What investors need to know about going to cash during stock market corrections

  • Now is a good time to consider the benefits of a money market fund that yields 2 percent.
  • Cash should always be part of an investor's portfolio planning process rather than a moment of panic decision made after the Dow or S&P 500 swoons.
  • With stock prices at high levels and the bull market a decade old, considering how cash fits your financial needs makes more sense than being overconfident in the market.

Say hello to investors' new best friend — cash. It is an old friend, as well. Cash is an important part of any investor's portfolio, but how much you should allocate to it depends on a number of factors, and not all of them have to do with how old you are.

Marcos Brindicci | Reuters

For investors who resisted the urge to rebalance their portfolio as recently as a month ago, you may be feeling more than a tinge of regret right about now for not doing so, with the S&P 500 and the Dow Jones Industrial Average both sinking into negative territory for 2018 on Wednesday after setting new all-time highs just one month ago.

But with bonds also in negative territory year-to-date, as measured by the benchmark 10-year Treasury, it's important to remember that cash offers both a stabilizing force within your portfolio and a source of funds for new opportunities that come along.

Bond funds and ETFs are on track for their biggest monthly outflows in three years and first monthly outflow since December 2016, according to TrimTabs, with $23 billion pulled from bonds through Oct. 19, even as stock conditions worsened. Now that money market funds are yielding 2 percent, the "cash drag" from the days when interest rates were pegged at zero are gone. In fact, a money market position yielding 2 percent may prove to be your biggest winner for 2018.

Age isn't everything

As a financial advisor who likes to assort my clients' accounts based on time horizons and the timing of cash needs — as opposed to the old way of just based on client age or account value — I can tell you that cash and cash equivalents play a critical role in portfolio composition.

A few things to consider with regard to allocating to cash the right way.

Age is not the only determinant when it comes to it. If you're 35 and you are saving money to buy a home in less than a few years, your down-payment money should be in cash. If you are 65, retired and have a pension, your cash needs may very well be only six months' worth of expenses.

If you're 45 and you are investing every month into a retirement plan, your cash is actually the future dollars that you'll be contributing to it. When that same person reaches 60, he or she will have fewer years of contributions, so it'll make a lot of sense to move some of your current holdings to cash.

Then again, if you're like most people, you'll have different accounts with different goals. An example could be three 529 college savings plans, one for each of your three children; a checking account for bills; a savings account for unexpected emergencies and various retirement accounts. Now, if your kids are ages 4, 10 and 17, the 17-year-old's 529 will most likely have a much greater percentage allocation to cash than the 4-year-old's. The money in the savings account would most likely be in liquid, stable cash equivalents so that it could easily be liquidated without risk to principal.

"Now could be the time to reevaluate the upside of earning only 2 percent on cash versus being overconfident in the stocks that have done so well for you in a low-rate environment."

The bottom line is that there is no single one-size-fits-all way to allocate to cash.

For the retail investor — my client — cash is a part of the asset-allocation pie chart, not the whole thing. I explain it like this: A portfolio is somewhat like an accordion; its stock holdings expand and contract to the opposite of cash. This does not imply 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 or all bonds.

ETFs with biggest outflows in past month

ETF
Monthly outflow
Ticker
S&P SPDR 500 $5.4 billion SPY
iShares Russell 1000 $2.5 billion IWB
iShares Core US Aggregate Bond $2.4 billion AGG
SPDR Barclays High Yield Bond $2 billion JNK
iShares iBoxx Investment Grade $1.8 billion LQD
XTF.com, as of 10/24/2018

Investors will always have lots to be nervous about, be it the stock market, economy or their own personal finances. This is why investors need to focus on their risk tolerance and time horizon, which go hand in hand, but the time horizon is a lot easier to identify. You could take all of the risk-assessment tests in the world, but until you live through a bear market, you really have no idea what your true risk tolerance is. But keeping your cash needs set aside a year or more ahead of schedule should take care of your risk tolerance.

It doesn't matter that markets are rebounding on Thursday. This isn't about markets being up or down, by a little or a lot, the last time you checked the ticker tape. With the sharp October swoon from the September high of a very long-in-the-tooth bull market, now could be the time to reevaluate the upside of earning only 2 percent on cash versus being overconfident in the stocks that have done so well for you in a low-rate environment. I have never seen a bull market end that didn't hurt badly the most vulnerable investors. That's the way all bull markets end. And many investors may be way deeper into stocks than they ever thought their own risk tolerance would have allowed them to become.

Remember, the stock market doesn't care about your time horizons. If the value of your child's 529 goes down 30 percent, the college he or she wishes to attend isn't going to give you a 30 percent break on tuition. Under the right circumstances — and with interest rates higher — thinking of cash as a portion of an overall investment portfolio is not a sign of panic. It is an indication that investors are dealing with their own reality and how it matches up against the current market environment.

By Mitch Goldberg, president of investment advisory firm ClientFirst Strategy

WATCH:Why you shouldn't panic when stocks are getting slammed

Funds and ETFs

Latest Special Reports

  • The Edge explores the limitless potential of innovation.

  • A look at 50 private companies set to reshape the business landscape.

  • Automation, AI and machine learning will radically influence the relationship between employers and their workforce.

Squawk on the Street

Markets

Investing