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The Case for Cash

As stocks soar and the risk of a correction grows, it makes sense to add more cash to your portfolio to hedge against a possible downturn.

The stock market has been on a tear this year, reaching record highs in eight of the first nine trading days. This kind of strong performance can go on for a while, but I see increasing risk of a correction as valuations climb and certain market indicators reach extreme levels.

For this reason–and others–I think now is a good time for investors to consider adding more cash to their portfolios. By cash, I don’t meet paper bills and coins. I mean very short-term fixed income holdings, such as money market and short-term bond funds. They offer conservative yield currently, but can also serve as ballast in your portfolio, adding stability in case of a market correction. 

Another plus: That cash can quickly be put to work to take advantage of potentially cheaper stock prices following a possible correction.

Cash-like investments are yielding more these days as interest rates rise–and I expect rates to keep rising in 2018. The Federal Reserve has indicated it may raise short-term rates three times this year, in addition to the three hikes last year. Plus, I expect inflation, still very low, to start to perk up.

Rising rates means that investors can potentially earn a real return (above the rate of inflation) on their cash for the first time since the financial crisis. Now the yield on the two-year Treasury is approaching 2%. For the first time in more than a decade, it is meaningfully above the dividend yield of the S&P 500, which is now just 1.84%. 

There are some risks associated with holding cash–you don’t want to overdo it. Opportunity cost is the risk that you could miss out on potential stock market gains. There is also the risk that your portfolio won’t keep up with the pace of inflation. If rates don’t move up, but inflation does, the value proposition of cash could once again become tough.

Bottom line: I think investors should take a very disciplined approach to rebalancing their portfolios this year. Take profits in stocks and corporate bonds, bringing your asset allocation back to target levels. Use the proceeds from those sales to rebuild your cash balances.

A meaningful cash position may not only generate potential income, but can cushion against volatility and set you up to take advantage of opportunities that could arise following a market pullback.

Ready to invest in what matters to you?

MORGAN STANLEY ACCESS INVESTING