The question of how much cash to keep is a tricky one. Sink your entire capital into your investments, and there’s a high chance you’ll derail them in an emergency. But keep too much in cash, and inflation swallows more of your wealth each year. It’s a fine balancing line, and here’s how to maintain it:
What’s important about keeping cash?
A typical portfolio may be along the lines of 70 per cent equities, 20 per cent bonds, and 10 per cent cash (although that isn’t true for everyone). The reason for keeping cash is threefold:
First, cash can be spent immediately when you need it. This is different from assets like gold, property, or fine art, that need to be sold and converted to cash first.
If you need $100,000 due to legal issues by the end of the week, then you’re in trouble if your main asset is property. There’s almost no way to sell your home that fast, without taking major losses.
Since we can’t foresee every potential disaster in life, at least some portion of the portfolio must be in cash, to cope with emergencies.
Second, cash holdings are a form of diversification. If other markets tank, your cash might still hold its value. A simple example would be a recession in the stock market: the more you kept in cash (instead of in stocks), the less you would lose from falling stock prices.
Third, cash holdings provide opportunities in uncertain or sideways moving markets. There are invariably periods where even the top experts are divided on how the market would move. Right after Covid, for instance, many analysts had contradictory predictions on how various stocks or bonds would perform, and investors were left uncertain.
In these instances, it may be smarter to hold on to your cash until a clearer pattern emerges. By keeping cash, you’re in a position to buy if prices suddenly tank (and you’ve also minimised your losses, by not investing in those sinking assets).
Mind you, this doesn’t mean you should keep huge portions of your portfolio in cash. Bear in mind that cash does not – in and of itself – grow with inflation. If you have a portfolio that’s 100 per cent cash (i.e., zero investments), and inflation is at three per cent per annum, you’re effectively losing three per cent every year.
So you can’t have too little, or too much cash
To further complicate things, some people need more cash than others.
An 80-year-old retiree, for instance, may hold a higher percentage of cash to cover the last decade or so of their life. They don’t need to worry about inflation anymore, but will be in trouble if all their remaining wealth is in stocks and the market plummets.
The percentage of cash you need to hold will change throughout the course of your life, and also with changing market situations. There’s never a single correct answer for all times and people.
Here’s what to look consider:
Key factors in determining how much cash you need to hold
- Your regular expenses
- Liquidity of your other investments
- Age
- Going defensive or offensive in changing markets
- Core inflation rates in your country of residence
1. Your regular expenses
As a rule of thumb, you should always have at least six months of your expenses in cash. Anything less, and you may risk derailing your other investments.
If your income falls or stops (e.g., your business shuts down), and you have no cash, this could result in having to liquidate your other assets. This can result in less-than-ideal circumstances, such as having to sell your shares in a recession, or sell your property during a real estate downturn.
This, in turn, results in missed retirement targets, and an underperforming portfolio.
For those on variable income, such as if you live on commissions, it may be necessary to keep as much as 12 months of your expenses in cash.
But don’t overdo the size of your emergency fund, as it doesn’t grow with inflation and is stagnating. Once you have enough for six to 12 months of expenses, start investing the cash in other growth assets.
2. Liquidity of your other investments
Some investments, such as stocks, REITs, unit trusts, and others, are more liquid than others. You can, for instance, sell unit trusts without any real penalty (assuming prices of the units haven’t dropped drastically when you sell).
But try to pull money out of a fixed deposit before the maturity date, and you’ll usually be penalised by losing the accrued interest up to that point. Some financial products will have even harsher penalties, for those who sell before maturity.
So the less liquid your various assets, the more you might have to keep in cash, and vice versa.
If you’re heavily invested in property and gold, for instance, you may need higher cash reserves as those are tougher to liquidate on short notice.
For the same reason, financial planners usually recommend insurance policies that are flexible. These have options such as premium holidays, or the ability to sell units in a sub-fund to pay for your insurance premiums (so that if you become cash strapped, you don’t need to let your policies lapse).
Some insurance policies also let you alter the premiums to raise of lower your coverage, which can help to lower the cash reserves you need.
3. Age
As we age, our portfolios become more defensive. We tend to switch from wealth growth to wealth protection. Retirees, or just investors nearing retirement age, may see increasingly large allocations toward cash.
A retiree who has already built a large amount of cash – such as a single-digit millionaire with $5 million – might even end up with cash reserves as high as 50 or 60 per cent by the age of 60 to 70+.
This makes sense because, if the market crashes, a 30-year-old investor might have 30+ years to recover from the loss. But a 60 to 70+ year old retiree has no such luxury.
Hence, younger investors tend toward minimal cash allocations (as they need to beat inflation over a longer period), while older investors tend toward higher cash allocations (as they need to stretch out what wealth they already have).
4. Going defensive or offensive in changing markets
In an uncertain economy, it’s sometimes important to just focus on not losing money. When expert investors or financial advisors are uncertain, they often start whispering “overweight cash.”
This might simply mean that the market is so volatile, or so likely to crash, that you had better keep your cash and not invest in anything. This is especially true if you have a low-risk appetite, and investing in a recession would send you straight to a therapist.
On the flips side, being overweight cash can be an offensive move, if you’re a risk-taker or feeling optimistic. If you foresee a bear market for gold, for instance, you may decide to load up on cash and wait till prices fall – then swoop in and buy loads of discounted gold once the market tanks.
5. Core inflation rates in your country of residence
The biggest risk of holding cash is inflation rate risk. If a country puts more money into circulation (loosely referred to as “printing more money”), your cash reserves can quickly start to lose value.
Singapore’s central bank generally doesn’t act this way; the Singapore dollar is pegged to a basket of 12 different currencies. But other countries – including the US – are more interventionist. They may decide to circulate more money to stimulate a weak economy, pay off debts, implement social aid policies, etc.
So if your plan is to retire somewhere else, or you hold cash in different currencies, you may need to vary your holdings based on monetary policies. Loosely speaking, the higher the inflation rate caused by the monetary policies, the less cash you want to keep.
There really isn’t a single formula to cleave to, when deciding how much cash you need to hold. It’s more of a sliding scale, that you change based on circumstance. Ongoing financial planning is a big part of coping with this; and you should review your asset allocation every six months at least.
If you have questions on how to do this, or more queries about keeping cash, reach out to us on Single Digit Millionaire so we can help.
