Strategic Cash Holdings: How Much Is Enough?

Cash investments are a great way to diversify your portfolio and protect your capital. They are short-term financial instruments with high liquidity, minimal market risk, and a maturity period of less than three months. While cash investments may not provide the same high returns as stocks, they are a safe and reliable option for investors looking to preserve their capital. The amount of cash an individual should hold in their portfolio depends on their financial goals, risk tolerance, and current life stage. For example, younger investors in their 20s tend to hold a higher percentage of their assets in cash, while investors approaching retirement may want to reduce the risk in their portfolio. Ultimately, the decision of how much cash to keep in your portfolio should be informed by your financial goals and risk appetite.

Emergency funds

The general rule of thumb is to save enough to cover three to six months' worth of living expenses. This ensures you can manage spending shocks, such as medical emergencies or home repairs, and income shocks, like job loss. For example, if your monthly expenses are $5,000, aim for an emergency fund of $15,000 to $30,000.

Where to Keep Emergency Funds?

It is recommended to keep emergency funds in highly liquid, low-risk, and easily accessible accounts. This includes savings accounts, money market accounts, and high-yield savings accounts. These options provide flexibility and quick access to funds without incurring penalties.

Benefits of Emergency Funds

• Financial Stability: They provide a buffer during financial emergencies, reducing the need to rely on high-interest credit cards or loans.
• Better Decision-Making: With an emergency fund, you can avoid making impulsive financial decisions out of desperation.
• Stress Reduction: Having an emergency fund gives you peace of mind and helps reduce stress when unexpected events occur.
• Disciplined Spending: By keeping emergency funds separate from your regular accounts, you're less likely to spend the money on non-essential purchases.

Strategies for Building an Emergency Fund

• Set a Realistic Initial Goal: Start by saving enough to cover an important bill, such as $500, and gradually work towards your long-term goal.
• Automate Your Savings: Utilize direct deposit or automatic transfers to build your emergency fund effortlessly.
• Take Advantage of Technology: Use mobile apps or savings accounts that round up purchases and transfer the difference to your emergency fund.
• Save Your Tax Refund: Consider depositing your tax refund directly into your emergency fund to boost your savings.
• Regularly Assess and Adjust: Periodically review your savings and make adjustments as needed to stay on track.

In summary, emergency funds are a vital component of financial planning, offering security and peace of mind during unexpected events. By understanding how much to save, where to keep your funds, and employing effective savings strategies, you can ensure you're prepared for life's financial surprises.

Liquidity needs

Emergency Funds

It is generally recommended to have enough cash on hand to cover emergency expenses. This could include unexpected disasters or financial surprises. A common guideline is to have three to six months' worth of living expenses readily available in a savings account or highly liquid investments. This ensures that you don't have to sell your assets prematurely or at unfavourable prices, helping you avoid excess taxes and suboptimal returns.

Age and Risk Tolerance

Your age and risk tolerance play a crucial role in determining your liquidity needs. Younger investors, who have a longer time horizon, are often advised to hold less cash. They have more time to recover from market downturns and can take advantage of dollar-cost averaging to acquire more shares at lower prices. On the other hand, older investors, especially retirees, may want to hold a larger proportion of cash to provide peace of mind and stability.

Market Conditions

Market conditions can impact your liquidity needs. During periods of high interest rates and market volatility, the temptation to increase cash holdings may be stronger. However, it is important to remember that making long-term investment decisions based on short-term conditions can be detrimental. Instead, focus on your long-term investment strategy and consider the potential opportunity cost of holding too much cash.

Investment Opportunities

Holding a significant cash allocation in your portfolio can provide immediate liquidity, which is advantageous not only for emergencies but also for seizing new investment opportunities. It allows you to act quickly when attractive opportunities arise, especially during market disruptions or fluctuations. However, it's important to strike a balance, as holding too much cash can cause you to miss out on market gains.

Large Expenses

If you are planning for a large expense in the near future, such as purchasing a car or a house, it is prudent to have a larger-than-average cash holding. This ensures that you don't put those funds at risk of short-term market fluctuations and provides the flexibility to make significant purchases without relying on credit or selling other assets.

In summary, when considering liquidity needs, it is essential to assess your personal circumstances, including your age, risk tolerance, financial goals, and market conditions. While holding cash can provide stability and peace of mind, it is important to strike a balance to avoid missing out on potential market gains and ensure your portfolio aligns with your long-term financial objectives.

Risk tolerance

However, holding too much cash can be detrimental to long-term investment goals. Cash investments generally offer lower returns compared to stocks or bonds, sacrificing potential higher returns. Therefore, investors need to balance their risk tolerance with their financial goals.

For example, younger investors in their 20s tend to hold more assets in cash, with a median cash balance of 30.8%, due to their relative inexperience and potential risk aversion. On the other hand, investors with a higher risk tolerance and a longer time horizon, such as those in their 30s and 40s, may allocate a smaller percentage of their portfolio to cash, typically around 26.9%.

Additionally, investors who are nearing retirement age may want to reduce the risk in their portfolios. A portion of their retirement portfolio can be directed towards cash equivalents to provide stable income over a few years, ensuring those funds are not subject to the fluctuations of the stock or bond market.

It's important to note that there is no one-size-fits-all approach to determining the right amount of cash in an investment portfolio. The appropriate level of cash investments will depend on an individual's risk tolerance, financial goals, time horizon, and current life stage.

Age and life stage

The amount of cash a person should keep in their investment portfolio depends on their age and life stage. Generally, younger investors tend to hold more cash, while older investors hold less.

According to Empower, investors in their 20s hold the highest percentage of their assets in cash (30.8%) compared to any other age group, except retirees in their 70s (35.3%), 80s (39.8%), and 90s (43.9%). The median cash balance for those in their 20s is $43,639, while investors in their 30s keep an average of $62,449 (26.9%) in cash.

Younger investors have a longer time horizon, so they can afford to take on more risk and allocate less of their portfolio to cash. They also have more time to weather market corrections and can take advantage of down markets to buy more shares at lower prices. However, holding too much cash can cause younger investors to miss out on opportunities for long-term compounding and portfolio growth.

As investors approach retirement, they may want to reduce the risk in their portfolios and increase their cash holdings. Retirees may shift their focus from growth to income and dividend-paying stocks, fixed-income bonds, and other safe assets. They may also rely on Social Security benefits and pensions.

Financial advisors recommend having sufficient liquid reserves to cover living expenses for at least three months to two years, depending on the stability of your income. This emergency fund can help you deal with unexpected costs or a downturn in the economy.

Additionally, individuals planning a significant expense in the near future, such as buying a car or a house, may want to keep a larger-than-average cash balance to avoid the risk of short-term market fluctuations.

Short-term goals

When considering short-term investments, it's important to understand the different types of goals and how to prioritize them. Short-term goals can be categorized into two main parameters: the tenure of the goal and its importance.

Tenure of the Goal

• Emergency goals: These are short-term goals that are typically one week to three months away. Examples include sudden sickness, home repairs, and essential purchases.
• Ultra-short goals: Goals that are four to twelve months away. Examples include school fees, advance tax payments, and expensive gadgets.
• Short-term goals: Goals that are one to three years away. Examples include a vacation or an installment for a home.

Importance of the Goal

Goals can also be ranked based on their importance. For instance, an emergency fund, school fees, or loan installments are crucial, while a vacation or an expensive phone can be postponed and are less important.

When planning for short-term goals, it's helpful to allocate a higher proportion of your investments to instruments with minimal risk as the goal becomes closer and more critical. This ensures that your capital is safe and easily accessible when needed.

• Savings accounts: These are highly liquid, allowing easy access to funds through online transfers, ATMs, or bank branches. Savings accounts are insured by the FDIC (Federal Deposit Insurance Corporation) in the US, providing an added layer of security. While the interest rates are typically low, online banks tend to offer higher rates than traditional brick-and-mortar banks.
• Cash management accounts: These accounts combine features of checking and savings accounts, often offering competitive interest rates and minimal to no fees. They are highly liquid and may provide additional benefits such as paper checks and debit cards.
• Money market accounts: These accounts usually offer higher interest rates than regular savings accounts but may require a higher minimum investment. They are FDIC-insured, ensuring the safety of your funds.
• Short-term corporate bond funds: These funds invest in a diversified portfolio of corporate bonds, reducing individual risk. They are suitable for investors who want exposure to corporate bonds without analyzing each bond. Short-term bond funds are relatively low risk and provide stable returns.
• Short-term US government bond funds: Government bond funds invest in low-risk securities issued by the US federal government and its agencies. These funds are highly liquid and considered very safe due to the full faith and credit of the US government backing them.
• Money market mutual funds: These funds invest in short-term securities, including Treasurys, municipal and corporate debt, and bank debt securities. While they are generally safe, they are not FDIC-backed like money market accounts. Money market mutual funds offer reasonable liquidity and provide a yield on your investment.
• No-penalty certificates of deposit (CDs): CDs are time deposits where you agree to hold your money for a specified period in exchange for a higher interest rate. No-penalty CDs allow you to withdraw your money without incurring a fee, making them more liquid than traditional CDs. They are insured by the FDIC, providing security for your funds.

When choosing short-term investments, it's essential to consider safety, liquidity, and return potential. While short-term investments may offer lower returns than long-term ones, they provide stability and easy access to your funds, making them suitable for achieving your short-term financial goals.

Frequently asked questions