Inflation tends to reduce the purchasing power of cash over time
Keeping some cash as “dry powder” may allow you to take advantage of bargains
Consider cash equivalents, but be sure they align with your strategy
The stock market has made more swings than a batter trying to get some wood on a Clayton Kershaw curveball. And like that batter trudging back to the dugout shaking his head, many market participants may be tempted to give up and stuff their cash in a mattress until they get a market that’s willing to throw them something more predictable.
This topic—cashing out stocks amid market volatility—is one that comes up during our weekly trader Q&A webcasts whenever the market starts swinging around.
Although the 4th quarter has historically been a time of elevated stock market volatility, the Cboe Volatility Index (VIX), started the final quarter of 2019 in the low-to-mid teens. Back in 2018 the VIX saw a number of volatile periods, culminating in its most whiplash-inducing day of the year—Christmas Eve—when the VIX hit 36. In fact, between October 8, 2018 and February 4, 2019, the VIX never fell below 15.
A little cash on hand can be useful, especially during a period of volatility, because volatile periods can mean opportunity as well as risk. But taking a sky-is-falling approach to investing can do more harm than good. For those thinking of cashing out stocks and loading up on greenbacks, here are a few points to ponder.
Cash Doesn’t Lose Nominal Value, But Inflation Can Erode Its Buying Power
Cash often seems like the calmest harbor in a market storm. It can feel safe, and if strict preservation of capital is your main goal, then cash is hard to beat. One big problem with that mentality: Inflation. The most recent Consumer Price Index reading showed that consumer goods prices rose at an annual rate of 1.7%. Meanwhile, the interest rate on most traditional savings accounts has been well under 1%, meaning that the purchasing power of cash would be going backward (on anything earning less than 1.7%).
Eyeing a Coming Storm? Consider Spreading Out Portfolio Risk
Diversification strategies can help investors try to reduce portfolio exposure to market volatility. It’s the proverbial “don’t put all your eggs in one basket.” One way to pursue diversification is by allocating investments across a larger range of sectors and investments to spread out risk. When the market eventually rebounds, investors can readjust their asset allocation back to its preferred status.
Shareholder interest tends to ebb and flow between sectors depending on economic cycles and changes in monetary policy. Some sectors benefit more than others. But rather than trying to guess which general areas may rise or fall, some investors make a broad allocation to many or even all of the sectors. That way if one portion of their stock investment portfolio suffers a cyclical setback, another might be at the front end of a cyclical upswing. Investors may also want to divvy up their holdings between stocks and bonds, as the values of these two instruments tend to move inversely.
Interested in Money Market Funds?
You can learn more about money market funds by visiting the TD Ameritrade Money Market Funds page. Remember that these funds are part of a much larger family of mutual funds offered at TD Ameritrade.
Keep Dry Powder on Hand
Not all cash is bad. A bit of a cash reserve can let you take advantage of price swings. Having some spare cash can let you swoop in to buy bargains when prices drop. Many self-directed investors keep at least some cash available at all times just for this reason.
Let’s use the 2018 fourth-quarter market drop as an example. When the S&P 500 fell 593 points from early October to late December, it made the average S&P component company 20% cheaper than in the third quarter.
This meltdown turned out to be a temporary blip, and many investors who invested some of their cash during that time were able to do so at relative bargain prices. Granted, past performance doesn’t guarantee future results, and the market could have just as easily deteriorated further from that point. But if you happened to have had your eye on a stock or other investment, and you were just waiting for the right price, you would have wanted that dry powder available.
If you decide to bump up your cash reserves, you might consider a few alternatives to a traditional savings account earning a paltry interest rate.
Amp up your investing IQ.
Many investors opt for one of several “cash equivalents,” such as brokered CDs, short-term Treasuries, or money market funds. Each of these investment types shares common traits with cash: typically high liquidity and a low risk of loss of capital.
But each has its own potential drawbacks. Money market funds, for example, aren’t FDIC insured (unlike most CDs and bank accounts—including the so-called money market accounts offered by banks). And although most CDs are FDIC insured, they typically come with substantial penalties for early withdrawal. So if you’re planning to use your cash reserve as “dry powder,” a CD with a long-dated maturity might not be your best bet.
Hey, Batter Batter!
Like the ace pitcher on the mound, the market serves up an ever-changing assortment, and it’s hard to know what’s coming next. Sometimes it’s a fat pitch down the middle; other times it’s a changeup or a curveball. As an individual investor, it’s up to you to be ready to respond to whatever may be thrown at you. When it comes to holding cash, consider how cashing out stocks might fit in with your objectives, risk tolerance, and investing horizon.