Dear Member,

“Is it time for you to move to cash?” was a headline I saw on Reuters.com yesterday. Just two days earlier, I had spoken to a member who was considering putting part of his portfolio into a money market fund.

This was likely just a coincidence, but both occurred as the U.S. debt ceiling debate remains unresolved (something that may or may not change by the time you read this) and Europe is dealing with its own problems. Plus, the economy is moving along at a sluggish pace.

Yet, despite the Reuters’ headline implication that investors are moving to cash, the data suggests otherwise. Retail money market funds held $919 billion in assets as of July 13, according to the Investment Company Institute (ICI). This is down from $947 billion at the start of the year. Institutional money market funds also hold fewer assets now than they did at the start of the year.

This is not to say that there aren’t some investors who have shifted to cash. Cash allocations were at 21.5% in our June Asset Allocation Survey, the highest levels since August 2010. I have also heard from some AAII members who have decided to increase their cash allocations. But there has not been a run to cash. In fact, cash allocations remain below their historical average, according to our survey.

Cash does have an allure when times are uncertain because its reported value is not impacted by the fluctuations of the market. Your purchasing power (what a dollar can buy) will eventually be eroded, and there are risks associated with where cash is stashed, but the account balance of cash isn’t impacted by the market’s ever-changing mood. I should add an asterisk to that last sentence because there have been discussions about letting a money market fund’s reported net asset value float daily. The result would be that a fund’s net asset value could drop below a $1 per share on a given day, the so-called “breaking of the buck.”

The problem with moving to cash when market conditions are considered to be unfavorable is knowing when to get back out of cash. Selling out of stocks during the summer of 2007 and getting back into stocks in March 2009 would have been a great strategy, but few people actually did that. Thus, while you may limit your downside risk, you also risk losing out on potential gains. One of the most common mistakes that investors make is moving into and getting out of cash too late, locking in big losses and missing out on big gains.

Over short periods, an allocation to cash is not a bad thing, especially if it accounts for a small portion of your portfolio. This is particularly the case if you sold a security or fund and are trying to decide where to reinvest the proceeds. Cash also makes sense if you know you are going to have an upcoming withdrawal from your account, such as a required minimum distribution (RMD) from an IRA.

You also need to look at what you have outside of your brokerage accounts. Financial planners recommend that employed individuals have cash savings equal to several months of expenses. Retirees should also have a certain amount of savings to cover unexpected events and emergencies. If there is a large expense that you expect to incur within the next couple of years, such as a new car, you should keep those funds in cash as well. I bring this up because all of your accounts contribute to your net worth, and anyone with a savings account already has an allocation to cash. Thus, you already have some protection against the market’s volatility.

The key to portfolio risk is to find a balance between what allows you to sleep at night and what allows you to achieve your financial goals. If you want to protect your wealth against the eroding effects of inflation, you will need some exposure to stocks. Cash can provide short-term safety, but it won’t protect you against the dual threats of inflation and the risk of outliving your money.

Do you tactically shift your portfolio into cash? If so, how do you determine when to move into and out of cash? Tell us on the AAII.com discussion boards.

CDs Providing Higher Interest Rates

One of the problems with holding cash is that interest rates are extraordinarily low. Three-month Treasuries are yielding a mere 0.03%. According to Bankrate.com, the average money market fund yields 0.60%. If your goal is to hold cash for a very short period of time, you will have to grin and bear the extremely low interest rates.

But what if you want to hold to onto cash for more than just a few months? Three-year Treasury notes yield 0.69%. Five-year Treasury notes are better, but still only yield 1.53%. An alternative may be a certificate of deposit (CD). Yields for the average one-year CD and five-year CD are 0.90% and 2.14%, respectively, per Bankrate.com. CDs do not offer any capital appreciation, and you will have to consider taxes, penalties for early withdrawal and FDIC limitations, but if you are committed to holding cash for an extended period of time, they could be an option. A Time for Time Deposits explains some of the factors you need to consider, including what to look for and how to compare aftertax yields.

(The article was originally published in the December 2010 AAII Journal. If you are interested in looking at CDs, I would check with your bank and websites such as Bankrate.com for current yield information. You can also take a look at Discover Bank, which has made competitive rates available to AAII members.)

AAII.com Screens Updated

The stock screens on AAII.com have been updated with the latest results. There are over 60 strategies, based on famous investors such as Benjamin Graham, William O’Neil, John Neff and Charles Kirkpatrick.

The Week Ahead

More than 150 S&P 500 members will report second-quarter profits next week. Dow components scheduled to release results include 3M (MMM) on Tuesday, Boeing (BA) on Wednesday, DuPont (DD) and Exxon Mobil (XOM) on Thursday and Chevron (CVX) and Merck (MRK) on Friday.

On the economic calendar, the Conference Board’s July consumer confidence survey and June new home sales will be released on Tuesday. Wednesday will feature June durable goods orders and the periodic Beige Book. June pending home sales will be released on Thursday. Friday will feature the first estimate of second-quarter GDP, along with the final July University of Michigan consumer confidence index and the July Chicago PMI.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

Richmond Fed President Jeffrey Lacker and San Francisco Fed President John Williams will speak on Thursday.

AAII Sentiment Survey

Bullish sentiment, expectations that stock prices will rise over the next six months, edged up 0.5 percentage points in the latest AAII Sentiment Survey. This week’s reading of 39.9% keeps optimism close to its historical average of 39% for the second consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially flat over the next six months, fell 1.9 percentage points to 29.5%. This is a four-week low for neutral sentiment. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.4 percentage points to 30.6%. This is a four-week high. The historical average is 30%.

Both bullish and bearish sentiment are close to their historical averages. Optimism about better-than-expected second-quarter earnings is tempered by concerns about the slow pace of economic growth, the lack of a resolution to the U.S. debt ceiling debate and European sovereign debt.

This week’s special question asked what the chances were of a third round of stimulus from the Federal Reserve. Responses varied, though the largest number of respondents said the odds were low (less than a 35% chance). A smaller, but significant group said the odds were high (greater than 65% chance). Several said it was essentially a coin toss (between a 40% and a 60% chance).

Here is a sampling of the responses:

• “Depends on the economy. If the economy continues to stall, the Fed will act.”
• “High. With the economy continuing to languish, the Fed will likely provide a new round of stimulus.”
• “Hopefully low. Monetary stimuli have had very little effect on the economy so far.”
• “I think the chances are low. The economy is improving, albeit slowly. As long as there is improvement, the Fed can’t justify QE3.”
• “I think the chances are very high. As much as I favor free markets and decreased taxes, this is an upcoming election year.”
• “Stimulus efforts have not worked so far in creating employment. I doubt they will repeat the same policy.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Asset Allocation
Our asset allocation area is an unbiased educational resource for anyone interested in asset allocation and portfolio building.

AAII Investor Classroom
The Investor Classroom provides a step-by-step understanding of important investment ideas and techniques. Take an Investor Classroom “mini-course” today!

AAII Model Portfolios
AAII model portfolios provide members with stock and mutual fund research and analysis. Our ultimate goal with these portfolios is to provide you with the best of both worlds—investment ideas and investment education.

If you do not wish to receive the weekly AAII Investor Update, please unsubscribe now.

To edit your email subscriptions or to manage your profile, please go to the My Account area on AAII.com. Here you can also update your email and shipping address, change your login information and select a Local Chapter affiliation.

© 2011 The American Association of Individual Investors