(Originally published on ValueWalk March 10, 2020)
Volatile markets can be scary. Even for investors who understand that long-term investing is the most proven way to earn returns, watching a sea of red engulf your portfolio can be nerve-wracking. Maintaining the mental stamina required to stay the course and not sell requires fortitude.
With cases related to the novel coronavirus cropping up all over the world, markets have been in panic mode. No one knows what the economic impact will be of the virus or the widespread quarantines that many expect will shut down more cities like Hong Kong and Tokyo.
The Importance Of Maintaining A Cash Cushion
The stock and bond markets can be volatile; that’s a fact of life. No one can control or predict where markets will go or when they will go there. Over the course of an investor’s lifetime, stocks will go up and down, often for reasons unrelated to company fundamentals. That’s why it’s crucial to maintain a cash cushion.
A cash cushion is different from an emergency fund, which you should also have. An emergency or rainy-day fund segregates a year’s worth of living expenses in a savings account (ideally a high-yielding one). This fund is designed for true emergencies: losing your job, unexpected medical bills, or a surprise house move or repair. It’s savings, not investments, because it should be in completely liquid cash so that it’s easy to access rapidly if you need it.
A cash cushion is the next step in your financial fortress and serves two purposes. First, it’s a psychological buffer against worrying about losing money in a market downturn. When the market becomes volatile, you can feel comfortable ignoring those gyrations because you know you have enough cash in the bank. It also allows you to avoid selling at the wrong time—when everyone else is selling. While others are panicking, you can stay invested, which historically has been the smart long-term strategy.
Second, a cash cushion functions as “dry powder.” You can use it to buy more of positions you believe in during a downturn—or keep it waiting until you see value in buying more. In markets like these, having the ability to buy when you feel an investment is cheap can be the difference between strong long-term performance and a lagging portfolio. While few investors can time the market, dollar-cost-averaging has proven to be an effective strategy. Having enough cash on hand to stick with that strategy and keep buying on a pre-determined periodic basis, even while others are selling, can lead to better returns over time.
Keep Pace With Inflation
If cash can be such a helpful asset to have, why don’t more people follow this strategy? The trouble with cash as an asset class is that it drags down your portfolio’s overall returns. Typically, cash barely keeps pace with inflation—and often lags it. The national average interest rate on a savings account in the U.S. is ten basis points, or 0.10%. That’s essentially zero, and far below inflation. This means that for most people holding cash, they lose purchasing power each and every year.
To make your cash more competitive and keep pace with inflation, the most logical place to keep it, by far, is in a high-yielding online bank savings account. Since online banks don’t have branches, their costs are lower, allowing them to pass some of these savings along to their customers in the form of higher interest rates. Banks that are FDIC-insured are safe options for holding cash since as long as you keep your balances below the FDIC insurance limits at each bank, your deposits are backed by the full faith and credit of the U.S. government. From there, you want to make sure you’re tracking which of these banks will offer the highest yield on your cash.
Rates change frequently, so you’ll want to monitor your online savings banks closely to make sure you’re always getting the best rate. Solutions like MaxMyInterest.com track changes in rates and can help you earn more on your cash automatically.
The Coronavirus Panic
If you’ve been earning a decent yield on your cash, and you have enough both for an emergency fund and a cash cushion, you’re in a good situation when a natural disaster like the new coronavirus causes markets to fall. You’ll be able to avoid selling your stocks in a panic because you know you have cash available to meet your expenses. It’s rarely a good idea to join the hysteria when other investors are rushing to get out of stocks, and cash will give you the discipline to avoid selling in a panic. You’ll also be free to buy more shares as the market goes down. Remaining invested and adding to positions methodically has proven to be a time-tested way to generate better returns on your portfolio over the long term.
Everyone holds cash somewhere—it’s the one asset class every investor and household has in common. How you manage your cash can make a big difference in times of volatile markets.