Cash Investments: Current State And Trends

Determining the right percentage of cash to keep in an investment portfolio depends on several factors, including age, risk tolerance, and financial goals. While some investors prefer to hold a significant amount of cash for liquidity and stability, others argue that too much cash can slow down portfolio growth and lead to missed opportunities. So, what is the current percentage of investments that are in cash, and is it a good idea to hold that much?

What percentage of cash should be in my portfolio?

The percentage of cash in your portfolio depends on several factors, including your financial goals, risk tolerance, and current life stage. While some investors hold as much as 20% to 30% of their portfolios in cash, a general rule of thumb is to maintain between 2% and 10% in cash and cash equivalents.

The Role of Cash in Your Portfolio

Cash and cash equivalents, such as savings and money market accounts, provide liquidity, portfolio stability, and emergency funds. They are considered safe and liquid investments, but they may not provide returns above the inflation rate, impacting your long-term purchasing power.

Factors Affecting Cash Percentage

• Financial goals and objectives: Your investment objectives, such as wealth accumulation or retirement income, will influence your cash allocation.
• Time horizon: Your investment timeframe plays a role in deciding cash levels. For example, those nearing retirement may opt for a more conservative approach with a higher cash position.
• Risk tolerance: Your risk tolerance affects your comfort level with different asset allocations. A higher cash position may be preferred if you are risk-averse.
• Income and net worth: If you have a steady income or a high net worth, you may require a smaller cash position in your portfolio.
• Emergency fund: It is generally recommended to keep at least three to six months' worth of living expenses in cash reserves to cover unexpected costs.
• Market conditions: The current market conditions and interest rate environment can impact your cash allocation decisions.

Advantages and Disadvantages of High Cash Levels

Holding a large percentage of cash in your portfolio can provide benefits such as defensive protection during market declines and the flexibility to seize investment opportunities. However, a potential downside is sacrificing the superior long-term returns associated with stocks and bonds.

Strategies for Managing Cash

When managing your cash position, consider the following strategies:

• Emergency fund: Ensure you have sufficient cash reserves to cover at least three to six months' worth of living expenses.
• Investment opportunities: Keep a portion of cash set aside for investment opportunities that align with your financial goals.
• Laddering cash equivalents: Diversify your cash holdings by investing in short-, mid-, and long-term investment vehicles, such as CDs, bonds, or Treasuries, to take advantage of different maturity dates and yield opportunities.
• Regular review: Assess the percentage of cash in your portfolio at least annually as part of your financial plan review to ensure it aligns with your goals.

In summary, the percentage of cash in your portfolio depends on a combination of factors, including your financial goals, risk tolerance, life stage, and market conditions. While cash provides stability and liquidity, it is important to be mindful of the potential impact on your long-term investment returns.

What is the role of cash in a portfolio?

Cash is often thought of as a defensive asset, providing a minimal yield in return for minimal risk. However, it can also be an offensive asset, providing dry powder to be deployed when opportunities arise in the market.

Liquidity and Opportunity

Cash holdings provide liquidity, allowing investors to make opportunistic purchases when company valuations become attractive. For example, during a market downturn, even 'good' companies may fall in value alongside the broader market, creating a chance for investors with cash reserves to buy stocks they see as undervalued.

Reduced Portfolio Volatility

Holding cash in a portfolio may reduce overall returns as markets appreciate, but its stable value can limit losses during declines. For example, a 20% cash position in a portfolio reduces a 20% market decline to a 16% portfolio loss. Cash holdings can also reduce the likelihood of panic-selling when markets get volatile and provide peace of mind.

Emergency Funds and Peace of Mind

Cash can provide emergency funds, especially for retirees who may need liquid reserves to weather uncertain periods or an economic downturn. It can also be useful for those with inconsistent income streams, providing protection against unexpected shortfalls or expenses.

Age Considerations

The amount of cash held in a portfolio often varies with age. Younger investors in their 20s tend to hold more assets in cash, with a median cash balance of $43,639, while investors in their 30s keep an average of $62,449 (26.9%) in cash. This may be due to younger investors' relative inexperience and potential risk aversion. However, by keeping too much of their financial assets in low-yielding cash instruments, young investors may miss out on opportunities for long-term compounding to help grow their portfolios.

As investors approach retirement, it is generally recommended to increase cash holdings as a form of risk management. The "100 minus your age" rule is sometimes used as a rule of thumb to calculate relative equity/fixed income and cash portfolio allocations.

Market Conditions

The amount of cash held in a portfolio may also depend on market conditions. If the market expansion is expected to continue with a low risk of correction, investors may allocate less to cash. Conversely, if the market is nearing the end of a growth cycle and becoming riskier, holding more cash may be prudent.

Emergency Savings and Expenses

It is generally recommended to keep enough cash to cover anywhere from three to six months of day-to-day expenses in case of emergencies, such as job loss or unexpected bills. This emergency fund may or may not be inside the investment portfolio, affecting the overall cash allocation.

Tax Efficiency

In certain jurisdictions, such as the UK, investing in a cash fund within a tax-efficient wrapper like an ISA or SIPP can provide additional benefits. Any returns taken from these wrappers are tax-free, making them an attractive option for cautious investors seeking modest returns with low risk.

Dollar-Cost Averaging

Holding cash allows investors to utilise dollar-cost averaging strategies. For example, an investor who sees a particular stock as being attractively valued might use 25% of their allocated funds for an initial purchase. With dollar-cost averaging, more shares are bought when prices are low, and lower share amounts are purchased when prices are high, reducing the average cost per share.

Overall Portfolio Composition

While cash can serve important roles in a portfolio, it should be noted that it is generally recommended to comprise only a small portion of a portfolio relative to stocks and bonds. A general rule of thumb is that cash and cash equivalents should make up between 2% and 10% of a portfolio, although this can vary depending on individual circumstances and goals.

What are the pros and cons of holding cash?

While there is no clear consensus on the current percentage of investments that are in cash, it is generally agreed that cash and cash equivalents should comprise between 2% and 10% of an investment portfolio. This percentage can vary depending on individual circumstances, financial goals, risk tolerance, and time horizon. For example, younger investors in their 20s tend to hold a higher percentage of their assets in cash (around 30%) compared to other age groups.

Now, onto the pros and cons of holding cash:

Pros of Holding Cash:

• Liquidity: Cash provides immediate access to funds, allowing individuals to purchase goods and services when needed. It also enables investors to act on immediate investment opportunities without having to sell other assets.
• Stability and Peace of Mind: Cash is often seen as a stable and safe asset class, providing peace of mind during uncertain economic times or market volatility. It can serve as a buffer against negative stock and bond market performance.
• Emergency Funds: Holding cash can provide financial security in case of unexpected expenses, such as medical bills or household repairs. It is generally recommended to hold at least three months' worth of expenses in cash for emergencies.
• Investment Opportunities: Holding cash in an investment portfolio allows investors to quickly take advantage of market disruptions or fluctuations. It provides flexibility to invest in other opportunities without having to sell assets or borrow funds.

Cons of Holding Cash:

• Opportunity Cost: Holding a large amount of cash can result in an opportunity cost, as individuals miss out on potential higher returns from investing in stocks, bonds, or other asset classes. Cash has historically struggled to keep up with the rate of inflation over the long term.
• Reinvestment Risk: Cash holdings may lose value over time if the interest rate received is lower than the inflation rate. This can lead to a decrease in purchasing power.
• Tax Implications: Interest earned on cash holdings may be subject to taxation, especially for individuals with high incomes.
• Underperformance Compared to Other Asset Classes: Other asset classes, such as fixed-interest securities, alternative investments, property, or equities, have generally outperformed cash over the long term in terms of returns.

In conclusion, while holding cash provides liquidity and stability, it may hinder individuals from maximizing their investment returns and achieving their long-term financial goals. Therefore, it is essential to carefully consider one's financial goals, risk tolerance, and time horizon when deciding how much cash to hold.

How much cash should be kept in an emergency fund?

The amount of cash that should be kept in an emergency fund varies depending on an individual's unique circumstances. However, financial experts generally recommend keeping three to six months' worth of essential expenses in an emergency fund. This amount can be determined by calculating your monthly expenses and multiplying that number by three or six. For example, if your monthly expenses are $3,000, your goal would be to keep between $9,000 and $18,000 in an emergency fund.

It is also important to consider your lifestyle, monthly costs, income, and dependents when determining the size of your emergency fund. Additionally, you should regularly monitor and adjust your emergency fund as your financial situation changes.

When building an emergency fund, it is recommended to start by saving $1,000, and then work towards the three to six months' worth of essential expenses. It is important to keep your emergency fund in a safe and easily accessible place, such as a savings account, money market account, or short-term certificate of deposit. These accounts offer liquidity and some interest on your savings.

It is worth noting that cash and cash equivalents, such as savings and checking accounts, money market accounts, and short-term investments, should comprise between 2% and 10% of your investment portfolio. While cash provides liquidity and stability, it is important to invest in a diversified portfolio of stocks and bonds to achieve higher returns and meet long-term financial goals.

What are some alternatives to holding cash?

While cash and cash-equivalent securities such as savings, checking, and money market accounts are among the safest and most liquid of investments, they offer low returns. Therefore, investors are always on the lookout for alternatives to holding cash.

Short-term bond funds

These funds typically invest in bonds with maturities of three years or less. As long as you pick a fund that invests only in investment-grade paper, the credit risk is negligible. Vanguard and Fidelity are two fund families that offer short-term bond funds.

Ultra short-term bond funds

In 2015, Vanguard opened a new bond fund specialising in ultra-short-maturity bonds, with maturities between 0 and 3 years. The advantage of ultra-short-maturity bond funds is that they are not very sensitive to interest rate fluctuations and provide better capital preservation in a rising rate environment.

Online banks

Online banks have lower operational costs, allowing them to offer better rates on deposits. They offer traditional money market accounts, high-yield savings accounts, and certificates of deposit (CDs).

Stocks

The stock market normally generates higher returns than cash, although it is more risky. For example, according to Barclays Smart Investor, someone who saved £10,000 in cash in January 2010 would have accumulated £10,580 by December 2018. But if they’d invested the same amount in shares, they’d have a pot of £23,760.

Gold

Gold is viewed as low risk in a crisis due to its defensive qualities and lack of correlation to equities and bonds. In September 2020, The Pure Gold Company reported a 683% increase in first-time investors purchasing physical gold bars and coins.

Pay off credit card debt

If you have credit card debt or an overdraft, the interest rate on these debts will almost definitely be more than your cash savings are earning. Therefore, it makes sense to use your savings to pay off your debts.

Overpay your mortgage

If your mortgage allows it, you can save a lot of money by overpaying. Making lump sum or monthly overpayments will reduce the amount you owe more quickly and also save you money in interest over the term of the loan.

Peer-to-peer lending

Before the pandemic, peer-to-peer lending was viewed as a viable alternative to cash savings, with higher returns on offer. However, many peer-to-peer investors have reported difficulties withdrawing their cash during the pandemic, and money held in peer-to-peer accounts isn’t covered by the Financial Services Compensation Scheme (FSCS).

Frequently asked questions