Investors…want to know how much of their portfolio they should be in cash…[but] there is no absolute answer to this question. Some investors and traders will hold no cash when they have a strong opinion on the market while others will always hold some cash (e.g. at least 10%) no matter how strongly they believe in their market outlook. You can decide what percentage of your portfolio you should hold in cash right now by considering several factors:
The original article has been edited here for length (…) and clarity ([ ])
Let’s take a deeper look at how to decide your cash allocation based on these factors.
How much conviction do you have for your market outlook?
You are going to have a different level of conviction for each and every trade.
- There will be some trades for which you have a very high degree of conviction. Almost all the factors support your case, and you can easily refute the factors that go against your market outlook.
- There will be some trades for which you have a relatively low degree of conviction. Most of the factors support your case, but you can’t easily refute the factors that go against your market outlook.
You should not be taking trades for which you have a very low degree of conviction. Only trade what you believe in. Do not take trades that aren’t supported by data-driven analysis. Otherwise you’re just gambling.
- The more conviction you have for a trade, the less cash you should keep.
- The less conviction you have for a trade, the more cash you should keep.
The benefit of having less cash when your conviction is wrong is obvious: you will make a lot more money if the market moves in your anticipated direction.
Sometimes trades that you don’t have a lot of conviction for aren’t wrong – it’s just that your timing is too early. Having more cash will allow you to average-in your entry price if the market moves against you in the short term. This decreases your risk and decreases the probability of you losing money…
The market stage should also factor into your conviction. The later we are in the long term trend, the more you need to question your conviction. This means that:
- You should hold more cash during the final leg of a bull market. This is because there’s a bigger possibility that the long term trend will reverse sooner than you expected, so you should be more concerned about short term losses. If you don’t hold more cash towards the end of a bull market, at least reduce your leverage…
- You should hold less cash during the first-middle legs of a bull market. This is because there’s a smaller possibility that the long term trend will reverse sooner than you expected, so you should be less concerned about short term losses.
How much successful experience do you have trading and investing?
New traders and investors should hold more cash than experienced traders and investors and, by “experience”, I don’t refer to how many years you’ve been in the markets. “Experience” refers to the number of successful years of trading and investing you’ve had.
- Consistently profitable traders and investors should hold lower levels of cash in their portfolio. The probability of them taking a big loss on a single trade is smaller.
- Conversely, new and inexperienced traders/investors should keep a higher percentage of their portfolio in cash. It’s normal to make more mistakes when you’re new to the markets or don’t have much successful experience.
- Holding more cash reduces your risk in the event that a trade/investment “blows up”.
- Keeping more cash reduces your potential profits but also your potential losses.
- Consistently profitable investors and traders should focus on increasing potential profits. Beginners should focus on decreasing potential risks. All it takes is one major mistake to blow up your portfolio. You can’t make a comeback from $0.
What are your portfolio’s goals?
Trading and investing is about finding a balance between risk and reward. It is not possible to increase one (e.g. reward) without increasing the other (e.g. risk)…
This doesn’t mean that it’s a good idea to increase risk and reward disproportionately forever. Increasing both risk and reward disproportionately becomes dangerous past a certain point. That “certain point” depends on your portfolio’s financial goals.
- You should keep a smaller percentage of your portfolio in cash if your goal is to maximize long term performance.
- You should keep a bigger percentage of your portfolio in cash if your goal is to achieve a stellar but safer long term performance…
- Having more cash allows you to be ready in case these never-seen-before events happen in your lifetime.
- Holding more cash will lower your long term performance, but at least you will never face the prospect of being wiped out by a “sky is falling” event…The Great Depression is not a fairy tale. The 1987 crash could happen again. You never know.
People who are older or who have families have a lower tolerance for risk. Everyone love’s large returns in their portfolio, but these people can’t afford to take such high risks. It’s not a good idea to hold no cash and potentially jeopardize your family’s financial future just for the sake of potentially higher returns.
What is your financial situation?
- People who are more financially stable should keep less of their portfolio in cash.
- People who are less financially stable should keep more of their portfolio in cash.
…Everyone should have emergency savings and these savings should be placed aside from your portfolio in case some personal emergency arises…[because] sudden disasters often force investors and traders to dip into their portfolio, liquidate assets and raise cash [and] the danger here is that you could be liquidating assets at the worst time possible…
The more financially stable you are, the less you have to worry about dipping into your portfolio to raise emergency cash. Hence, you can keep a bigger percentage of your portfolio in assets and a smaller percentage in cash.
The less financially stable you are, the more you have to worry about dipping into your portfolio to raise emergency cash. Hence, you should keep a smaller percentage of your portfolio in assets and a bigger percentage in cash. You must be more prepared for the worst case scenario because you don’t have as big a buffer to fall back on in case the worst case scenario happens.
How many good trading and investment opportunities are available today?
Some investors and traders always feel the need to “be in the market”. This is silly. There’s no point in being in the market when there are no good opportunities. Cash is a position too! Cash might not make you money, but at least holding cash won’t lose money when the entire market is crashing.
- There will be times when good investment and trading opportunities seem to be everywhere. This is generally near the bottom of a bear market when markets and assets are insanely undervalued. You should hold very little cash during times like these and become close to fully invested.
- There will be times when good investment and trading opportunities seem to be scarce. This is generally near the top of a bull market when markets and assets are insanely overvalued. You should hold more cash. There’s no point in making an investment or trade when the risk is very high…
Holding more cash right now allows you to take advantage of new opportunities when they present themselves. Imagine the cash in your portfolio as bullets. The more cash you have, the more bullets you have to take advantage of good opportunities that arise in the future.
- Imagine cash as an opportunity cost.
- The opportunity cost of holding cash is high when there are a lot of good investment and trading opportunities.
- The opportunity cost of holding cash is low when there are few good investment and trading opportunities.
How high is inflation right now?
Cash loses its value over the long run because inflation eats away at it. That’s why $100 today is worth far less than $100 from 30 years ago.
- Holding cash is not a problem when inflation is low. There’s no point in investing in something just to “beat inflation” if inflation is e.g. 2-3% a year. The cash that you hold will retain most of its value over 1-2 years.
- Holding cash is a problem when inflation is high. High inflation eats away at cash, which means that holding a lot of cash in your portfolio will lead to large losses in real terms (inflation-adjusted)…The chart below illustrates how high inflation can go historically.
What financial products are you trading?
Holding stocks, ETFs, or options do not force you to hold more cash. You risk only what you have in the position [but] futures traders need to hold cash to prevent the possibility of a margin call. This is the nature of futures as a financial product. The more you trade futures, the more cash you will need to keep in your portfolio.
What is your trading or investment time frame?
- Traders and investors with longer time frames should hold a smaller percentage of their portfolio in cash.
- Traders and investors with short term frames should hold a larger percentage of their portfolio in cash.
- The longer your time frame, the less you should care about day-to-day fluctuations in your portfolio’s value.
- Short term losses are more acceptable to long term traders whereas short term traders need to hold cash in order to average-in after the market falls…
- Long term investors have no need to hold cash for averaging-in after the market falls. Longer term investors are generally unfazed by short term movements in the market.