With online savings accounts and money market funds offering attractive returns for the first time in years, some investors may be considering increasing the cash positions in their portfolios. Stock market returns have been volatile over the past year, and with a possible recession on the horizon, some may view cash as a safer alternative to stocks.
However, selling stocks to maintain cash is not a decision you should make lightly. If you are considering withdrawing money from the stock market, carefully evaluate these five factors before doing so.
What to consider before taking money out of stocks
1. Short and long term goals
Before you swap stocks for cash, it’s probably worth reminding yourself why you invested in stocks in the first place. Stock market investments should be held as part of a long-term investment plan, which means you shouldn’t expect to need the money for at least five years or even longer.
However, sometimes goals change, so it’s important to reevaluate them regularly. Stocks are often held as part of retirement planning, which for many people will take decades. In this case, selling stocks in favor of cash could harm your long-term returns and put you at risk of not achieving your investment goals.
However, safety should always come first with money kept in an emergency fund. The purpose of an emergency fund is to have the money there when you need it, so it’s best to keep this money in FDIC-insured accounts. High-yield savings accounts are great options and typically offer higher annual percentage rates (APYs) compared to brick-and-mortar banks. Check out Bankrate’s list of the best high-yield savings accounts to find the best online savings account for you.
Finally, ask yourself or a financial advisor whether your overall portfolio still fits your goals. If so, it’s probably better that you stick to your plan rather than jumping in and out of the market. Time in the market is better than timing the market.
2. Tax consequences
If you hold stocks in a taxable investment account, selling them will likely have tax consequences. For shares sold at a profit, you will have to pay capital gains tax, which will eat into the profits you have earned. Selling investments at a loss can result in tax savings, but you also lock in these losses and cannot recover unless you get back in at the right time.
You don’t have to worry about the tax impact if your investments are held in tax-advantaged accounts like traditional or Roth IRAs, but there are still things to consider before you decide to move all or part of your portfolio to cash.
3. Market timing is difficult
Often the reason you want to move money out of stocks and into cash is because you think the market is headed for a downturn and you think you can avoid this by holding cash. But this strategy is known as market timing, which has not been a successful investment approach in the long term.
Market timing refers to the idea that you can avoid losses and take full advantage of the market’s gains by buying and selling at just the right times. It sounds great in theory: who wouldn’t always want to buy low and sell high? In reality, it is virtually impossible to actually do this. People worry about more recessions than are actually happening, and stocks often turn positive before the economy actually improves after a recession. You are mistaken if you think you can predict every move in the stock market.
Sticking to a long-term investing approach and regularly contributing to retirement accounts is likely a more successful strategy than market timing. Train yourself to understand that market downturns are a normal part of long-term investing, and try to take advantage of them by increasing investments during these times rather than avoiding them altogether.
4. Inflation
With high-yield savings accounts offering yields of around 4 percent and other short-term fixed income securities also offering higher interest rates than they have in a long time, it’s only natural that you’d be attracted to the decent returns offered by these safer investments. But it’s important to remember that as long as inflation remains above these levels, you are actually losing purchasing power by holding them.
Of course, earning 4 percent with 5 percent inflation is better than earning nothing, but your actual return is still negative. With a potential recession looming, people often talk about the need to hold cash to prepare for the recession, but cash has a bad reputation as a long-term investment.
“All I can tell you is that the worst investment you can make is cash,” legendary investor Warren Buffett told students in the wake of the 2008 financial crisis. “Cash will become less valuable.”
5. Alternatives to holding cash
If your exposure to the stock market makes you nervous or you want to position your portfolio for some protection in the event of a recession, there are some other steps you can take besides switching to cash.
- Defensive stocks: By shifting your portfolio out of areas that may be hardest hit during a recession, you can avoid pain without exiting the market completely. One strategy we can pursue is moving away from cyclical stocks and increasing exposure to relatively safer sectors such as consumer staples and utilities.
- Asset allocation changes: You may also consider reevaluating your overall asset allocation. If your current level of stock ownership makes you uneasy, consider increasing exposure to bonds or other assets such as real estate through real estate investment trusts (REITs).
- Portfolio rebalancing: Regular portfolio rebalancing can also be a way to profit from market downturns. When stocks fall, they become a lower percentage of your overall portfolio, all things being equal. By rebalancing a certain percentage of your portfolio, you can take advantage of low prices without turning to cash.
In short
Moving your portfolio from stocks to cash is an understandable instinct when savings rates are high and there are concerns about a possible recession. But it’s important to remember that stock investments are part of your long-term plan and selling can have tax consequences. Jumping in and out of the market has not been a successful strategy in the long term, and cash will almost certainly be a losing investment over time.
To reduce risk in your portfolio, consider shifting your asset allocation to defensive sectors of the economy or other assets that can outperform stocks in a recession.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.