When the market is looking grim and all red, investors tend to get jittery. Selling your investments to cash might seem effective to cut down losses. But is that really the case? Is there really a financial benefit in doing so?
If you’re planning to sell your investments for cash, you’re subjecting yourself to three main things, namely opportunity cost, inflation risk, and locking in losses. You should only liquidate your investments if it is aligned with your investment strategies and goals.
If you are going to sell your investments for cash because of fear or unexpected cash requirements, you have failed in the first steps of your financial journey. Now is an excellent time to re-evaluate your financial goals, trajectory, and strategies as well as the basic tenet of investing. This article will further examine when and why you should/should not move your investments to cash.
When should you not move your investments to cash?
- Using cash for unexpected, emergency purposes; and/or
- Fear of losing money in a market downturn
Before anything else, let’s clear up the very first thing you should do before investing – that is, building an emergency fund. Why? Because nobody should sell their investments to cash because of unexpected expenses, especially when the market is volatile – you may sell your position at a loss. That, my dear reader, is not a smart financial move.
So, What is an Emergency Fund?
Simply put, it is money saved for unexpected expenses because, whether we like it or not, some unpleasant things happen in life, and most of the time, it comes with the financial burden.
Features of an Emergency Fund
- It should be your living expense for 3 to 6 months. But personally, if you’re starting to get serious about your investing, I would stretch it 6 to 12 months if able. But really, whatever makes you comfortable. You do you, and that’s okay. Just know that keeping so much cash in your savings account is not productive.
- Easily accessible and liquid. You can withdraw readily from a savings account or save it under your mattress. Whatever works for you, the important thing is it is liquid, and you should not pay fees to get it.
As with all things, investing and savings should serve a purpose. An emergency fund’s objective is to serve as a financial cushion. It ensures that you will follow your financial plan and strategies even with road bumps along the way.
Since we got this out of our way already, let’s move on to the other instance when you should not move your investment to cash.
Fear of Losing Money in Market Downturn
In times where markets are crazy volatile, especially on the downside, investors typically feel a stabbing feeling in their gut to run for the hills – meaning liquidate their holdings as they perceived the market to falling forever with no hope of recovery. Do you remember the basic tenet with investing or trading? No? Well, let me remind you. It is “sell to greed and buy on fear” and not the other way around.
This is an excellent time to check with yourself. Did you overestimate your risk tolerance? Is this an unnecessary fear? Maybe you should remind yourself of your goals, and although no one could really know what will the market do in the short term, the market will recover. And maybe this is a good opportunity to add to your positions.
One of the most effective solutions in avoiding this fear is not checking your investments Every. Single. Day. You have to remind yourself that you are an investor and not a trader. Investors should not constantly check their positions, especially if this investment is tied to your long term goals as the market goes up and down each day.
Some might have the stomach for these changes, but most people could make this second-guessing their decisions. But keep in mind that, base on historical data, the market, even with the downturn or bear market, will generally move up over time.
Why should you not sell your investments for cash?
Fear is not really a bad thing; however, how you act on it will heavily impact the consequences of your decisions in the future. You would not want your future self to be full of regret, right? When fear is creeping in, the following four reasons remind you why you should not move your investment to cash:
- Inflationary risk;
- Opportunity Cost;
- Uncertainty in timing the market; and
- Paper loss becoming an actual loss
1. Inflation Risk
Having a ton of cash gives you relief from the emotional burden of market swings. This might be because it seems a safe bet to not be affected by the downturn. However, even if you don’t see it, cash is defenseless against inflation. It slowly nibbles away the value of your hard-earned money. Inflation is the rate at which prices of goods and services rise. I’ve written a great article called ‘Investing To Beat Inflation? Here’s How‘ which talks you through exactly what inflation is and how to beat it!
The limited return potential or cash in a savings account… or worse, just letting it sit under your mattress – would never outrun the pace where the prices of goods and services rise. For example, $100 in the year 2000 is equivalent to the purchasing power of about $156.33 today, 2021. According to the CPI Calculator, the dollar had an average inflation rate of 2.15% per year between the year 2000 and today, producing a cumulative price increase of 56.33%.
If you have deposited $100 in a savings account with a 0.50% annual percentage yield in 2000, it would be $111.04 by 2021. Only gaining $11.04. Looking at this value, it is evident that it did not break even with the current purchasing power of $100.
In simpler terms, the $100 you saved in 2000 can only buy goods and services worth around £50 more or less in today’s day and age
If you decided to take out your investments and not re-enter the market. You will just wake up one day and the money you saved can no longer sustain you.
2. Opportunity Cost of Holding Cash
Opportunity cost is defined from Investopedia as ‘the foregone benefit that would have been derived from the option not chosen’. Simply put, it is something you miss out on when choosing one alternative from another.
In this case, it is the gain that could have been realised if you had invested in financial instruments like stocks or bonds. In relation to investments, there is two main opportunity cost of holding onto cash.
- Dividends from stocks or interest from bonds; and
- Growth through appreciation.
Dividends from stocks or interest from bonds
When investors receive their proceeds from investments, it may be in the form of interest or dividends. They can re-invest these earnings into their holdings and take advantage of compounding interest. Compounding interest is best described as “interest on interest”. To have a clearer picture of the power of compounding, let’s examine the example below:
Andre has invested $100,000 in a 10-year bond with 5% interest. Andre will receive $5,000 every year for the next 10 years. If he re-invests the $5,000 every year and not splurge it on stuff, his earning will grow exponentially.
Instead of just calculating the interest based on the principal, with compound interest, you will add your earnings to the principal and then multiply it again to the interest rate. So, by the end of year 1, Andre will have 105,000. Then multiply it again to 5% to arrive at 110,250 at the end of year 2, and it goes on and on. You can try experimenting with computations in this tool.
| Time Period | Simple interest @ 5% | Compound Interest @ 5% |
| Start | 100,000 | 100,000 |
| 1 year | 105,000 | 105,000 |
| 2 years | 110,000 | 110,250 |
| 5 years | 125,000 | 127,628 |
| 10 years | 150,000 | 162,889 |
If Andre has decided to take out his investment in the 5th year because of some crazy market volatility and just stashed the proceeds in a 0.5% interest rate savings account for the next 5 years. His opportunity cost (without accounting for the inflation, taxes, and fees) would be $32,039***. This would be the amount of money he could have earned if he did not liquidate his investments.
***$127,628 in saving bank would grow to $130,850 over 5 years at 0.5%. $162,889 less $130,850 is $32,039.
Growth through investment appreciation
Capital appreciation is a rise in the market price of an investment. If an investor bought a stock for $5 apiece, and then the stock price rose to $8 apiece, the investor has earned $3 through appreciation. Growth through investment appreciation could only be achieved when you hold onto your investment as long as you had initially planned. When you sell your investment to cash, instead of growth, it will decline in value – as discussed in the inflation risk section above.
3. Uncertainty incorrectly timing the market.
Are you confident in your skill/experience to time the market? The answer is probably No. For you to avoid losses and beat regret, you have to make two consecutive correct decisions. When to exit, and when to re-enter the market. However, the fact that you are considering withdrawing your investment when your portfolio is already deep red, you fell at the first hurdle. Remember the “buy low, sell high”? While your fear is telling you to run for the hills, you might actually be falling off a cliff.
The other correct decision you should also make is when to re-enter the market. The best time would be during market reversals or market recovery. However, even the seasoned investors and financial advisors could not effectively time the market. Usually, people who get out of the market tend to miss the best days. Jumping in and out of the market causes you to have significantly lower potential gains.
4. Paper Loss vs Actual Loss
It is easy to feel like you have lost a significant portion of your money during market downturns, but really, you haven’t. All of this red you see is paper loss.
Actual loss is only recognised when you sell your investments – meaning you cannot take back those losses anymore. It is already locked in and set in stone. However, if you just ride out the market volatility and don’t sell your position, your investments will eventually recover.
Moving your investments to cash during this time would rob you of the chance to let your investment recover.
Quick Reminder
It is very tempting to jump out of the market when faced with wild swings. All of the risk we thought we prepared for now becomes this big thing when actually faced in real life. However, a market downturn like this also presents an opportunity to check in with your current investment plan. Is it serving you well? Do you still have your desired portfolio balance? Are you diversified enough to dampen the wild swings of the market?
Ultimately, don’t make short-term decisions for your long-term goals. More often than not, this will hurt your investments, as discussed above. You shouldn’t worry about market volatility if you’re investing for your long-term goals. Keep in mind that the long term only favours those who stay invested.
We have already discussed why and when you should not move your investments to cash. Let’s move forward in the instance where it is reasonable to liquidate your assets.
When should you sell your investments for cash?
I will probably say this a million times, but identifying your financial goals and planning around them is the most essential step before embarking on your investment journey. Aside from building an emergency fund. With that being said, when SHOULD you move your investments to cash?
- You’ve already hit your key goal and need money to fund that goal; you no longer need to take a financial risk to hit that goal. One example would be investing for your kid’s university education, and the fund is invested in stocks. When they are nearing the age, and you already hit your target. It does not make sense to keep that fund invested. Although it might be tempting to hold it when the market outlook looks promising.
But before greed got a hold of you, as we cannot predict when the market will take a sour turn, you should take out your investments since they already fulfilled their purpose.
If the amount of this fund is significant and you still want to earn from it – an alternative is moving it to safer investment vehicle like recurring time deposits or treasury bills.
- Relying on your investment to cover your cost of living. You are already retiring from your 9 to 5 job! Great! You can now use your investments to cover your living expenses.
- Taking profits. When the market gave you a gift, it is okay to take it as long as it wouldn’t hurt your investments; you took a financial risk, so you could gain something out of it. It’s been a crazy ride! So go on, take that reward!
Just make sure you are not withdrawing your principal investment, and you’re not constantly taking profits to cover the cost of your life. Examples of this could be vacations, a major gift to yourself or family, or donation. Think in terms of one-time expenses.
Rebalance your portfolio instead of selling your investment for cash
The knee-jerk reaction investors get during a bear market is to sell off their investments for cash as it seems safer. But what if there is a better solution? So what is that solution, you may ask. The answer: Rebalancing. If you are not familiar with it. It is the act of selling your investments, like stocks, for another type of investment, like bonds, to adjust the allocation mix of your portfolio to match your investment goals and risk tolerance.
Instead of selling your investments for cash in a market downturn, consider rebalancing your portfolio, leaning more on safer investment vehicles like bonds. Another option is scooping in blue-chip stocks, as they have lower volatility than growth stocks and offers larger dividends.
The journey with investing is not always rainbows and sunshine. More often than not, it is a long journey filled with bumpy roads. While navigating the market during times of turmoil becomes pretty tough, what’s important is staying focused on your goals. In times like this, zooming out and looking at the big picture will help you be reminded that this is just a part of a normal market cycle. It will have its ups and downs, but it generally moves up with time.
Summary
To round up this article let’s take a look at the key takeaways we have explained earlier:
- You should not liquidate your investments because of unexpected expenses and fear of losing money in a market downturn or correction;
- Four reasons you should not move your investments to cash are inflation risk, the opportunity cost of holding cash, incorrectly timing the market, and locking in your losses;
- It is okay to sell your investments to cash if it is aligned with your investment plans like – you already hit your key goal, and taking on additional financial risk is no longer needed; and
- Instead of selling your investments for cash, a better option is rebalancing your portfolio to adjust for your risk tolerance or market outlook.