According to Cornell Law School, an investment is "to put money in a certain manner so that it will generate revenue, such as investing money into a business, property, securities, a house, stocks, etc. with the purpose of generating income and obtaining a profit." Individuals invest for countless reasons, namely capital appreciation and wealth preservation.
For investors, one of the most important financial decisions is when to exit an interest in a business, property, or security. Read on to learn more about the three times where closing or cashing out of an investment makes financial sense.
What Is A Cash-Out?
Cash-out has multiple meanings, with one being local to real estate and the other being a connotation regarding investing. Generally speaking, a cash-out is the act of converting noncash assets to cash. Essentially, it is a liquidation of assets. For active traders and investors, cashing out is the buying or selling of forex pairs, shares or cryptocurrencies.
As the phrase pertains to real estate, a cash-out refers to refinancing one's house and taking a lump sum payment for the home equity. Homeowners accomplish this by renegotiating the loan term of an existing mortgage and a payout amount (hopefully at a lower interest rate). Known as cash-out refinancing, the process is a popular endeavour when home values are high and interest rates are low.
For active traders, the general definition of cash-out applies; it is the act of closing out an open position. Consider this example sentence for context: Erin the euro trader is cashing out of a EUR/USD long for 500 pips.
3 Times To Cash Out Of An Investment
Depending on the asset class and situation, there are countless reasons to exit an investment. Many are personal, such as paying off credit cards or scheduling home improvements.
In any market, there are three times to cash out of an investment: to realise gains, limit systemic risk exposure or react to a change in sentiment. Below is a brief look at each situation.
One of the best reasons to cash out of an investment is to realise gains. It's important to note that when an asset or market position appreciates, the gains go unrealised until the position is liquidated. Upon liquidation, it's time for the investor to cash in and pad their bank account with the proceeds.
No matter if one is liquidating a paper asset such as shares or a tangible one such as a home, the process for realising gains is the same. Essentially, an asset is sold for a higher value than when it was bought. Here are two instances where gains from a tangible and financial asset are realised:
- Financial: Erin the euro trader buys five lots of the EUR/USD at 1.0000 using margin furnished by forex broker lines of credit. In the subsequent six months, the market rises to 1.2500, at which time Erin sells five lots of EUR/USD. A 2500 pip profit per lot is locked in; the net realised gain is the position's total gain minus the six month accrued rollover fees.
- Tangible: With proceeds from the EUR/USD trade, Erin decides to purchase a home for US$500,000. Two years later, the home's value grows to US$750,000, at which time Erin sells. After she pays off the mortgage loan, underwriting fees and closing costs subtracted, Erin locks in a tidy profit.
Limit Risk Exposure
Another reason to cash-out of an investment is to limit risk exposure. As markets evolve, whether in forex trading or real estate, conditions change. What looks to be a good investment one year can become a cash drain the next. When faced with uncertainty, many investors take action to minimise risk.
There are myriad factors that can boost uncertainty and market risk. A few examples are geopolitical angst, natural disasters or central banking monetary policy. Each of these market drivers can impact the values of both tangible and financial assets.
To illustrate, assume that Erin is holding a long position in the EUR/USD and has bought another house. Erin is growing concerned about risk exposure in both positions; U.S. inflation is robust and the United States Federal Reserve (Fed) is expected to begin raising interest rates to restore pricing stability. Erin employs two cash-out strategies to manage the risk:
- The EUR/USD long position is closed to eliminate exposure to hawkish Fed policy. Through cashing out of EUR/USD buys, the risk posed by a strengthening of the USD driving rates down is mitigated.
- Before interest rates go up, Erin negotiates a cash-out refinance loan on the home. With the new mortgage, Erin can secure a beneficial term, a desirable monthly payment and a cash payout. If a recessionary cycle does ensue, she could use the extra cash to address the risks posed by the coming economic storm.
The Cambridge dictionary defines market sentiment as being the mood and level of confidence in a financial market. Sentiment plays a key role in the pricing of both tangible and financial assets in two ways:
- Positive: When sentiment is positive, market participants have confidence in the upside potential of an asset's price. Given positive sentiment, bullish pricing is likely.
- Negative: Negative sentiment occurs when there is considerable uncertainty plaguing a market. When sentiment is negative, bearish asset pricing is the norm.
Sentiment can shift quickly and without warning for a vast array of reasons. In the example above, Erin cashes out of EUR/USD longs and negotiates a new loan amount because of a change in sentiment. Erin was in a position where higher interest rates posed substantial risk in the financial and real estate markets—this negative sentiment prompted cash outs on both fronts.
The phrase cash-out means to convert non-cash assets to cash. Cashing out is prevalent in all asset classes, both financial and tangible. There are three times when someone could consider this practice: to realise gains, limit risk exposure or to address shifting market sentiment.
No matter if you want to capitalise on the value of your home or exit a forex trade, executing a cash-out may be a viable financial avenue. However, it is the individual's responsibility to perform any and all due diligence before executing a cash-out strategy.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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