Cash is the most risk-free position in your portfolio: you can’t make money but you also can’t lose money. That’s why investors and traders shift from holding assets to holding cash when they think that the market’s risk is increasing.
Investors and traders who are starting to learn how to invest and trade want to know how much of their portfolio they should keep in cash right now. This question is especially pertinent now that the bull market in stocks only has a few years left, which increases the risk of a 40%+ bear market.
There is no absolute answer to this question. Some investors and traders like myself will hold no cash when they have a strong opinion on the market. Others will always hold some cash (e.g. at least 10%) no matter how strongly they believe in their market outlook.
You can decide what percentage of your portfolio you should hold in cash right now by considering several factors:
Let’s take a deeper look at how to decide your cash allocation based on these factors.
How much conviction do you have for your market outlook
You are going to have a different level of conviction for each and every trade.
*You should not be taking trades for which you have a very low degree of conviction. Only trade what you believe in. Do not take trades that aren’t supported by data-driven analysis. Otherwise you’re just gambling.
The benefit of having less cash when your conviction is wrong is obvious: you will make a lot more money if the market moves in your anticipated direction.
Sometimes trades that you don’t have a lot of conviction for aren’t wrong – it’s just that your timing is too early. Having more cash will allow you to average-in your entry price if the market moves against you in the short term. This decreases your risk and decreases the probability of you losing money.
Here’s an example. Traders who went long but had a lot of cash in early-2016 could have averaged-in and lowered their average BUY price. Bullish traders who didn’t have a lot of cash would have suffered larger losses in the short term.
The market stage should also factor into your conviction. The later we are in the long term trend, the more you need to question your conviction. This means that:
