New investors often want to know how much cash they should keep in their portfolio, especially in a world of low or effectively 0% interest rates.
Learn more about how much cash to keep in your portfolio.
How Much Should I Keep in Cash Reserves?
The fact that the question is asked as frequently as it is these days is indicative of a new era of interest rates, which was first brought about during the Great Recession.
It wasn't all that long ago you could open a brokerage account, select a money market account or a similar alternative, and patiently wait to find an attractive investment while you collected 4%, 5%, or even 6% on your money. You could collect dividends and interest as a reward for keeping liquidity on hand.
The logic behind the cash question can be dangerous. It generally goes something like this: "If I have a percentage of cash in my portfolio, and cash is earning nothing, why not throw it all into blue chip stocks, index funds, or other securities so I'm at least getting something, even if it is only a few percentage points?" It might sound reasonable on the surface, but if you watch the investment habits of professionals, you'll see it pays to keep cash on hand.
Determining the Level of Cash to Keep in Your Portfolio
For most people, the absolute minimum level of cash to keep on hand is an emergency fund that would cover typical expenses for least six months. Emergency funds allow you to get through unexpected disasters or surprises without having to sell off your assets. Being forced to sell assets at an inopportune time could trigger excess taxes and suboptimal returns—potentially at a time when you're already struggling financially.
For investors with less than $500,000 in net worth, and who are at least 10 years away from retirement, it can make sense to keep your brokerage account 100% invested in equities, either directly or through funds of some sort. However, this should only be done if you have an emergency fund at the local bank.
If you do decide to invest your emergency fund, the funds must be managed with a capital preservation or asset protection strategy. You should not take risks with your emergency funds. Earning a return is secondary. The key is to continue dollar-cost averaging into your portfolio.
Dollar-cost averaging is an investing practice where the investor contributes the same amount of money every period regardless of market occurrences.
After Building Your Emergency Fund
Once you're able to move beyond dollar-cost averaging, the minimum cash levels that are considered prudent can vary. Those who open themselves up to huge exposures in search of outsized returns have a hard time escaping the fate of Long-Term Capital Management.
They may appear to produce returns of 21%, 43%, and 41% after fees, for instance, in years one through three, but in year four a downturn could effectively wipe out all those gains.
A Common-Sense Strategy
A common-sense strategy may be to allocate no less than 5% of your portfolio to cash, and many prudent professionals may prefer to keep between 10% and 20% on hand at a minimum. Evidence indicates that the maximum risk/return trade-off occurs somewhere around this level of cash allocation. If you combine cash with fixed income securities, the maximum risk/reward level is slightly higher, somewhere along the lines of 30%. For a portfolio of $5 million, that could mean anywhere from $250,000 to $1.5 million.
You should always try to keep at least six month's living expenses in cash to avoid running out of money if something happens.
Of course, some families hire portfolio managers and instruct them to remain fully vested. For example, if you approached a niche asset manager and told them you were handling your liquidity requirements, it would be perfectly reasonable for them to keep no funds on hand. You've essentially told them, "I've got cash covered, my emergency fund is stashed somewhere else, I want you to invest without worrying about cash and liquidity."
Top Investors Know Cash in a Portfolio Has Multiple Roles
The best investors in history are known for keeping large amounts of cash on hand. They know through first-hand experience how terrible things can get from time to time—often without warning. In August 2019, Warren Buffett and his firm Berkshire Hathaway held a record $122 billion in cash. Charlie Munger would go years building up huge cash reserves until he felt like he found something low-risk and highly intelligent. As of April 13, 2020, the legendary Tweedy Browne Global Value Fund allocated 13.82% of the fund's holdings to cash, T-Bills, and money markets.
Privately, wealthy people like to hoard cash, as well. A 2019 Capgemini World Wealth report released found that people with at least $1 million in investable assets kept nearly 28% of their portfolio in cash. If (or when) the economy enters another recession, those cash reserves will allow these wealthy investors to buy cheap homes, stocks, and other assets.
Cash facilitates all of an investor's success, even if it looks like it's not doing anything for long periods.
In investing parlance, this is known as "dry powder." The funds are there to exploit interesting opportunities—to buy assets when they are cheap, lower your cost basis, or add new passive income streams.
Cash as Liquidity Reserves
Another role cash plays in your portfolio is to serve as a liquidity reserve you can draw down when markets seize or stock exchanges are closed for months at a time. Under these circumstances, it's nearly impossible to liquidate assets—you can't turn your investments into real cash at these times.
Buffett is fond of saying cash is like oxygen—everyone needs it and takes it for granted when it's abundant, but in an emergency, it's the only thing that matters. The leading personal financial gurus recommend keeping at least six months' worth of expenses reserved in an FDIC insured checking, savings, or money market account.
In this capacity, the cash goes beyond giving you the ability to acquire attractive assets, it's an insurance policy when you need to cover the bills and you can't tap your other funds. Benjamin Graham once said that the true investor is rarely forced to sell their securities—if the portfolio management system is good enough, you'll have the cash to make it through the darkest of times.
Retired investors are especially in need of cash to prevent losses when the economy begins a period of shrinkage.
Imagine you determine a safe retirement withdrawal rate is 3%, all else being equal, for your portfolio. You put $500,000 aside and invested it at a cash yield of 2.8%. By keeping at least 10% in cash, or $50,000, the economy could experience a 1929-style collapse, and you wouldn't have to sell any of your holdings to fund your cash flow needs, no matter how bad it got.
Cash Is Comfort
Another role of cash in your portfolio is psychological. It can get you to stick with your investment strategy through all sorts of economic, market, and political environments by providing peace of mind. When you look at reference data sets, like the ones put together by Roger Ibbotson, you can peruse historical volatility results for different portfolio compositions.
Though these studies tend to use a stock/bond configuration, the basic lesson is that diversified portfolios minimize losses without significantly missing out on gains. Having a well of reserve capital into which you can dip, and which serves as an anchor when markets fall, is a source of comfort that little else in financial life can offer.