The global investment markets provided another lesson last week on the benefits of diversification and holding some cash. If you have a diversified portfolio, including some bonds and cash, you did not experience as deep a drop in value as in stock markets. As a side benefit, you had the opportunity to buy investments at a discounted price with part of your cash. The nagging question for many investors is that holding cash has a cost when markets are performing well.
I suggest looking at cash as protection and giving you the chance to take advantage of good deals when they appear. As with other types of protection, such as insurance or maintaining good health, there are costs. By having cash reserves, you can take advantage of good investments or needed items (appliances, car, home repairs) when they go on sale. You can avoid panic selling of longer term investments for immediate cash needs or during market drops.
So how do we avoid losing value on cash we have set aside for reserves or to diversify our portfolio?
If you leave cash in a brick and mortar bank savings or money market account, you are likely earning less than .5 percent annually. Even in today's low inflation world, 1.8
percent annually over the last five years, you are losing value on your cash holdings. Moving these savings to an online bank could increase your return to 1.0 percent and maintain the same FDIC coverage.
One option is to split up your cash into three different investments whose combined returns, after taxes, are expected to equal the inflation rate. Over the last three- and five-year periods you could have put a third in a high-yield savings account, a third in a high-quality short-term bond fund and the remainder in a floating rate bond fund. Doing this would give you an after-tax return that approximates the inflation rate.
The bond investments are different than cash in a savings account. The bond funds do not have FDIC coverage and do have the potential to lose some value. The high-quality short-term fund's greatest risk is due to market interest rate increases. Short-term bonds have a short duration and are less affected by changes in market interest rates. (Duration is used to measure the interest rate risk of bonds. It factors in the length of time until the bond matures and yields) For a short-term bond fund with duration of 2.6, if rates increase .25 percent the loss in value is approximately .7 percent. The after-tax return for the last three years was 1.7 percent annually.
For floating rate bonds, the primary risk is holding bonds issued by lower credit rated companies. These bonds adjust their interest rates several times a year to stay close to the market interest rates. This is similar to an adjustable rate mortgage and means the potential loss due to interest rate changes is minimized. Credit risk is more of a concern when the economy is weakening. During times of growth, the risk is minimized. You should evaluate the fund's performance over different economic cycles.
Marrying these three investments together in equal shares would have had an after-tax return (25 percent bracket) of 1.3 percent annually for the last three years. This matches the inflation rate. Results are similar for the last five-year period. The potential loss due to interest rate increases was .5 percent. As with all investments, there is no guarantee on future performance. But the expectation is for risk-adjusted returns to beat the savings and money market account returns, and match inflation.
An alternate for bank savings or money market accounts is a ladder of CDs. While this will maintain FDIC coverage, you may lose some interest payments if you withdraw cash early. By laddering you will get higher rates, if they are available, when the CDs mature. A ladder is constructed by splitting up your cash and buying CDs that mature in six months, one year, two years, etc. Using a ladder of CDs spread over five years, you could have an after-tax return of about 1.2 percent.
Optimizing your cash reserves can help you reduce the loss of value from inflation, provide protection for emergencies, open up opportunities and manage your emotions. Of all of these, managing your emotions has the most potential to help you achieve your financial goals. How did you react to market losses last week? If you were very uncomfortable, you could help yourself by diversifying your allocation and better managing your cash.
Tom Roberts, a financial planner and owner of A New Approach Financial Planning in Lakewood Ranch, can be reached at 941-927-9590 or by email at Tom@ANewApproachFP.com.