Know Your Limits

I wanted to add some color to a comment I made last week about not using crypto or precious metals as a place to store short-term cash. It’s not that these can’t be good longer-term speculative investments, just that each category is far too volatile for keeping your cash “safe”. That’s ironic because safety is one of the main justifications for owning both categories. But safety from inflation and eventual debasement of the dollar, and host of other reasons such as market structure and trading issues, are very different from ensuring your cash is available in the right amount when you need it (= safe).

First, I admit it’s tempting to buy into an investment that’s been doing extremely well. “The trend is your friend,” and other sage sayings of the investment world can be convincing enticements to just make a little extra on your cash over the next few weeks, few months, etc, before buying that car or paying your kid’s next tuition bill. These days you’re validated by friends and colleagues who’ve done the same thing. Plus, you have influencers on the socials (with expertise/opinions often tainted by conflicts of interest that can be difficult to see), and even big business and government, whose rallying cries get louder as prices rise.

You’re also validated by recent performance. Depending on when you bought your bitcoin, gold, or silver, for example, it would have done extremely well for a while. But would your timing have been right when you needed to sell to cover whatever your expenses were? Would you have sold bitcoin early last October when its value was high? Or would you have held a little too long and were forced to sell after the value had dropped nearly 40% by last weekend?

Then there are precious metals like gold and silver that trade nearly round the clock. (Bitcoin trades 24/7, but trading access to crypto and precious metals depends on how you own them, directly or via a fund that holds the actual “thing” versus futures contracts – it’s complicated.) Both have been popular lately and beat the S&P 500’s return over the last couple of years. But much of that performance occurred just last year, even last month. Prices went parabolic before having a rough go last week, Friday especially. This outperformance and subsequent decline were caused by a variety of factors having little directly to do with the fundamental value of either metal.

I mention all this not as an, “I told you so”, sort of chiding. The price of bitcoin and both metals have risen from their lows so far this week. Instead, it’s another in a long list of reminders the markets throw at us about the importance of drawing clear lines between what should be three buckets of money within your broader household portfolio: short, medium and long-term.

When storing short-term money, we simply must acknowledge the opportunity cost that comes with it. Sure, make cash work as hard as possible, but this should be done without meaningful market risk. Think of bank and brokerage CDs, and government bonds maturing in a year or less. This money shouldn’t be expected to earn what risky asset classes might earn because those are subject to wide volatility swings and come with a risk premium, and cash investments don’t. Blur those lines at your own risk.

But once we have our cash needs covered, we should venture into the realm of risk because, at least in theory, we can afford to wait out market volatility. This can be where a medium-term bucket, like an enhanced emergency fund, comes into play. Certain types of bonds with specific maturity dates can work well for this money. Or mutual funds that only buy bonds of appropriate maturities. These options usually have a higher return than cash because there’s some market risk. But the risk is less than investing in stocks and so is the expected return.

Beyond that your options are wide open. Stocks certainly, but also alternative asset classes like real estate, crypto, and precious metals if those appeal to you. All things in moderation as the saying goes, and don’t neglect diversification. Your strong conviction about these alternatives could play out within your retirement account, especially your Roth IRA, because those account types are built for the long-term and are tax advantaged. How much should you invest in alternative asset classes? Prudence suggests maybe 5% of your portfolio, but you might exceed this if you’re closely monitoring things and have your other bases covered. And if you’re paying attention, large price declines can be a time to stock up because it’s a long-term account, right?

Ultimately, every saver should at least have the short and long-term buckets working for them, perhaps adding medium-term as their personal financial complexity grows. Just keep them separate, even if in the same account. Knowing your limits should make volatility within parts of your portfolio easier to stomach because your cash needs are met without having to sell a risky investment at the wrong time.

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