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This article appeared in the September 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Holding cash and shares in a portfolio can boost returns and aid diversification.

Photo of Nerida Cole By Nerida Cole, Dixons

Many investors are re-examining the role that cash plays in their portfolio. Increasing a portfolio's allocation to cash enables investors to boost their flexibility in volatile markets and widen diversification, as well as protecting their capacity to cover living expenses.

Cash, unlike shares, is a very defensive asset and does not fluctuate in value (except against other currencies). An investor should always allocate some funds to cash because it contributes to a portfolio's diversification, increases overall protection of capital and, importantly, increases adaptability to changing market conditions. As a highly liquid investment, cash is accessible quickly, usually within 24 hours, and with minimal or no transaction costs.

Differentiating between cash and cash-like investments is important because the risks are not the same. Many cash management trusts or cash investment accounts are actually made up of cash-like investments that include short-term money market securities such as bank bills, which are generally purchased for a 30-day to 180-day term. The value of these securities is primarily affected by movements in interest rates as well as the credit risk of each underlying issuer.

Investors using cash-like investments can inadvertently take on a higher level of risk than they realise. Investors need to be aware that the risks and returns of cash-like investments can be more variable than those of bank deposits. Additional returns received should be commensurate with the additional risks involved.

This can affect superannuation fund members because many industry and retail super funds only provide access to cash-like investments. Trustees of self-managed super funds (SMSFs) and individual investors do not need to face this same limitation as they are able to access a much broader range of investments. SMSF trustees are able to take advantage of cash accounts backed by the Federal Government's Financial Claims Scheme (FCS), commonly known as the government guarantee, to improve the security of their capital and achieve good levels of interest.

The FCS was instituted in October 2008 in response to the collapse of several high profile banks worldwide during the global financial crisis. It is currently capped at $1 million per depositor per authorised deposit-taking institution. The Government recently released a consultation paper containing recommendations that the cap be reduced to between $100,000 and $250,000. The current government guarantee on cash accounts runs to October 2011.

Finding the best deals

Investors are able to access rates of up to around 6 per cent per annum across various cash accounts with banks and building societies. However, investors often need to hunt around, or employ an adviser, to ensure they get the best cash rates and quality on offer.

Reputable portfolio managers can really add value in this area by looking at the global macro conditions and assessing the effect that interest rate changes may have on cash accounts compared to short-dated term deposits. Facilities that allow surplus cash to be swept to higher-yielding accounts also helps time-poor investors make the most of their portfolios.

Retaining a portion of an investment portfolio in cash enables investors to continue covering personal expenses without the need to sell other investments. Holding an appropriate weighting to cash can be critical during market downturns and extended periods of volatility. For investors in the final stage of a wealth accumulation phase and approaching the time when they need to access funds (for example, paying private school fees or retirement income) it may be wise to build a pool of cash in preparation.

Assessing how much cash is needed

Determining exactly how much cash to hold will depend on an individual's personal circumstances. Investors may use an investment time horizon approach to their overall asset allocation. This requires funds to cover expenses anticipated in the short term, one to two years, to be held in cash. Funds for medium-term expenses should be held in defensive investments such as bonds or preference shares. Funds not required over the long term should be invested in growth assets such as equities.

Some professional portfolio managers will advise investors to hold up to three years' of personal expenses in cash to cover day-to-day living, investment and accounting fees, and short-term lump sums for one-off purchases. Dividends received on the growth part of the investor's portfolio can be used to top up the cash account throughout the year. This approach can minimise the need to sell equity investments to provide cash flow in the event of a market downturn.

Another common approach used to establish how much to allocate to cash is to undertake an assessment of the investor's tolerance to risk. This would normally include prioritising the desire to protect capital against growing the portfolio above inflation. Keeping in mind that cash provides no capital growth; the value of funds held purely in cash will be eroded over time by inflation. To protect against this, investors should consider the suitability of growth investments such as equities.

Setting priorities helps to guide portfolio managers on how much of the portfolio should be allocated between equities and cash. A professional adviser is likely to use a combination of these approaches.

Allocating a portion of your investment portfolio to cash not only improves liquidity and reduces risk, but can increase the overall return of the portfolio. Investors who hold a level of cash to cover living expenses and short-term needs over two to three years are more comfortable during volatile markets and are likely to end up on top both financially and emotionally.

Further, an allocation to cash within an investment portfolio can be beneficial as part of a long-term portfolio management plan to allow further equity purchases when prices are attractive. Cash may then be topped up as other equity investments are sold, either to take profits or as part of a disciplined portfolio rebalancing strategy. As investors leave the market, this can provide particularly attractive opportunities for value investors and speculators to take advantage of an anticipated market recovery.

Although cash investments may seem straightforward, it is important that investors seek professional advice. A reputable portfolio manager or adviser will ensure a portfolio is suited to an individual's needs and includes the necessary amount of cash to manage volatility, cover liquidity needs and improve overall portfolio performance.

About the author

Nerida Cole is Head of Financial Advisory at Dixon Advisory, a leading wealth-management advisory firm.

From ASX

ASX Interest Rate Securities provides useful information for those who want to learn more about fixed-income products, such as:

  • Corporate bonds
  • Floating notes
  • Convertible notes
  • Hybrid debt securities.

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