Lester Freeman
Cash and cash equivalents are an important part of any investment portfolio. They provide liquidity, stability, and emergency funds. While the percentage of cash in a portfolio depends on various factors, it typically ranges from 2% to 10%. This percentage can vary based on an individual's financial goals, risk tolerance, and life stage. For example, retirees may want to hold a larger percentage of cash to provide peace of mind and cover living expenses, while younger investors can afford to hold less cash and focus on wealth accumulation. Ultimately, the role of cash in an investment portfolio is to balance short-term needs with long-term growth strategies.
| Characteristics | Values |
|---|---|
| Percentage of cash in portfolio | Between 2% and 10% is a general rule of thumb, although this varies from person to person |
| Cash equivalent securities | Savings, checking and money market accounts, and short-term investments |
| Determining factors | Financial goals and objectives, time horizon, risk tolerance, current market conditions, income and net worth |
| Emergency fund | Enough to cover expenses for at least three months, although some sources recommend six months to two years |
| Advantages of cash | Liquidity, portfolio stability, emergency funds |
| Disadvantages of cash | Sacrificing potential higher returns from stocks and bonds |
What You'll Learn
Liquidity and stability
Liquidity
Cash and cash equivalents, such as savings accounts and money market funds, provide investors with immediate liquidity. This means that cash can be easily accessed and spent, or used to make purchases, asset transfers, or debt payments. This is especially important in the case of an emergency, such as job loss, car repair, or unexpected medical bills. Most financial advisors recommend keeping at least three to six months' worth of living expenses in cash as an emergency fund.
Stability
Cash is often seen as a safe asset because it is supported by the full faith and credit of the US government and is not backed by any physical assets. The US dollar is also a major reserve currency, held by central banks and major financial institutions for international transactions. As a result, the US dollar is generally considered a reliable store of value globally.
Additionally, cash is safe because it does not lose value over time, at least in nominal terms. This stability comes at a price, however, as cash has lower returns compared to other investments. Cash has no potential for capital appreciation, and returns are driven by yield. Over the past 40 years, yields on cash have ranged from a high of 16.3% to a low of 0.002%.
In summary, while cash provides liquidity and stability, it is important to consider the trade-off between these benefits and the potential for higher returns with other investments.
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Emergency funds
Amount of Emergency Funds
Most financial advisors recommend keeping at least three to six months' worth of living expenses as an emergency fund. However, some suggest extending this to cover up to twelve months' worth of expenses. This ensures that you have sufficient funds to cover unexpected costs or losses in income without having to sell your assets or investments prematurely.
Location of Emergency Funds
It is generally recommended to keep your emergency funds in highly liquid, easily accessible accounts. This includes bank savings accounts, checking accounts, money market accounts, or short-term instruments like certificates of deposit (CDs). These options provide flexibility and quick access to your money when needed.
Risk and Returns
While cash provides safety and liquidity, it is important to understand that it offers lower returns compared to other investments. Cash has historically struggled to keep up with rising prices and often fails to generate returns above the inflation rate. Therefore, it is crucial to strike a balance between having sufficient emergency funds and not missing out on potential market gains by keeping too much cash.
Investor Profile and Goals
The appropriate level of emergency funds varies depending on your life stage, risk tolerance, and financial goals. For example, younger investors with a longer investment horizon may require smaller emergency funds, while retirees or those closer to retirement age may need a larger cushion to cover short-term expenses without tapping into their investments.
Dollar-Cost Averaging
If you have built up your emergency fund, you may consider investing any additional cash. One strategy mentioned is dollar-cost averaging, where you contribute the same amount of money to your investments regularly, regardless of market conditions. This approach helps smooth out the impact of market fluctuations and can be beneficial for long-term investing.
In conclusion, emergency funds are an essential component of a well-rounded investment strategy. They provide a safety net, allowing you to cover unexpected expenses or weather market downturns without derailing your financial plans. By assessing your personal circumstances and seeking guidance from financial professionals, you can determine the appropriate amount and placement of your emergency funds to align with your investment goals.
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Risk tolerance
The percentage of an investment portfolio that should be in cash depends on an individual's risk tolerance, financial goals, and life stage. While some investors keep large amounts of cash on hand, others argue that cash holdings should be minimal. Here's how risk tolerance plays a role in determining the cash percentage of an investment portfolio:
Emergency Funds and Risk Management
Building an emergency fund is a fundamental aspect of risk management. Financial advisors often recommend keeping at least three to six months' worth of living expenses in a savings account as an emergency fund. This fund ensures that individuals can cover unexpected costs without having to sell their investments at inopportune times. For retirees, it is generally advised to keep one to two years' worth of expenses in cash or low-risk assets to prevent the need to sell during market downturns.
Diversification and Opportunity
Holding a modest percentage of a portfolio in cash and cash equivalents allows investors to quickly take advantage of new investment opportunities, especially during market disruptions or fluctuations. Cash reserves can be used to "scoop up investments on the cheap" when asset prices fall. Diversifying a portfolio with cash can also reduce overall risk and provide a buffer against negative stock and bond market performance.
Age and Risk Considerations
Age plays a role in determining risk tolerance and the appropriate cash allocation. Generally, younger investors are advised to hold less cash since they have a longer time horizon to recover from market corrections. As investors approach retirement age, setting aside a larger cash buffer becomes more important to cover short-term spending needs and avoid selling stocks or bonds during market downturns.
Weighing the Risks of Cash Holdings
While cash provides safety and liquidity, it also has drawbacks. Cash holdings may miss out on market gains if a large portion is parked in cash when the market turns higher. Additionally, inflation can erode the purchasing power of cash over time. Therefore, it is crucial to strike a balance between cash holdings and investments that align with an individual's risk tolerance and financial goals.
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Age and life stage
The percentage of an investment portfolio that should be in cash depends on several factors, including age, risk tolerance, and financial goals. Here's a breakdown of how age and life stage can influence the percentage of cash in your investment portfolio:
Younger investors in their 20s tend to hold more assets in cash, with a median cash balance of 30.8% and an average of $43,639 in their portfolios. This may be due to their relative inexperience and potential risk aversion. However, by holding too much cash, young investors may miss out on opportunities for long-term compounding and growing their portfolios. As investors move into their 30s and 40s, the percentage of cash in their portfolios tends to decrease, with an average of 26.9% and $62,449 in cash holdings, respectively.
As investors approach retirement age, their portfolios may start to shift again. For example, retirees in their 70s hold a higher percentage of cash (35.3%) than any other age group, except those in their 80s (39.8%) and 90s (43.9%). This shift towards higher cash holdings may be due to a preference for liquidity and stability during retirement.
It's important to note that while cash provides stability and liquidity, it may not provide the same growth potential as other investments over the long term. Therefore, younger investors may benefit from allocating a smaller percentage of their portfolios to cash and focusing more on stocks and other investments. However, as investors approach retirement, they may want to increase their cash holdings to provide a buffer and peace of mind during their golden years.
Additionally, life stage and financial goals can also play a role in determining cash holdings. For example, if you're saving for a down payment on a house or planning for a significant expense, you may want to increase your cash reserves to ensure you have the necessary funds when needed.
In summary, the percentage of cash in an investment portfolio can vary depending on age and life stage. Younger investors tend to hold more cash, while investors approaching or in retirement may also increase their cash holdings. However, it's important to balance the stability of cash with the potential for growth offered by other investments to ensure a well-rounded and diverse portfolio.
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Interest rates
In the current high-interest-rate environment, savers have various options to optimise the return on their cash holdings. These include money market funds, high-yield savings accounts, and certificates of deposit (CDs). Money market funds, which can be purchased through brokerage accounts, mutual fund companies, or directly from banks and credit unions, are offering attractive yields of around 5%. High-yield savings accounts can also provide reasonable returns with no additional effort required. For those looking to maximise their cash returns, CDs may be a good option, but it's important to remember that the interest rate is locked in for the duration of the term.
While it may be tempting to allocate more funds to cash when interest rates are high, it's important to consider the opportunity cost of missing out on market gains. Stocks and bonds have historically delivered average annual returns that exceed the rate of inflation, while cash has barely kept up with rising prices. Therefore, it's crucial to strike a balance between having enough cash for liquidity and emergency funds while also investing in assets with higher growth potential.
The percentage of an investment portfolio that should be in cash depends on various factors, including an investor's age, risk tolerance, financial goals, and current market conditions. Generally, younger investors are advised to hold less cash since they have a longer time horizon and can take on more risk. As investors approach retirement age, it is recommended to increase cash holdings to at least six months' worth of living expenses, and preferably one to two years' worth of expenses, to provide a buffer during market downturns.
In summary, while high interest rates may make cash holdings more appealing, investors should carefully consider their overall investment strategy and financial goals when determining the percentage of their portfolio to hold in cash. Striking the right balance between liquidity and growth potential is crucial for long-term investment success.
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Frequently asked questions
Cash and cash equivalents such as certificates of deposit (CDs) or money market funds are among the safest and most liquid of investments. Cash is available when you need it and, unlike stocks, there’s little risk to principal.
A general rule of thumb is that cash and cash equivalents should comprise between 2% and 10% of your portfolio. However, this will vary from person to person depending on factors such as your financial goals, risk tolerance, and time horizon.
While cash can provide liquidity and stability, holding too much cash in your portfolio means sacrificing superior, long-term stock and bond return potential. It can also lead to reinvestment risk, which is the financial cost of having to invest cash flows at potentially lower yields in the future.
Instead of keeping a large amount of cash in your portfolio, you could consider investing in stocks, bonds, real estate, or other assets that have the potential for higher returns over the long term.
