami hits Japan. Greece teeters on the brink of default. Chinese growth slows. Every morsel of bad news accentuates the pessimism.

At this stage, people start to think about selling everything and going to cash. Some actually do so. Others make some portfolio adjustments. The majority, worried about locking in losses, do nothing. Who fares best?

If the markets continue to fall, those who went to cash are likely to be the short-term winners. But here’s the problem: if they fail to get back in at the right time, they will eventually end up on the losing side of the equation.

Think back to the crash of 2008-09. The optimum time to sell was actually in early June of 2008. The TSX was about to touch an all-time high, oil was closing in on US$150 a barrel, and commodity prices were heading to the moon. Many investors were sitting on huge capital gains. Most were not ready to take their winnings off the table and retreat to the sidelines.

Flash forward to November. Lehman Brothers had collapsed. The U.S. was frantically bailing out its banks, mortgage insurers, and auto makers. Europe’s financial system was on the brink of a meltdown. The markets were in tatters. At that point people were rushing to cash. But the worst of the stock market plunge was already over. The lows were still a couple of months away but by early March a rebound had begun which was to carry the TSX 60 per cent higher over the next 18 months. How many cash hoarders took advantage of that? Very few — most were sitting in long-term GICs that were paying around 2 per cent.

That’s the problem with cash. It’s all in the timing. With interest rates so low, your money is earning almost nothing. It’s true, you’re not losing either and if you’re already wealthy that’s good enough. But most people aren’t that lucky.

This is not to say that cash has no place in your portfolio. Of course it does. But like any other type of asset it needs to be properly deployed. Here are my suggestions for making the most effective use of cash.

To protect income. Anyone who relies on investments for income should always maintain sufficient cash reserves to ensure that securities don’t have to be sold at what could be an inopportune time. This is especially true in the case of RRIFs where the government requires that a minimum amount be paid out each year.

As a general guideline, you should have enough cash to cover income requirements for the next six months during periods of market strength or stability. When markets are in turmoil, like now, extend the cash protection to one year. Very conservative investors may wish to keep two years worth of cash in reserve. I would not go much beyond that.

“Cash” in this situation may include high-interest savings accounts, money market funds, Treasury bills, term deposits, cashable GICs, and short-term bonds or funds that invest in them.

To provide for emergencies. Everyone should have a cash reserve to cover emergency situations. The amount will depend on personal circumstances. For example, a family with small children and/or only one wage earner needs a larger emergency fund than a single retired person with substantial assets. Tax-Free Savings Accounts are a good place to hold emergency money provided there are no fees and no limitations on the number of withdrawals. These funds should always be in highly-liquid assets in case they are needed quickly. Don’t lock them into a long-term non-cashable GIC.

To take advantage of opportunities. When stock markets slide, investment bargains appear. Within the past decade, we have seen some incredible opportunities such as Apple at less than US$100 a share and Bank of Montreal with an 11 per cent yield. Right now natural gas stocks appear to be seriously oversold. But you need cash to take advantage of these situations when they occur — the window doesn’t stay open for very long. That’s why I recommend that you keep at least 5 per cent of your investment account in cash or the equivalent. That way, the money will be there when opportunities present themselves.

To go back to our reader’s question, should you sell everything and go to cash if you are worried about the markets? My answer is no — but you should always be ready to make adjustments to your portfolio depending on the situation and increasing the cash allocation to between 10 per cent and 20 per cent is certainly a viable option.

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