Summary: The simplest way to reduce your market risk is by being less invested in the market. Going all out, this means that you sell all your holdings for cash. But there are important nuances that you need to be aware of if you consider 'going cash'.
When you buy stocks, bonds or any other financial instrument, you have exposed yourself to market risk. You have probably done this with the goal of being rewarded for this exposure in the form of a return. Below you see a visual representation of different types of exposure you can have to the market. If you are fully invested (all your capital is on the table), you have created maximum exposure. High rewards are possible but there is also significant risk.
In the middle of the graph you will see a blue mark, where your portfolio only consists of cash. Here you have no market risk but needless to say, you won’t have any chance to make money in the markets either. You can read more about the third position, short, here
Over time, markets tend to go up. But there might be times where you feel uncomfortable with how the markets are moving. You might for example feel that the valuations are too high given the economic outlook. This could be a reason to reduce your exposure by selling all or parts of your portfolio.
Another reason to go cash is flexibility. Having cash at hand means that you can act on opportunities that arise along the way. Thirdly, a cash position will enable you to absorb rising margin requirements if you invest in more complex products such as options. Lastly, a decent cash position will increase your level of comfort and confidence generally speaking.
Put another way: the stronger you believe markets will go up, the more you tend to be invested. Following that line of thinking you should decrease your exposure if your conviction declines.
If you are at a point in time where you think going cash will be the right thing for you to do for a while, let’s look at how you actually do it. The easiest answer is that you can close all your positions, i.e., sell all your financial instruments. That is the most radical solution that would leave you with a cash only position. But there are other means to reach that result.
As you can see, there are several ways to reduce your market risk – going all cash isn’t the only opportunity. The method you choose depends entirely on your view of the markets. If you are completely convinced that everything will fall, you might opt to sell everything. But if you are not so sure that we are on the edge of very strong market decline, other approaches might suit you better.
One way or the other, the amount of cash has increased on your account. And that leaves the question of what to do with it. Of course, you can just leave it there. Then you will have no market exposure and you can start investing again once you are convinced that 'the only way is up'. But be aware that inflation is eating away the purchasing power of your cash!
Another possibility is to invest your cash in a money market fund that gives (some) return on your investment, although these can also face negative returns depending on the financial outlook and the currency it is denoted in.
Going cash is one of the easiest ways to reduce your market risk. And although that simple, this method of reducing market risk is often overlooked. There are several ways to reduce market risk which don’t necessarily involve going all cash. Still, the most radical solution is to sell everything now. But other options exist depending on your viewpoint of the current market environment. Once you have a (maybe even 100%) cash position, it is clever to weigh the possibilities that exist to put that cash position to work in the lowest risk environment possible via e.g., a money market fund.
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