It’s not a good idea to react to a down day on the market by converting everything in your portfolio to cash. If you do, odds are you’ve just taken a loss on all of your investments. What’s more, it can be very difficult to know exactly when to hop back in – and staying out means losing out on potential gains when the market does go up again.
Market Realist – Holding cash is not a good strategy in the long run, as inflation reduces your purchasing power.
Although holding US dollars (UUP) could benefit you when stock markets are down, holding them over the long term could be detrimental for your portfolio.
First of all, you lose spending power. If you’ve been holding $1,000 since 2005, it would be worth only around $821 today. This is because inflation eats into your purchasing power over time. You would have lost close to 18% if you had used that strategy. We’ve used year-over-year inflation rates based on the CPI (consumer price index) for the illustration above.
Secondly, you would have lost the opportunity to get the decent gains that equities provide. If you had invested the same $1,000 into the S&P 500 (SPY), you would have earned returns of ~75%. This is despite the deep cuts in the equity markets during the financial crisis. Although equities are more volatile (VXX) than most other assets, equities give the best returns over the long term. We’ll discuss this more in the next part.
As we saw in the previous part, investors should sit tight during volatile times and resist the urge to sell during such times. This will make sure that you capture the whole of the bull market.
Invest in US Treasuries (TLT) (IEF) and other assets to diversify your portfolio. However, Treasuries don’t provide lucrative, long-term returns like equities do, but they offer protection when equities are falling.