Why you should hedge your portfolio with cash

Julie Brownlee, Fsp Invest, 11 Jul. 2014

Tags: inflation, cash, investing, effect of inflation on cash, deflation, holding cash, cash and high inflation, hedge your portfolio, role of cash

It may come as a surprise, but cash can serve as a good hedge in your portfolio. Including cash as part of a diversified portfolio reduces your overall risk.

Why? Because cash comes with very little risk. And this offsets investments you have in higher risk assets, such as shares.

But by holding cash, are you not at risk of inflation nibbling away at it? Let’s take a closer look…

How cash responds when inflation is falling

Different assets act differently to periods of high inflation or periods of falling inflation.

For example, when prices are falling (deflation), this is generally bad news for assets like shares and gold. But in times like this, bonds and cash do better.

Why is that?

This is because in deflationary times, the real value of your rands increases, meaning your rands go further.

You choose to invest your money because you want it to grow, Phil Oakley in Money Week explains. You want to increase its purchasing power. So when prices are falling, holding cash can make good financial sense.

But what about when inflation is on the rise? Surely your cash is better off in the market?

Why cash makes sense when inflation is rising

When inflation is increasing, the opposite is true. Your rands won’t go as far as inflation makes the cost of living more expensive.

In times like this, like at the moment, it can seem a better option to invest your cash in other assets like shares, gold and property.

Yet studies show that holding cash when inflation is rising might not be as bad as you might think.

Let’s take a look at one of these studies…

In the 1970s in the UK, inflation rose to a staggering 13%! That’s double the current rate of inflation in South Africa at the moment.

Interestingly, the real return on cash was the same as the real returns on shares over the period, even though shares would have been the obvious choice to keep your cash.

Why is that?

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Well when inflation starts to climb, central banks tend to increase interest rates to try and control it. This means, if you have money in the bank and interest rates go up, your money earns a better rate of return.

Holding a portion of cash as part of your investment portfolio makes financial sense, whether inflation is on the rise or falling.

So there you have it, why you should hedge your portfolio with cash.

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