My wife and I currently have roughly $250,000, with half in our Roth individual retirement account (IRA) and a few small annuities, and the other half in various checking accounts and a money market account. We are both retired, have no bills and save a good amount every month. With things very uncertain right now, should we keep those few investments or cash them in? All they seem to be doing is dwindling away slowly.
-John
Economic uncertainty can increase household anxieties. When stock markets are volatile, and in what feels like endless declines, the fear of losing hard-earned money and experiencing a reduction in lifestyle quality motivates individuals to sell at low points.
While fleeing to cash may seemingly ease the pain and quell the uncertain feeling of not knowing the bottom, it can bring more painful long-term effects. Here’s the answer to your question.
If you have questions specific to investing strategies, a financial advisor can help.
Behavioral Finance and the Flight to Cash
Fleeing from investments to cash introduces two questions.
The first is this: After you exit the market, when do you re-enter? The second is this: When is the market going to recover?
Nobody knows when the market will switch from a sustained downturn to a definitive upswing. Furthermore, investors tend to overestimate their ability to time this market increase.
Market studies show that after considerable decline periods, such as bear markets, some of the best-performing days tend to occur during the early stage of the rebound period. Missing the strong performance days reduces the return of your portfolio during the recovery period and the strong market that follows.
While seizing control by selling during declining markets may ease near-term pain, the temporary good feeling may contribute to future long-term pain.
Understanding ‘Buckets’
Investors often build a retirement income that uses money from different “buckets.” The buckets represent short-, middle- and long-term income needs. Your buckets work together and have different functions to fund your lifestyle and provide confidence and flexibility during uncertain times.
Social Security, annuity income and liquid cash reserves reside in your short-term bucket. Additionally, Social Security and annuities provide guaranteed income that helps fund fundamental wants and needs based on your lifestyle preferences.
Your middle bucket consists of investments with more risk than those in your short-term bucket and less risk than those in your long-term bucket. It helps replenish your short-term bucket.
Your long-term bucket holds the most market risk and the best chance to generate a return to match or outpace inflation.
Staying in front of inflation is essential to maintain the purchasing power of your dollar and standard of living during retirement. Americans are living longer. While that’s a wonderful trend, it presents longevity risk, which includes the risk of outliving your money. Inflation and longevity risk make it imperative that investors maintain some exposure to long-term investments.
Your Short-Term Bucket
Your short-term bucket helps you manage behaviors, provides flexibility and upholds confidence during market volatility. Liquid cash positions during retirement hold one to two years’ worth of living expenses.
Coupled with guaranteed income streams such as Social Security, this bucket allows you to preserve your standard of living during market volatility while not forcing you to sell low during significant downturns.
Drawing on your cash reserves maintains your market portfolio and grants you time to participate in a (hopefully) long-term market recovery and subsequent early best performance days during the initial rebound.
Should You Flee to Cash?
When deciding whether to cash out, consider your risk capacity and tolerance, which are your ability and willingness to assume risk. Just because you are willing to assume certain risks, however, does not mean that you should.
Conversely, if you are unwilling to assume market risk, but should because avoiding it could negatively affect your goals, you should consider responsible risk. For example, staying in cash for 20 to 30 years would not address longevity or inflation risks.
A cash-reserve investment “bucket” can help your long-term bucket remain invested during market volatility, so it can capture your automated savings contributions and low-price opportunities. Your long-term bucket can then stay positioned for future growth that addresses longevity and inflation risks.
What to Do Next
Historically, timing the market has proven difficult. We have historical guidance, however, on the investment market and individual investment behavior. Investors often build a retirement income that uses money from different “buckets.” The buckets represent short-, middle- and long-term income needs. This helps maintain liquidity while sustaining exposure to the markets in your long-term accounts.
Preston Cherry, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email AskAnAdvisor@smartasset.com and your question may be answered in a future column.
Please note that Preston is not a participant in the SmartAdvisor Match platform, and he has been compensated for this article.
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Source: finance.yahoo.com