How Much Cash Should I Keep in My Portfolio?
Finding the Right Balance Between Investment and Cash Reserves
New investors often want to know how much cash they should keep in their portfolio, especially in a world of low or effectively zero percent interest rates. The fact the question itself is asked as frequently as it is these days is indicative of the unique interest rate environment in which we find ourselves; an interest rate environment caused by the Federal Reserve's attempts to save the country from careening into the abyss of another Great Depression back in 2008-2009 when the real estate, equity, and debt markets seized, much of Wall Street imploded, and the banks began to fail.
Prior to an unprecedented amount of fiscal stimulus that drove rates into the ground, 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 percent, 5 percent, or 6 percent on your money; dividends and interest paid solely as a reward for keeping liquidity on hand.
The seeming logic behind this question involves a dangerous line of thinking. It generally goes something like this: "If I have [x percent] of my portfolio in cash, 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 it's an amateur mistake; one that you hardly see replicated among the wealthy or professionals who know better.
The Best Investors Know Cash in Your Portfolio Has Multiple Roles
The best investors in history are known for keeping large amounts of cash on hand, often because they are aware through the first-hand experience how terrible things can get from time to time; more often than not without warning. Warren Buffett is sitting on $60 billion at the moment.
Charlie Munger would go years building up huge cash reserves until he felt like he found something low-risk and highly intelligent. Tweedy Browne, managers of the legendary Tweedy Browne Global Value Fund, have 18 percent of the fund's holdings in cash. They are not at all unusual. In fact, when the nation's largest and oldest trust company did a study of the 1,821,745 households in the United States with investment portfolios worth $3,000,000 or more, they found something shocking. As I explained when parsing the data:
- 8 out of 100 held 50 percent or more of their portfolios in cash
- 14 out of 100 held 25—50 percent of their portfolios in cash
- 40 out of 100 held 10—24 percent of their portfolios in cash
- 38 out of 100 held less than 10 percent of their portfolios in cash
I see this all the time. I know one senior citizen who amassed a personal fortune in the low seven figures. This person invests almost entirely in real estate, has little to no debt, doesn't use credit cards, pays cash for everything, and keeps an absolute minimum of $150,000 at all times in the local bank. Every time we go into a recession, he/she will buy up more distressed homes, upgrade them, then rent them out to tenants, creating another source of revenue.
It's the cash in the portfolio that makes this possible; quick closing and title transfer when an opportunity is spotted, no need to get permission or competitive terms from a bank when calculating the cash flows. The cash facilitates all of the success even if it looks like it's not doing anything for long stretches of time. In investing parlance, this is known as "dry powder". The funds are there to exploit interesting opportunities; to buy assets when they are cheap, lowering your cost basis or adding new passive income streams.
(The danger in advocating for cash reserves in a portfolio focused on equities that inexperienced investors frequently don't understand the difference between: 1. rebalancing/formula strategies, like those advocated by John Bogle and Ben Graham, 2. valuation-based strategies, like those advocated by Peter Lynch, Ben Graham, Warren Buffett, and Charlie Munger, and 3.
market timing, the latter of which is incredibly dangerous and almost certain to lead to subpar results. I've quite literally seen the first two, both of which are backed by generations of academic data that is beyond refute at this point, called market timing with absolutely no sense of self-awareness by the people who are holding forth as if they were experts! It would be funny if it weren't tragic because this is real money on the line; money that the ill-informed need to pay their bills, put food in their pantry, and keep a roof over their head.)
Another role of cash in your portfolio is serving as a liquidity reserve you can draw down when markets seize or stock exchanges are closed for months at a time, making asset liquidation nearly impossible. Buffett is fond of saying it 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. Even the leading personal financial gurus recommend at least six months' worth of expenses reserved in an FDIC insured checking, savings, or money market account. In this capacity, cash is an insurance policy of sorts totally independent of the ability to acquire attractive assets; you need it there to cover the bills when they come due as the storm rages and you can't tap your other funds. It goes back to what I said when I quoted Benjamin Graham: The true investor is very rarely forced to sell his or her securities. The plan, the portfolio management system, is so good, it's not necessary to even in the darkest of times.
This is especially true for retired investors. Imagine you determine a safe retirement withdrawal rate is 3 percent, all things considered, for your portfolio. You have $500,000 put aside and it's invested at a cash yield of 2.8 percent. By keeping at least 10 percent, or $50,000, in cash, we could go into an epic, 1973-1974 style meltdown or worse, a 1929-1933 collapse, and you wouldn't have to sell any of your holdings to fund your cash flows needs, no matter how bad it got even if the dividends and interest payments were missed or shut off by panicked management trying to save the firms they are running, for an entire 3 years and 3 months. With whatever cash was still coming in — and there would definitely be some as most firms worked hard during even the Great Depression to keep shipping profits to their owners, even if the dividend yields exceeded 10 percent — that would stretch out to a longer effective period.
Still 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 Ibbotson, you can peruse historical volatility results for different portfolio compositions. Though it tends to use a stock/bond configuration, the basic lesson still holds when you examine how the introduction of between 10 percent and 30 percent of assets in the form of non-equity significantly reduces the volatility of the portfolio in any given real-world backtesting. Having a well of reserve capital into which you can dip, and that serves as an anchor when equity markets, real estate markets, or even bond markets, are in a total free fall, is a source of comfort little else in financial life can offer.
Determining the Level of Cash You Should Keep in Your Own Portfolio
For most people, the absolute minimum level of acceptance cash to keep on hand is an emergency fund for at least six months, as already mentioned in passing. Emergency funds allow you to get through non-expected disasters or surprises without having to sell off your assets, triggering taxes and potentially at times not favorable to your best interest. 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 remain 100 percent invested in equities, either directly or through funds of some sort, as the emergency fund at the local bank (or wherever you've chosen to invest it) fulfills the same role. Without exception, and under all circumstances, these emergency funds must be managed with a capital preservation strategy. Do not take risks. Earning a return is secondary. Keep dollar cost averaging into your portfolio.
Once you've moved beyond that, the minimum cash levels that are considered prudent can vary. Sure, there are fools who do things like over-leverage hedge funds with huge exposures that seek to generate outsized returns but when things go south — they always do and they always will — they have a hard time escaping the fate of Long-Term Capital Management, the legendary meltdown that appeared to produce returns of 21 percent, 43 percent, and 41 percent after fees, respectively, in years one through three, only to experience effective total wipeout in year four. Then again, they're playing with "other peoples' money" and have almost no incentive not to swing for the fences; a terrible moral tragedy that doesn't do the civilization a bit of good. I've never seen anyone with a decent amount of common sense advocate for less than 5 percent and many prudent professionals prefer to keep at least 10—20 percent on hand. In my opinion, the academic evidence overwhelmingly indicates that the maximum risk/return trade-off occurs somewhere between 10—20 percent of cash reserves (or 30 percent if you combine cash and fixed income securities). For a portfolio of, say, $5,000,000 that could mean anywhere from $250,000 to $1,000,000.
Of course, some successful 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 own liquidity requirements, it would be perfectly reasonable for them to keep no funds on hand of the capital you put under their control because you've made the decision as to what you want your cash allocation to be and are giving them the entire equity allocation you want them handling.