This question could be answered in just one sentence, but the better answer dives deeper. Typically cash in US Dollars carries the least amount of risk of any investment type. This could be cash in a savings account, a checking account, or under your mattress. And, as investments go, the least amount of risk typically has the least amount of potential return. Some might say cash doesn’t count as an investment type, but it is undoubtedly an asset class.
So, let’s take this a step further. After cash, then what type of investment has the least amount of risk?
Cash equivalents, such as money markets and CDs, are the next riskiest, and after that, it is treasury bills. See the below graph showing this spectrum. I’m going to assume you are moderately aware of financial markets, so I won’t dive too deeply into why this is laid out the way it is.
Instead, rather than asking, which investment type typically carries the least risk, let’s ask a different question: Why are you asking this question in the first place? Is it because you only want to invest in safe investments? Is it because you’ve lost money on an investment that you thought was safer than in reality? If so, then let’s address that. Because if you are wanting to make an investment in something, yes risk is important, but so is return.
If you were going to make an investment based solely on asking which investment type typically carries the least risk, then you would just allocate to cash, or you would buy a CD yielding little. Those investment types are fine and have a purpose, but they should not be the only investments considered.
Instead, low risk investments, such as cash and cash equivalents, should be figured into your investment strategy so that it serves a purpose for you. For instance, we use cash and cash-like positions for downturn protection planning. Downturn protection planning is designed to ensure you do not need to sell off positions during a down market. The worst time to sell is when stocks are declining.
Living Off Dividends And Capital Appreciation
So, let’s say you are living off your investments. Each month you are drawing on your portfolio, living off dividends, interest, and capital appreciation. Then, a market drawdown occurs. Even though there is a market decline, you are still going to want to live your life. You are not going to want to reduce your monthly withdrawals from your portfolio just because we are in a down market. So, via downturn protection planning, we design a plan so that you can achieve that.
How do we do this? We create two “buckets” from which you can draw your money: your cash-like bucket and your investment bucket. When times are good, i.e. markets are going up, we’ll withdraw from the investment bucket, which includes dividend payments, interest, and capital appreciation. We don’t want to rely solely on dividend payments for income because a drop in share price can wipe away that yield in an instant. Also, a company’s management can cancel dividend payments at any time. Then, during bad times, i.e. markets are going down, we withdraw from the cash-like bucket.
When Stocks Decline
Instead of predicting when a market drop is going to happen (stocks decline), which is nearly impossible, we plan for it regardless of when it happens. We all know a market decline is going to happen at some point, we just don’t know when. So, let’s plan for it so we are ready for it when it does happen. And for this, we use the least risky investment type: cash or cash-like. Sometimes we will earmark a fixed income holding as a portion of it, but that just depends on the specific portfolio.
How Much Cash Should I Have?
So, how much cash should you have? First and foremost, you should have an emergency fund. Think of this as a safety net of cash held in the bank for the unexpected. This might be for a car repair or furnace repair. It might be used if you are without a job unexpectedly and need cash to live on. Typically, you should have about 6-12 months of living expenses in an emergency fund.
So, let’s say you have that. What’s the next most important reason to hold cash? For upcoming, known expenses. This might be for your child’s college tuition coming up in less than a year. It might be for a down payment on that new home you haven’t found yet. Those are all reasons to hold cash or cash-like above and beyond your emergency fund. Other than those reasons, if you are young, have consistent income, and have the risk tolerance required, investing in the equity market (the stock market) is a good idea. Time is on your side and you have the other issues covered. If there is a market downturn, it shouldn’t affect your lifestyle as long as you still have your job and won’t need to withdraw from your portfolio. You won’t have to sell in a declining market. You can ride out the storm so that hopefully it ends in the same way as past downturns of the last 100 years.
What if you aren’t young? Or, maybe you are young, but you are living off your investments. Then there is another need for your investment strategy to include low risk investments like cash, and I’ll refer you back to paragraphs 6-8 above for as to why.
So, what else should be considered? Perhaps you have heard about earning higher interest elsewhere. Or maybe you’ve read that mutual funds have a good track record. There is a lot of noise out there. The next question to ask is, how do you define risk?
What Does Opportunity Cost Mean?
Opportunity cost is a risk. Opportunity cost is defined as the potential benefits or investment gains that are missed out on when choosing one alternative over another. Said differently, isn’t it a risk if your money sits in a savings account and is not invested, missing out on potential returns? Isn’t not making a return on your money a risk? If you think so, then you might want to move further out on the risk and reward graph.
Other Types Of Risk
Risk cannot be defined strictly as volatility. Instead, there is also the risk of missed opportunities. There is the risk of not taking advantage of a longer time horizon when you are young. There is the risk of inflation. If your money sits in cash, but things keep getting more expensive, then you’re cash is becoming less valuable. There is political risk and default risk, which is why the greenback has been the safest form of cash. There is liquidity risk, too, and cash is very liquid (low liquidity risk).
So, where does cash fit into your overall asset allocation? It depends on your specific situation and hopefully this provides some insight into how we approach it and design a plan addressing it. To learn more about risk management check out what we offer. Also learn about the triple tax advantage account you need to take advantage of here.
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