Cash holdings become more attractive

Returns have grown to just a little less than riskier alternatives such as options

Your Money

July 18, 2006|By JEFF BROWN | JEFF BROWN,MCCLATCHY-TRIBUNE

Read the investment news - accounts of Friday's big stock plunge, for instance - and it seems as if everyone is anguishing over risk.

Will the Fed keep raising interest rates? Will foreign stocks resume their spring tailspin? Will another jump in oil prices inflame inflation? Will second-quarter profits disappoint Wall Street?

How can an investor get some protection?

There are lots of fancy ways - by moving money from Sector A to Sector B, by giving your broker "stop-loss" orders, or by using stock options as insurance policies.

But the simplest is to keep a little more cash on the sidelines. With interest rates relatively high, this approach is a lot more appealing than it was a couple of years ago, when cash holdings earned next to nothing.

First, let's dispense with some of those alternatives.

Moving money from, say, the foreign stock sector to the domestic one can reduce the amount of risk built into a portfolio. Stop-loss orders tell your broker to automatically sell a specified investment if its price falls to a certain level, thus minimizing losses if the price falls further.

But both maneuvers can involve costs such as broker's commissions - and taxes if you sell at a profit. And amateurs take big chances when they try to time the market's ups and downs.

Lock in value

Put options give their owners the right to sell at a specified price over a given period. Thus, they allow you to lock in an investment's value, insuring against loss if prices fall. But buying puts is not cheap. And if you guess wrong, you lose all you've spent.

So ... back to cash - bank savings or money market funds, for example.

Most investors have cash reserves that ebb and flow. Maybe you generated some cash by trimming an investment that had grown to be too big a part of your portfolio. You might build up your cash by putting regular contributions - in a 401(k), for instance - into a money market fund instead of a stock fund.

Over the long term, cash is the worst investment, historically returning about 3 percent a year, versus 5 percent for bonds and 10 percent for stocks.

Why have money sitting in cash at 3 percent when stocks make 10 percent?

Because cash holdings are safe. A stock might drop 10 percent or 20 percent overnight; a bank deposit won't.

Now, thanks to the Federal Reserve's two-year series of interest-rate increases, many ultra-safe bank savings such as one-year certificates of deposit pay about 5 percent. By comparison, the Standard & Poor's 500 stock index is up only 4.4 percent over the past 12 months.

It's best to assume the historical averages will hold up, making stocks a far better long-term bet than cash. But even if you assume the averages will reassert themselves right now, you wouldn't lose much by choosing the peace of mind that a bigger cash holding can provide.

Imagine a portfolio that's 60 percent stocks, 30 percent bonds and 10 percent cash.

With those holdings returning 10 percent, 5 percent and 3 percent, respectively, every $10,000 invested would grow to $10,780 over 12 months.

Now change the allocation to 50 percent stocks, 30 percent bonds and 20 percent cash, and assume the cash return rises to 5 percent. Every $10,000 would grow to $10,750 - only $30 less over 12 months.

Cash for bargains

Cut the stock portion to 40 percent and increase cash to 30 percent, and the same returns will give you $10,700 after 12 months - just $80 less than with the classic 60-30-10 allocation.

So, with today's more generous bank and money market rates, you don't give up much by keeping a bigger chunk of your holdings in cash. And if stock prices do fall, you'll be pleased to have that cash to spend on bargains.

Having a cash cushion helps one sleep at night - and that's worth paying for if the price is right. These days, it is.

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