The pros constantly tell us that the financial markets hate uncertainty. If so, investors have a lot to worry about, with a new administration taking over in Washington, the world economy dragging and international relations unusually touchy.
One investment option is to put money on the sidelines. Cash is stable and safe, though interest earnings are so paltry these days that savings actually lose money to inflation. Even with that loss, you could come out ahead if the markets drop and you’re smart enough to get back in at a good time.
But does sidelining cash really make sense? And if you do it, where should the cash go?
Advisors typically recommend sticking with the long-term plan through thick and thin rather than reacting to short-term market swings.
“Part of my job as a financial planner/advisor includes preventing clients from getting overly emotional when it comes to investing. In other words, I try to prevent my clients from buying high and selling low,” says Michael Cirelli, a financial advisor at SAI Financial Services in Warrenville, Illinois.
[See: 7 of the Best Stocks to Buy for 2017.]
He says he’s generally optimistic about the financial markets, but has some pessimistic clients who want to play it safe. He often recommends building cash by unloading holdings that have losses or only small capital gains because that helps reduce taxes.
Andrew D. Martin, president of 7Twelve Advisors in Nashville, says he also urges clients to stick with a long-term plan and to be realistic about rough patches. But he says clients also too often ignore the prospect of loss.
“The problem is that clients are not asking, they do not seem to be worried,” Martin says. “They say the stock market climbs a wall of worry. This was certainly the case from March of 2009 for the next two or three years. But lately all the talk is Dow 20,000, Dow 30,000, even Dow 100,000 — not Dow 10,000.”
Martin says it is wise to keep 8 percent of a portfolio in cash, and prefers money market accounts and a “laddered” portfolio of certificates of deposit from short to long term. The short-term CDs provide quick access to funds, while the long-term ones pay a bit more but typically have penalties for early redemption.
Investors who want to trim can take various approaches.
The tax-efficient approach. You can trim holdings in a 401(k) or IRA to avoid tax on investment gains. Just be sure to keep the cash in the account — by using a money market fund, for example — to avoid tax and penalty on a withdrawal. If the trim must be in a taxable account, look for blocks of shares bought at the highest price in order to book a tax loss or minimize the taxable gain. You must tell your fund company or brokerage to do this at the time you order the sale, and not just claim to have done so afterward, in case the IRS asks.
[See: 20 Awesome Dividend Stocks for Guaranteed Income.]
Across the board. An investor happy with her holdings for the long term but looking to put a little cash on the sidelines can simply trim each holding by the same percentage. This does not have the tax efficiency mentioned above, but will preserve the portfolio’s risk-and-reward characteristics.
Diverting new money. If the goal is to build a cash position gradually, you can divert into cash any fresh money that would otherwise go into stocks or bonds. That includes interest and dividend earnings, capital gains distributions, automatic 401(k) contributions and any other funds you invest regularly or as one-time infusions.
Cash is a broad category that covers various options, from super-safe to slightly less safe but more generous:
Bank savings. Money that needs to be very safe can go into federally insured bank deposits like savings, checking and money market accounts. You’ll earn almost nothing, but that won’t look so bad if the stock market plunges and your cash has kept its value.
[Read: 4 Facts Investors Should Know About Bonds.]
Short-term bond funds. Corporate and government bond funds with average maturities of a year or less are not as safe as bank savings but probably more generous. Bonds with short maturities hold up well against negative factors like rising interest rates. Look for funds holding bonds with high credit quality.
An investor who feels large conversions to cash are in order probably should review the overall asset allocation, get on target and then hold steady, most experts say.
“The reality is that 99 percent of the time, the right thing to do is stick with the plan you’ve laid out and not react to short-term events,” says Ryan Frailich, founder of Deliberate Finances, a financial planner in New Orleans.
“There are mountains of research showing the average investor return lags far behind the return of the overall market, and the reason for this gap is investor behavior,” Frailich says. “When we let our own biases or political opinions dictate investment strategy, it often ends up costing us.”
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How to Build a Cash Reserve originally appeared on usnews.com
