Everyone knows what cash is, but do you know how to get the best return for your cash, or why you should have it in your portfolio? This week we cover the basics of cash as an asset class.
Why hold cash in your portfolio?
The key reasons that people keep cash in their investment portfolio are to:
Minimise risk: Cash is the ultimate risk free asset. The government provides a guarantee of up to $250,000 for any deposits held with an authorised bank, credit union or building society. This means that if a bank goes bankrupt, the Federal Government will make sure that you get your deposit back, up to a maximum amount of $250,000. Keeping some amount in cash helps reduce the total risk of your investment portfolio.
Liquidity: Liquidity is a financial term referring to how quickly an asset can be converted to cash. Shares in large, well-known companies are very liquid because you can sell them immediately on the stock-exchange and have the cash in a few days. Your house is less liquid, as it would take a minimum of a few months before any proceeds from a sale would arrive in your bank account. Cash is the most liquid asset.
Having access to some cash is important, it gives you the flexibility of being able to access money without being forced to sell your assets in an unfavourable market. For example, if you plan to spend $10,000 on a holiday this year, then it is best to keep that amount in cash. Otherwise the $10,000 you saved up and invested in shares, might be worth only $6,000 by the time you are ready for your holiday, if you have to sell in an unfavourable market.
It is important to have enough cash on hand to meet your short term expenses.Generally if you think you’ll need to access the money anytime in the next three years then it is best to keep the money in cash.
Opportunistic: If you can’t find a suitable investment opportunity, then it may be worth keeping your money in cash until you do. Then, when a suitable opportunity arises you will be ready to go.
Where to hold it?
Cash, like any other investment, needs to earn a return. The return will depend greatly on where you hold it. Your options are:
Standard Bank Account: This is the lazy option, and you’ll pay for it by way of abysmal returns. Most standard bank accounts pay interest of close to 0%.
High Interest Saving Account: This is a better option, particularly for money that you don’t need to access day-to-day, as these kind of accounts generally have limited accessibility (e.g.no ATMs). Many providers offer high introductory rates (currently around 3%). If you do take advantage of an introductory rate, make a diary note 2-3 weeks prior to the end of the introductory rate so that you can shop around for another introductory rate.
Term Deposit: A term deposit is money that you deposit with a financial institution for a particular length of time, anywhere from 1 month to 5 years. The benefit is that term deposits usually pay a higher rate (currently between 2% – 3%) than leaving your money in a standard bank account. The downside is that if you need to access the money before the end of the term, you will forfeit some or all of the interest.
Exchange Traded Funds: It is possible to invest in cash via an exchange traded fund (“ETF”). This means that you can purchase the cash ETF on the stock exchange (the same way you would a share) and get access to a number of term deposits. The upside is that someone else is managing your cash with the goal of maximising the interest rate. The downside is that you will pay a fee for this management.
Cash Management Fund: It is also possible to invest in a cash fund managed by professionals to maximise the return from your cash. Like all funds, you will pay a fee for this service.
Too much cash?
If you are a worrier, you might be tempted to hold all your assets in cash, given the low risk. However, it is possible to hold too much cash in your portfolio. Cash is very low risk, and consequently the return is also low. The bare minimum investment return that you should expect from your portfolio is inflation. The reason that $100 is worth more today than in 10 years’ time is due to inflation.
If you are earning less than inflation, then the purchasing power of your money is slowly being eroded. Over the last 20 years inflation has averaged 2.5% per year, this means that you should aim to earn at least 2.50% p.a. on your portfolio. This is not always possible with cash, as such, some of your investments should be held in other assets.
The information in this blog is of a general nature only and may contain advice that is not based on your personal objectives, financial situation or needs. Accordingly you should consider how appropriate the advice (if any) is to those objectives, financial situation and needs before acting on the advice.