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Getting to know the right "going to cash" philosophy

Cash dollars
Athit Perawongmetha | Reuters

A Bank of America fund manager survey found cash levels were at 5.8 percent in October — the highest they've been since 2001. On Wednesday, the largest weekly outflow from equity funds in five years was reported by the Investment Company Institute — close to $15 billion.

Investors are worried — about bonds as the Fed moves closer to a rate hike, about the election, and about a bull market now in its eighth year and supported by a so-so economy. The nervousness has fueled an increase in cash holdings. Hedge fund billionaires, including David Tepper of Appaloosa Management, have commented on how much cash they're holding. But famed value manager Bill Miller of Legg Mason says he's holding no cash and stock values abound.

So whom does the retail investor trust? Simple answer: None of the above. The investor should trust — and know — themselves, and understand what "going to cash" should — and shouldn't — mean.

"Investors have lots to be nervous about," said Mitch Goldberg, president of investment advisory firm ClientFirst Strategy. "But then again, for as long as I've been in this business, there has always been something to be nervous about. ... What we're really talking about is risk tolerance and how one should react to that."

If nervousness about the market is the motivation to increase cash allocation, then it should be obvious which investments that extra cash should be pulled from: the highest-risk positions.

Here are five more basics about holding cash that, for investors, it pays to understand.

1. The most important role of cash isn't downside protection — it's upside opportunity.

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, said holding too much cash will drag down performance when markets rally, but noted that it serves as downside protection and is useful when buying opportunities arise. "You want some cash available," he said. "It gives you flexibility."

Neena Mishra, director of ETF research at Zacks Investment Research, elaborated. She said the most important role that cash serves in a portfolio is that it enables investors to take advantage of opportunities that may arise suddenly.

"While cash also provides diversification and stability, holding too much cash can be a big drag on portfolio return as cash earns a negative real return. Some of this cash could be put to work if a sudden market sell-off — say, after the presidential election — results in attractive bargains," Mishra said.

There's a big caveat to this approach — the troubling result many investors experience when they go to cash. Most investors get out when it's too late and wait way too long to get back in, compounding losses and missing out on gains. But this market reality does reinforce how investors need to be opportunistic, and active in managing their portfolios, to make a move to cash rewarding. And investors need to understand the difference between buying specific assets that are attractively valued after a dip, and the odds of successfully timing the market as a whole. Those odds are stacked against them — and always have been.

2. It's not about being a market coward: Going to cash requires real guts.

Preparing to get back into stocks when there are buying opportunities isn't the only way that going to cash can be reinterpreted as a more active, or even more aggressive, approach to investing.

Goldberg believes that making the decision to go to cash means being aggressive, at least in the sense that a small allocation to cash isn't going to help much.

"A 1 percent to 5 percent cash holding probably won't change much in terms of reducing risk," he said. "Ten percent to 20 percent will help with that. Over 20 percent cash is quite a nervous reaction but not necessarily overboard. You are responsible for you, so you need to consider the extent to which you could be down in stocks and for how long; that's the essence of risk tolerance."

3. There's one question no expert can answer about a cash allocation.

Investment horizon, risk tolerance and emergency needs all make it impossible for there to be a single answer to the question, How much cash should an investor hold?

"The percentage of cash that should be in someone's investment portfolio is really impossible to give without knowing that person's circumstances," Goldberg said.

Mishra said that for most other investors, a 3 percent to 5 percent cash allocation is enough. But investors who are going to cash for opportunistic reasons — waiting for the right moment to get back into stocks — could keep a 5 percent to 10 percent cash allocation during uncertain times to give them the flexibility to buy on dips. For the nervous investor with almost zero risk tolerance, then probably a cash allocation as high as 15 percent to 20 percent makes sense. "If that helps you sleep better at night," Mishra said.

4. Age doesn't matter.

Thinking about cash in terms of risk tolerance could lead younger investors to think going to cash isn't ever for them. But it is.

Goldberg said younger investors should hope for a market retreat as an opportunity to accumulate stocks that are marked down. "Remember, every bear market has recovered and gone on to make new all-time highs. For the younger set, with many years until retirement, a down market would be more helpful than an up market," he said.

For boomers and seniors, cash is a "critical part of asset allocation," Goldberg said. But the use of cash is something that investors of all ages need to understand and implement.

"I explain it like this: A portfolio is somewhat like an accordion; its stock holdings expand and contract to the opposite of cash. Not trading, just rebalancing positions a little along the way. I advise my clients that this is a gradual process and that they shouldn't bother looking for the Sunday punch; it isn't a binary decision of either all cash or all stocks."

5. Every investor should always have an allocation to cash — just not the way the market wants you to think about it.

Goldberg said he feels strongly that raising cash could be very beneficial to investors. And in some ways, it makes more sense for individual investors than the big institutions and hedge funds that talk about it on TV, because individuals are not typically "out there hedging their portfolio with exotic securities and strategies," he said. "Their only hedge may be to sell down their stock holdings and hide in cash until they either find a new opportunity to invest in or until whatever made them nervous passes."

But there's an even more basic concept of a cash allocation, one that is more in line with basic personal finance than opportunistic investing.

Larry Swedroe, director of research at financial advisory network BAM Alliance, suggested keeping cash handy to cover living expenses, also known as a rainy day fund, which may need to be tapped for unexpected medical bills or a job loss.

"You should never hold cash because you think the market will go down," he said. "Correctly forecasting the stock market is almost impossible. Rather, you keep cash to cover a few months of living expenses. The more your labor capital corresponds to the economy, the more you should hold."

Someone with a reasonable expectation of employment stability — say, a unionized public school teacher or doctor — could get by having enough cash to cover three months of living expenses, while someone in a less-stable field should hold more. Investment portfolios, on the other hand, should hold equity and bonds, Swedroe said.

— By Joe D'Allegro, special to CNBC.com