Cash In Investment Portfolios: Asset Or Liability?

Cash and cash equivalents such as money market funds and certificates of deposit (CDs) are among the safest and most liquid investments. They are available when you need them, and unlike stocks, there is little risk to the principal. However, cash has historically not been able to achieve one of the most important long-term investment goals: returning more than inflation. So, should the cash in an investment portfolio count as an investment?

Liquidity and emergency funds

Liquidity

Cash and cash equivalents, such as money market accounts and short-term investments, provide liquidity to an investment portfolio. This liquidity can be advantageous not only in emergency situations but also during market downturns. A significant cash allocation offers immediate access to funds, enabling investors to weather volatile market conditions or pursue new work opportunities. However, it's important to strike a balance, as excessive cash allocation may result in missing out on potential market gains.

Emergency Funds

Maintaining an emergency fund is crucial for financial stability. The recommended amount for emergency funds varies, with suggestions ranging from three to six months' worth of expenses. This buffer allows individuals to cover unexpected costs without having to sell their assets prematurely or incur additional debts.

Recommended Cash Allocation

The appropriate percentage of cash in an investment portfolio depends on various factors, including age, risk tolerance, financial goals, and current market conditions. While there is no one-size-fits-all answer, a general guideline suggests that cash and cash equivalents should comprise between 2% and 10% of a portfolio. This range can be adjusted based on individual circumstances, such as upcoming large expenses or income stability.

Long-Term Considerations

While cash can provide stability and flexibility, it is essential to consider its long-term impact on investment portfolios. Cash has historically struggled to keep up with rising prices, and its purchasing power can diminish over time due to inflation. Therefore, investors should be cautious about making long-term investment decisions based solely on short-term conditions, such as high-interest rates.

Strategic Use of Cash

Cash serves multiple strategic purposes in an investment portfolio. Firstly, it provides emergency funds to cover unexpected costs. Secondly, it offers money that can be quickly invested when the right opportunity arises. Investors should be mindful of these dual purposes when managing their cash reserves.

Risk tolerance and life stage

The amount of cash in an investment portfolio depends on an individual's risk tolerance and life stage.

Risk Tolerance

A person's risk tolerance is a crucial factor in determining their ideal cash allocation. Those with a higher risk tolerance may be comfortable with a smaller cash position, focusing more on stocks and bonds, which offer higher potential returns but come with greater risk. On the other hand, those with a lower risk tolerance may prefer a more conservative mix of assets, including a larger cash allocation, to provide a sense of security and stability.

Life Stage

Age and life circumstances play a significant role in determining the appropriate cash allocation in an investment portfolio. Here are some considerations based on different life stages:

• Near or in retirement: Individuals nearing or in retirement may want to increase their cash allocation to ensure they have sufficient liquid reserves to cover their expenses for at least a year or two. This provides peace of mind and helps retirees avoid selling their investments to fund their lifestyle.
• Wealth accumulation stage: For those who are years away from retirement and focused on wealth accumulation, a modest cash position is advisable. This allows them to take advantage of investment opportunities, especially during market disruptions or fluctuations. However, they should also consider their risk tolerance and overall financial goals when determining the exact allocation.
• Young investors: Financial advisors typically recommend that younger investors hold less cash since they have a longer investment horizon. This gives them more time to weather market corrections and take advantage of dollar-cost averaging.
• Pursuing new work opportunities: Individuals exploring non-traditional work opportunities, such as tech workers or entrepreneurs, may require larger cash holdings to maintain sufficient liquidity. This cash reserve can be crucial for self-funding startups or making angel investments with potentially high returns.
• Large expenses: If you anticipate a large expense in the near future, such as buying a car or a house, having a larger-than-average cash holding can be prudent. It ensures that you don't put these significant purchases at the risk of short-term market fluctuations.
• Income stability: Your income stability also plays a role in determining your ideal cash allocation. If you have a steady income and can rely on regular paychecks or annual bonuses, a smaller cash position may be sufficient. On the other hand, those with variable income streams, such as independent contractors, may want to maintain higher cash reserves to protect against unexpected income shortfalls or expenses.

In conclusion, the appropriate cash allocation in an investment portfolio depends on a combination of factors, including risk tolerance, age, financial goals, income stability, and anticipated expenses. It's important to seek guidance from a financial professional to determine the right balance based on your unique circumstances.

Reinvestment risk

As interest rates can change rapidly, investors may be tempted to invest more in shorter-dated securities in order to earn higher yields. However, this investing strategy runs the risk that the yields on offer when these shorter-dated securities mature will be lower than those available today. This is known as reinvestment risk.

For example, an investor who purchased a 3-month US T-bill in December 2000 would have received a yield of 5.90% p.a. However, due to subsequent changes in yields, by investing in a series of 3-month T-bills over a 10-year period, they would only have achieved an overall annualised return of 2.29%.

To mitigate reinvestment risk, investors can:

• Be aware of which types of investments have more exposure to reinvestment risk
• Consider increasing portfolio allocation to longer-duration bonds
• Assess actively managed bond exposure
• Make sure to consider the future interest rate environment, as well as the current one, when deciding how to invest

Some investments with lower exposure to reinvestment risk include longer-term bonds, zero-coupon bonds, and non-callable bonds.

Inflation and purchasing power

Inflation is the rate of increase in prices over a given period, usually a year. It is a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. Inflation represents how much more expensive a set of goods and/or services has become over a certain period. Consumers' cost of living depends on the prices of goods and services and their share of each in the household budget.

Purchasing power is the value of a currency in terms of the number of goods or services that one unit of money can buy. It can weaken over time due to inflation as rising prices decrease the number of goods or services that can be purchased with a unit of currency. Inflation erodes the purchasing power of a currency over time.

The Consumer Price Index (CPI) is a measure of inflation and purchasing power. It calculates the change in the weighted average of prices of consumer goods and services, particularly transportation, food, and medical care, at a given time. The CPI can point to changes in the cost of living as well as deflation.

The purchasing power of a dollar in 2022 was about 92.6% of its purchasing power in 2021. This means that the purchasing power of the dollar declined by around 7.4% between 2021 and 2022 due to inflation.

Inflation can have a negative impact on purchasing power over time for recipients and payers of fixed interest rates. For example, consider pensioners who receive a fixed 5% yearly increase in their pension. If inflation is higher than 5%, their purchasing power decreases. On the other hand, a borrower with a fixed-rate mortgage benefits from inflation as the real interest rate decreases.

Central banks adjust interest rates to try to keep prices stable and maintain purchasing power. However, if inflation is not factored into nominal interest rates, some gain purchasing power while others lose it.

While cash and cash equivalents are among the safest and most liquid investments, they have historically not been able to achieve one of the most important long-term investing goals: returning more than inflation. If returns do not exceed the inflation rate, purchasing power remains stagnant, and investors are left on an "investment treadmill".

A general rule of thumb is that cash and cash equivalents should comprise between 2% and 10% of an investment portfolio. This can vary depending on factors such as financial goals, risk tolerance, and current market conditions.

Diversification and asset allocation

When it comes to cash, it is important to strike a balance. Cash and cash equivalents, such as savings and money market accounts, can provide liquidity, emergency funds, and portfolio stability. However, holding too much cash can sacrifice potential returns from other investments.

A general rule of thumb is to hold between 2% and 10% of your portfolio in cash and cash equivalents. This can vary depending on factors such as your financial goals, risk tolerance, time horizon, and current market conditions. For example, if you are a retiree, you may want to hold a larger percentage of your portfolio in cash to provide peace of mind and cover living expenses for a few years. On the other hand, if you are a younger investor with a longer time horizon, you may want to hold a smaller percentage of your portfolio in cash and focus more on investments with higher potential returns, such as stocks and bonds.

It is also important to consider the opportunity cost of holding cash. By keeping a significant amount of cash, you may miss out on market gains if the stock market or other investments perform well. Additionally, cash may not keep up with inflation over the long term, which can erode the purchasing power of your money.

Therefore, when deciding how much cash to include in your investment portfolio, it is crucial to consider your personal financial situation and goals, as well as the potential trade-offs involved. Diversification and asset allocation are essential for a well-balanced investment strategy that aligns with your risk tolerance and financial objectives.

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