Determining how much cash to hold at any given time depends on your investment strategies, various income streams, and future liquidity needs. Sit on too much cash and you can lose purchasing power over time due to inflation.
But having a cash balance can be a saving grace during volatile markets and gives you more firepower to take advantage of market dislocations.
In generally, I always recommend having roughly 5% of your net worth in cash or cash equivalents. This way, you can always come up with an unforeseen emergency. Further, you will always have some cash to take advantage of market selloffs.
Having cash on hand can also provide more agility when trading given orders can take up to two days to settle. So just how much cash should you hold as an investor? Let’s talk about the importance of liquidity and monitoring your cash balance in your investment portfolio.
The Basics Of Liquidity
Liquidity measures the degree to which an asset can be purchased or sold without affecting its price. In other words, the easier an asset can be converted to cash, the more liquid it is.
Highly liquid assets include bank deposits held in checking, savings and money market accounts. Blue chip stocks, T-bills and corporate commercial paper are also considered to be highly liquid.
Illiquid assets can include micro cap stocks, private equity, real estate, bank debt, and over the counter securities such as credit default swaps.
Benefits Of Maintaining A Cash Balance
Cash has many benefits. Using cash to pay for expenses instead of credit avoids pricey interest payments and the risk of late fees. Cash is also convenient because it’s easily transferred and can be accessed quickly.
Most financial institutions offer FDIC protection on balances up to $250,000. If you have more than $250,000 in cash, it’s to your benefit to spread it across multiple banks to maximize FDIC protection from bank failures or fraud.
Another benefit of cash is it helps preserve capital in a down market. It can also protect you from prematurely liquidating a long-term investment or valuable asset to pay for emergency expenses. Holding cash can also provide peace of mind during volatile markets and reduce the temptation to panic sell at the bottom.
Highly liquid cash equivalents such as money market accounts also accrue interest unlike physical cash under a mattress.
How Much Cash Are People Sitting On?
Beyond what’s needed for living expenses, risk tolerance can affect how much cash people keep in their accounts. Inexperienced investors often have high levels of cash because they lack confidence and the knowledge to invest it.
CNBC reported that on average, investors held 23 percent of their assets in cash and cash equivalents. That’s pretty high considering many registered investment advisors currently recommend holding only about 10 percent. “Cash drag” can weigh down a portfolio’s returns.
A study by Hearts & Wallets found that gender is also a factor. In their findings, women allocated 37 percent of their assets to cash compared to 25 percent for men.
What’s more surprising is that more than half of adult Americans don’t invest in the stock market at all according to a Bankrate survey.
In general, Financial Samurai recommends having no more than six months worth of living expenses in cash. And hopefully, the cash is optimized in a high yielding online savings account.
Determine How Much Cash You Want To Hold
There’s no right or wrong answer to how much liquidity you should hold as an investment. During the financial crisis of 2008-2009, it would have been wise to hold a majority of your portfolio in cash. Once it became more clear that the worst of the crisis was over by 2011, being fully invested would have been optimal.
Age is another factor in determining how much cash to hold. The closer you get to retirement, the more important liquidity typically becomes. When your primary source of income stops, access to cash and liquid assets is vital. Increased liquidity also helps you enjoy the fruits of your labor in retirement.
If you typically hold six to twelve months of emergency cash, consider increasing that as you approach retirement. Two to three years worth of living expenses in highly liquid assets could be a more practical amount. But again, the choice is different for everyone.
Strategies To Put Your Cash To Work
Once you’ve determined a target cash allocation, don’t forget to maintain that cash balance and deploy any capital above your target. Take advantage of account features such as automatic transfers. Systematically setting aside a set percentage of your income streams each month can help you maintain a steady inflow of cash.
How and when to deploy cash varies on your own personal strategies. Perhaps you’ll choose to set an objective to invest a third of your liquidity if the S&P 500 falls by 5 percent, another third if it falls 10 percent, and the remainder if prices fall 15 percent or more. Dollar cost averaging is a common approach to deploying capital. It helps take the stress out of trying to time the markets, especially during volatile periods.
Besides movement in a broader stock market index, you can also set triggers based on economic figures, actions by the Federal Reserve, the government, or exogenous events.
Analyze How Your Stocks Are Handling Liquidity
Once you have a grip on your own liquidity management needs, analyze what companies are doing with their cash. When a business holds excess cash on its balance sheet, that may signal the company is unsure of how to reinvest capital in its business. Maybe the company could raise or start paying a dividend in the near term. Or perhaps the company is raising cash for a potential acquisition.
Cash flow statements and earnings are commonly available on a company’s website and can also be accessed on sites like Yahoo Finance.
An interesting global study by Sungard found a rising trend in companies cash levels across industries. The charts below show the primary reasons why companies held as well as the forms in which they held liquidity.
Cash Deserves Love And Attention
It’s easy to look down upon cash during a bull market. But having liquidity on hand helps investors manage through times of volatility. Having a minimal liquidity buffer allows investors to more easily trade around their portfolio while providing ammunition to take advantage of downturns.
For more about how much liquidity you should hold, take a look at my Recommended Net Worth Allocation By Age And Work Experience. It will share with you my various liquidity recommendations and other asset allocation recommendations.
Manage Your Liquidity With Free Tools
It’s my belief that Personal Capital is hands down the best online wealth management platform with free financial tools you can use to help manage your finances and achieve a more secure retirement. I’ve tried everything from Excel, to Mint, a plethora of other financial apps, and nothing comes close to Personal Capital’s tools.
With Personal Capital, you can do the following things for free:
- Automatically track your net worth
- Analyze your investment portfolios for excessive fees
- Analyze your investment portfolios for proper asset allocation
- Track and manage your income and expenses
- Run various retirement planning calculations to ensure a better financial future
Staying on top of all of your financial accounts in one place offers simplicity and less stress. You can track your net worth, cash flow, save money on fees, balance risk, find investment efficiency and so much more. Leverage technology and sign up for your free account today. It takes less than a minute to sign up.Everybody should give it a try.
About the Author:
Sam started Financial Samurai in 2009 as a way to make sense of the financial crisis. He proceeded to spend the next 13 years after attending The College of William & Mary and UC Berkeley for b-school working at Goldman Sachs and Credit Suisse. He owns properties in San Francisco, Lake Tahoe, and Honolulu and has $810,000 invested in real estate crowdfunding.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $300,000 a year in passive income, partly thanks to his investments in real estate crowdfunding. He spends time playing tennis, hanging out with family, consulting for leading fintech companies and writing online to help others achieve financial freedom.
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