Remember the cash wedge strategy

There’s no shortage of strategies advisors use to help protect and grow their clients’ portfolios. One of the simplest and ignored approaches is the ‘cash wedge’.

At its most basic, the cash wedge strategy is about keeping one year’s worth of liquidity needs from your portfolio in cash or other liquid instruments like a redeemable GIC or an Investment savings account — especially if you draw most or all your income from your investments.

Let’s look at a straightforward example: Say you have $1 million in your portfolio, and you plan to draw five percent or $50,000 a year. If that’s the case, you should always have at least one year — or in this case $50,000 — set aside in assets that aren’t subject to volatility.

Why? The current market is a perfect example. Imagine you rely on your portfolio to generate income for your lifestyle, but your investment returns have turned negative. With the cash wedge strategy, you’ll already have a year’s worth of cash you can use while you wait for markets to start growing again. If you don’t have cash on hand and the market stays down for six months or a year, you may be forced to sell and take a loss on some of your investments to generate cash.

The key to this strategy is to build your cash wedge reserve when markets are strong. Many investors are naturally resistant to setting aside a large sum of money in an up market because confidence is usually high and there’s a feeling that cash is a drag on your investment earning potential. But when markets turn negative, as they always do eventually, you’ll be happy you don’t have to sell money-losing investments just to create the income you are used to receiving.

An exception — or perhaps, variation — to this strategy applies to more conservative investors or those who have a riskier investment plan, for instance those who retire early. In either of these cases, you may want to have two or even three years of liquidity in your cash wedge just to create a larger safety net.

Another thing to watch out for: always heed your advisor’s counsel about rebalancing your portfolio from time to time, especially after years of stellar growth. Why? Another example may help: Let’s say your portfolio was balanced at 50 percent equities and, after three years of amazing returns in the market, it’s now made up of 70 percent equities. If the market suddenly take a negative turn, 70 percent of your investments are exposed to potential losses. By rebalancing your portfolio back to 50 percent when markets are flying high, you’ll mitigate losses if and when they come.

Remember to ask your advisor about implementing a cash wedge strategy for your portfolio.