There’s nothing like a double-digit stock market correction to remind investors of the benefits of keeping some cash on hand. Indeed, the recent turbulence in the financial markets has resulted in losses in just about every asset class, except for cash. Even so, despite the short term allure of riding out this or future financial storms in a money market fund, liquidating all your investments in favor of cash is not advisable. While moving to all cash might give you some short term comfort when the markets are going haywire, trying to time when to get back in the market is next to impossible. By the time you decide the coast is clear, the markets will have likely recovered, leaving you and your portfolio behind. Furthermore, sitting in all cash will likely impede your ability to reach your long term financial goals and objectives.
So, what is the right amount of cash to hold? To answer this question, let’s first review the roles that cash can play.
Liquid, Available Funds – Having adequate cash on hand to pay bills, cover costs of unexpected emergencies, and give you staying power should your household income be interrupted (due to job loss, disability, or other reasons) is sound financial planning. If you don’t have sufficient cash reserves in place, you may be forced to take on debt, sell other less liquid assets at inopportune times or significantly alter your lifestyle when your income is interrupted.
Low Risk, but Minimal Income – Years ago, before the Fed embraced their current ZIRP (Zero Interest Rate Policy), savers could depend on a small, but decent return from their low risk savings account, CD, or money market holdings. Historically, the long term nominal return (return before inflation) on cash has averaged roughly 3.5%. Now, with short term rates at 0% and inflation running somewhere between 1% and 2% investor are actually losing purchasing power on their cash or treading water at best. So, until interest rates go up meaningfully (which may be quite some time), the role of cash as a slow and steady source of income is non-existent. Nevertheless, your principal is not at risk.
Strategic Allocation – From time to time, “cash is king.” Cash, which does not fluctuate in value like other asset classes, will not only cushion a portfolio against deep losses when the sky is falling in riskier asset classes (i.e. stocks, bonds, etc.), but will also enable you to take advantage of any opportunities created by cratering markets. If you don’t have any available cash for investment, you will have to liquidate something to free up cash to buy something else or miss out on potentially attractive buying opportunities.
So, what’s the right amount of cash on hand? It depends on your particular situation.
Rules of thumb like 3-6 months of living expenses or 3%-5% of your portfolio may not apply to everyone. The goal is to have enough cash on hand so that you don’t have a personal liquidity crisis or become a forced seller during market turmoil. If you have high levels of dependable household income you may only need a small emergency fund and only hold a couple percent of your portfolio in cash. Others, like retirees, may hold more than a couple of years of cash in their various accounts.
Here are some things to consider when determining the right amount of cash for you:
Going through the exercise of evaluating the right amount of cash reserves for your household is vital to attaining confidence in your financial plan. If you are positioned appropriately, you will increase the likelihood of sticking with your plan through difficult market periods as well as challenging personal times. Consult with your financial advisor to determine the appropriate amount of cash for you.