Cash is the most risk-free position in your portfolio: you can’t make money but you also can’t lose money. That’s why investors and traders shift from holding assets to holding cash when they think that the market’s risk is increasing.
Investors and traders who are starting to learn how to invest and trade want to know how much of their portfolio they should keep in cash right now. This question is especially pertinent now that the bull market in stocks only has a few years left, which increases the risk of a 40%+ bear market.
There is no absolute answer to this question. Some investors and traders like myself will hold no cash when they have a strong opinion on the market. Others will always hold some cash (e.g. at least 10%) no matter how strongly they believe in their market outlook.
You can decide what percentage of your portfolio you should hold in cash right now by considering several factors:
- How much conviction do you have for your market outlook?
- How much successful experience do you have trading and investing?
- What are your portfolio’s goals?
- What is your financial situation?
- How many good trading and investment opportunities are available today?
- How high is inflation right now?
- What financial products are you trading or investing in?
- What is your trading or investment time frame?
Let’s take a deeper look at how to decide your cash allocation based on these factors.
How much conviction do you have for your market outlook
You are going to have a different level of conviction for each and every trade.
- There will be some trades for which you have a very high degree of conviction. Almost all the factors support your case, and you can easily refute the factors that go against your market outlook.
- There will be some trades for which you have a relatively low degree of conviction. Most of the factors support your case, but you can’t easily refute the factors that go against your market outlook.
*You should not be taking trades for which you have a very low degree of conviction. Only trade what you believe in. Do not take trades that aren’t supported by data-driven analysis. Otherwise you’re just gambling.
- The more conviction you have for a trade, the less cash you should keep.
- The less conviction you have for a trade, the more cash you should keep.
The benefit of having less cash when your conviction is wrong is obvious: you will make a lot more money if the market moves in your anticipated direction.
Sometimes trades that you don’t have a lot of conviction for aren’t wrong – it’s just that your timing is too early. Having more cash will allow you to average-in your entry price if the market moves against you in the short term. This decreases your risk and decreases the probability of you losing money.
Here’s an example. Traders who went long but had a lot of cash in early-2016 could have averaged-in and lowered their average BUY price. Bullish traders who didn’t have a lot of cash would have suffered larger losses in the short term.
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The market stage should also factor into your conviction. The later we are in the long term trend, the more you need to question your conviction. This means that:
- You should hold more cash during the final leg of a bull market. This is because there’s a bigger possibility that the long term trend will reverse sooner than you expected, so you should be more concerned about short term losses.
- You should hold less cash during the first-middle legs of a bull market. This is because there’s a smaller possibility that the long term trend will reverse sooner than you expected, so you should be less concerned about short term losses.
If you don’t hold more cash towards the end of a bull market, at least reduce your leverage the way we did.
How much successful experience do you have trading and investing.
New traders and investors should hold more cash than experienced traders and investors. And by “experience”, I don’t refer to how many years you’ve been in the markets. “Experience” refers to the number of successful years of trading and investing you’ve had.
Consistently profitable traders and investors should hold lower levels of cash in their portfolio. The probability of them taking a big loss on a single trade is smaller.
Conversely, new and inexperienced traders/investors should keep a higher percentage of their portfolio in cash. It’s normal to make more mistakes when you’re new to the markets or don’t have much successful experience. Holding more cash reduces your risk in the event that a trade/investment “blows up”.
Keeping more cash reduces your potential profits but also your potential losses. Consistently profitable investors and traders should focus on increasing potential profits. Beginners should focus on decreasing potential risks. All it takes is one major mistake to blow up your portfolio. You can’t make a comeback from $0.
What are your portfolio’s goals.
Trading and investing is about finding a balance between risk and reward. It is not possible to increase one (e.g. reward) without increasing the other (e.g. risk).
What we do is increase risk and reward disproportionately. For example, the Medium-Long Term Model‘s trading strategy increases potential reward by 6x but only potential risk by 2-3x.
This doesn’t mean that it’s a good idea to increase risk and reward disproportionately forever. Increasing both risk and reward disproportionately becomes dangerous past a certain point. That “certain point” depends on your portfolio’s financial goals.
- You should keep a smaller percentage of your portfolio in cash if your goal is to maximize long term performance.
- You should keep a bigger percentage of your portfolio in cash if your goal is to achieve a stellar but safer long term performance.
Here’s what I mean.
You can create a wonderful model for investing and trading. But the markets are not driven by scientific laws. It is impossible to predict every major market movement. This means that there is always the possibility that a “never happened” before event will happen.
An October 19, 1987 crash did not happen before it happened (the S&P 500 fell 22% in one day). Traders before 1987 who thought “it’s impossible for the stock market to fall 20% in one day” would have been wrong and lost a lot of money in 1987.
Having more cash allows you to be ready in case these never-seen-before events happen in your lifetime. Holding more cash will lower your long term performance, but at least you will never face the prospect of being wiped out by a “sky is falling” event. Because the sky does fall once in every few generations. The Great Depression is not a fairy tale. The 1987 crash could happen again. You never know.
People who are older or who have families have a lower tolerance for risk. Everyone love’s large returns in their portfolio, but these people can’t afford to take such high risks. It’s not a good idea to hold no cash and potentially jeopardize your family’s financial future just for the sake of potentially higher returns.
What is your financial situation.
- People who are more financially stable should keep less of their portfolio in cash.
- People who are less financially stable should keep more of their portfolio in cash.
For starters, everyone should have emergency savings. These savings should be placed aside from your portfolio in case some personal emergency arises.
However, it’s not possible to always prepare for every personal emergency. Perhaps you have a sudden medical bill that costs hundreds of thousands of dollars. No one is going to always keep $200k in their bank account. That’s why these sudden disasters often force investors and traders to dip into their portfolio, liquidate assets and raise cash.
The danger here is that you could be liquidating assets at the worst time possible. Many investors and traders who lost their jobs in 2008 had to sell their stocks at the bottom of the stock market crash just to make ends meet at home. Their portfolios would not have lost so much money if they had just been able to hold onto their stocks for a few more months.
The more financially stable you are, the less you have to worry about dipping into your portfolio to raise emergency cash. Hence you can keep a bigger percentage of your portfolio in assets and a smaller percentage in cash.
The less financially stable you are, the more you have to worry about dipping into your portfolio to raise emergency cash. Hence you should keep a smaller percentage of your portfolio in assets and a bigger percentage in cash. You must be more prepared for the worst case scenario because you don’t have as big a buffer to fall back on in case the worst case scenario happens.
How many good trading and investment opportunities are available today.
Some investors and traders always feel the need to “be in the market”. This is silly. There’s no point in being in the market when there are no good opportunities. Cash is a position too! Cash might not make you money, but at least holding cash won’t lose money when the entire market is crashing.
There will be times when good investment and trading opportunities seem to be everywhere. This is generally near the bottom of a bear market when markets and assets are insanely undervalued. You should hold very little cash during times like these and become close to fully invested.
There will be times when good investment and trading opportunities seem to be scarce. This is generally near the top of a bull market when markets and assets are insanely overvalued. You should hold more cash. There’s no point in making an investment or trade when the risk is very high.
This is why Warren Buffett raises tens of billion of dollars in cash towards the end of bull markets. He doesn’t see many good investment opportunities, so he raises cash to ride out the coming storm.
Holding more cash right now allows you to take advantage of new opportunities when they present themselves. Imagine the cash in your portfolio as bullets. The more cash you have, the more bullets you have to take advantage of good opportunities that arise in the future.
Imagine cash as an opportunity cost. The opportunity cost of holding cash is high when there are a lot of good investment and trading opportunities. The opportunity cost of holding cash is low when there are few good investment and trading opportunities.
How high is inflation right now
Cash loses its value over the long run because inflation eats away at it. That’s why $100 today is worth far less than $100 from 30 years ago.
Holding cash is not a problem when inflation is low. There’s no point in investing in something just to “beat inflation” if inflation is e.g. 2-3% a year. The cash that you hold will retain most of its value over 1-2 years.
Holding cash is a problem when inflation is high. High inflation eats away at cash, which means that holding a lot of cash in your portfolio will lead to large losses in real terms (inflation-adjusted). This chart demonstrates how high inflation can go historically.
- Hold more cash if inflation is low right now. There’s no real harm in holding cash.
- Hold less cash when inflation is high right now. Holding cash = losing money in real terms.
What financial products are you trading.
Some financial products force you to hold more cash. This is not the case with stocks, ETFs, or options. You risk only what you have in the position.
Futures traders need to hold cash to prevent the possibility of a margin call. This is the nature of futures as a financial product. The more you trade futures, the more cash you will need to keep in your portfolio.
What is your trading or investment time frame?
- Traders and investors with longer time frames should hold a smaller percentage of their portfolio in cash.
- Traders and investors with short term frames should hold a larger percentage of their portfolio in cash.
The longer your time frame, the less you should care about day-to-day fluctuations in your portfolio’s value. Short term losses are more acceptable to long term traders. Whereas short term traders need to hold cash in order to average-in after the market falls e.g. 5%, long term investors have no need to hold cash for averaging-in after the market falls 5%. Longer term investors are generally unfazed by short term movements in the market.