How Much Cash Do I Need?
Key Takeaways
The answer to the question is - it depends. However, an important determinant is what your goals are and what is the priority and importance of achieving them.
Two significant broad elements to consider when figuring this out are, 1. Goal Horizon and 2. Funding Percentage which are inextricably intertwined. A long goal horizon and close to complete funding percentage can benefit from holding onto more cash and vice versa.
This may sound contrary to what is commonly practiced when looking at traditional risk profiling and investment horizons.
Working with a fiduciary advisor can help you maximise the likelihood of achieving your goals in a way that safeguards your current assets. All this comes together in an investment plan that can place the life you want within your reach.
Today people who hold cash equivalents feel comfortable. They shouldn't. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.
— Warren Buffett
We are all familiar with the phrase “Cash is King”. The feeling of superiority when holding a high level of safe assets is particularly evident especially when markets are collapsing around you. However, we have written before that the duration of bear markets pale in comparison to bull markets. As such, bear markets don’t happen so often, and they don’t last so long.
So whilst an allocation to cash as part of an investment portfolio can make sense for investors who are seeking stability, that comfort comes at the cost of lower market returns over the longer term. So a common question that we get asked is — “how much cash should I hold?”
Well the answer is… it depends.
An important determinant is what your goals are and what is the priority and importance of achieving them. From this, we can tag the appropriate horizons, funding needs, and loss metrics to each goal — working out the optimum amount of cash to be held.
The majority of financial planning recommendations highlight that investors keep some cash available for emergencies. In addition to this emergency cash, some investors also want to include cash in their portfolios. If all this cash is added up and not used, then it adds to performance drag — an opportunity cost that could have been used to grow wealth rather than lose it to inflation.
When looking at how much cash you need, we generally look at two broad factors:
1. Goal Horizon
The shorter that period is, the less likely they are to benefit from holding riskier assets like bonds and stocks. That’s because over the long term, the returns of those riskier assets tend to be higher than those for cash, while over the short term, they tend to be more volatile — and potentially even negative.
However, most people are unsure what “long-term” means. The diagram below could help you visualise that long-term investing for stocks means a holding period of 15 years or more just to ensure that you receive a positive return. If you are unlucky and you hold for 10 years or less, the worst scenario is negative. Note that this is for a diversified basket of global stocks. If you are holding onto single or a handful of companies, your outcomes could be much worse.
So the chart above shows that if we can hold onto a diversified investment for 15 years, we are quite assured of a positive return, even in a very bad situation.
2. Funding Percentage
This means reviewing regularly how much of the goal is already fulfilled through investment or other means. If you are close to fully funding the goal you set out in the beginning of your investment journey, then it makes sense to have some allocation to cash. However, if you are far from reaching your goal then you need to allocate more to riskier assets for potentially higher returns to improve your chances of success.
What About Risk Tolerance?
So where does risk tolerance come in, you may ask. For us, risk tolerance is a second order priority — note this does not mean we do not consider risk itself carefully, but rather there may have to be compromises to your comfort and tolerance to risk. If the goal is of utmost importance to you, then you must invest in a way that meets the necessary conditions to achieve that goal — whether it is a large allocation to risky assets or otherwise.
So the two factors of horizon and funding percentage need to work in tandem:
If you are far from your funding goal, have a short horizon (but are risk averse) then you may have no choice but to really allocate fully to risky assets to try to achieve the goal. However if the goal is not the priority and your tolerance for loss is low, then you will allocate a larger portion to safer assets like cash with the full knowledge that you will fall far short of your intended target.
Conversely, if you are midway or closer to your funding percentage, have a long horizon (but are risk tolerant), you need not fully allocate to high risk assets — just because your risk profile determines it. Allocating a portion to safer assets like cash, will make your journey smoother and provide for better sleep at night should markets take a tumble.
Case Study 1
Andy is in his early 50s but is a little risk averse after a few bad investment experiences. He wants to retire in 10 years time and has saved $1.2M out of his $2M retirement goal. He is holding a large proportion of cash as he is worried of losing a large chunk. However the only thing on his mind is to retire so that he can engage in his hobbies. As such, financing his retirement is a high priority.
Recommendation:
To maximise his liquidity and cash for allocation into a basket of global stocks. Achieving even an average return will ensure that he will be able to reach his target of $2M within his timeframe.
Case Study 2
Amelia is in her early 30s and is very open to taking risk — as she has read general financial planning guidelines and broad advice indicates that younger investors should be able to take on risk as their horizon is far. Retirement is far from her mind but as she is planning to start a family soon, she is worried about unexpected expenses that may pop up and also she needs to fund the downpayment of a home in 3 years time. She has around 6 months of her salary kept in the current account at the bank.
Recommendation:
As she already has a well funded emergency expense goal, she should continue to hold that amount in cash. As for the downpayment of a home, as the goal is only 3 years away and going by conventional risk profiling norms, a large allocation to global stocks may not be optimal for her. As the horizon is too short, she should continue to save to this goal, hold a large proportion in cash and high quality short maturity bonds and around 30% in global stocks. This ensures that her high priority goals do not get derailed from possible unforeseen circumstances.
As such, knowing the characteristic of how the various asset classes and your goals come into play is extremely important. There is no model answer to what portfolio an investor should choose at any given age or circumstance. Each person is unique in their ideals, goals and what they want to achieve. This is what we set out to do, when you work with us to create your investment plan.
For more insights on how we use these allocation frameworks in constructing your financial roadmap, come and speak with us.
