Portfolio Management October 17, 2016

    Smart investors know that it's wise not to put all of your investment eggs in one basket. Spreading your investments across stocks, bonds, commodities and cash can produce a diversified portfolio with the potential to grow over time, while also helping to moderate the inevitable ups and downs along the way.

    Most investors understand how stocks and bonds can work together within a diversified portfolio. Stocks have historically generated higher returns along with higher volatility, while bonds have lower long-term returns but also lower volatility. But when it comes to cash, investors are sometimes left scratching their heads. Cash provides little return today, so some wrongly assume that including cash in their portfolio means they're not "putting it to work." That assumption, however, ignores the benefits of cash and how it works in combination with other investments.

    Cash is an important component of a diversified portfolio, providing a stable foundation and ballast when financial markets inevitably become turbulent from time to time. Each investment in a portfolio—across stocks, bonds, commodities and cash—has its own risk-return characteristics and correlation with each of the other asset classes. The way these various investments are combined in a diversified portfolio is what matters, so it's important to understand the risk and potential return of the overall portfolio as well as the role of each component.

    Don't assume that cash is a drag on returns

    It may surprise you, but a cash allocation within a diversified portfolio can help reduce risk without necessarily sacrificing returns. You can see this benefit of cash by looking at the risk and return of two portfolios—one that consists of multiple asset classes including cash and one that consists of just one asset class, large-cap stocks as represented by the S&P 500® index. As shown in Figure 1, both the diversified portfolio and the concentrated portfolio had returns of about 5.5% per year between Jan. 1, 1999 and Aug. 31, 2016.

    A diversified portfolio including dash can reduce volatilitywithout sacrificing returns

    If all that mattered was returns, an investor would be indifferent toward selecting one of the two portfolios. The point being that over the period examined the 5.5% return could have been delivered either by a portfolio with one asset class or a portfolio with multiple asset classes including cash. So cash is not necessarily a drag on returns, because it matters how the portfolio is diversified across other asset classes that might provide higher expected returns as well as diversification benefits.

    Furthermore, risk matters. When risk is taken into account, it's immediately evident that the diversified portfolio with cash was preferable to the concentrated one over the period examined. The diversified portfolio's volatility, as measured by standard deviation, was a bit less than 10%, meaning that its returns tended to range between +15.5% and −4.5%. By contrast, the all-stock portfolio had a standard deviation of about 15%, meaning that its returns tended to range between about +20.5% and −9.5%.

    The narrower range of returns for the diversified portfolio with cash means that the investor had a smoother ride than the bumpier all-stock portfolio, while still achieving the same return over the long term. You might think of it as the choice between riding in a new car with shock absorbers vs. riding in a stagecoach. Both can deliver you to the same destination, but one's likely to leave you with a few more bumps and bruises.

    What about a diversified portfolio with no cash?

    Some investors might assume that a diversified portfolio without cash would improve returns while keeping the same level of risk. However, redistributing the cash in the diversified portfolio proportionately across the other asset classes actually just moves an investor up the risk spectrum into a riskier portfolio, resulting in a portfolio with slightly higher returns—but also higher volatility. For example, without its cash allocation, the diversified portfolio shown above gained an additional 0.3% per year in return over the period examined, but at the expense of an additional 1.1% volatility per year.

    Cash helps provide ballast in turbulent times

    One of the reasons for including cash in a diversified portfolio is to provide a stable foundation because it can help to moderate portfolio declines when stocks tumble. Looking at the best and worst quarterly returns for each portfolio during the study period, Figure 2 shows that the best quarterly return for the diversified portfolio was close to that of the concentrated portfolio.

    A dviersified portfolio includig cash can help reduce declines when stocks tumble

    What really stands out, though, is that the worst quarterly decline for the diversified portfolio was less than half that of the concentrated portfolio. This is key because times of market turmoil are when people's emotions may get in the way of making sound investment decisions, causing them to panic and abandon their financial plans. A diversified portfolio that includes the ballast of a cash allocation can help investors navigate these periods of turbulence while sticking with their plans.

    Schwab Intelligent Portfolios® is built on a foundation of broad diversification

    Within any single portfolio, Schwab Intelligent Portfolios includes up to 20 asset classes across stocks, bonds and commodities, plus an FDIC-insured cash allocation. The asset classes and their allocations in your portfolio are determined by your investment objectives, time horizon and risk tolerance. We include a cash allocation because it can provide stability and diversification as one piece of an overall portfolio. Rather than being a drag on returns, cash can help to moderate volatility, without necessarily sacrificing return potential—allowing you to keep focused on your longer-term investment goals.

    For more information on the benefits of cash within a diversified portfolio, please see our white paper.

    David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios®

    The cash allocation in Schwab Intelligent Portfolios is accomplished through enrollment in the Schwab Intelligent Portfolios Sweep Program (Sweep Program), a program sponsored by Charles Schwab & Co., Inc. (“Schwab”). By enrolling in Schwab Intelligent Portfolios, clients consent to having the free credit balances in their Schwab Intelligent Portfolios brokerage accounts swept to deposit accounts at Charles Schwab Bank through the Sweep Program. Schwab Bank is an FDIC-insured depository institution affiliated with both Schwab and Charles Schwab Investment Advisory, Inc. Cash balances held in the Sweep Program at Schwab Bank are eligible for FDIC insurance up to allowable limits.


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