When it comes to investing, one of the key decisions you need to make is how to allocate your assets among different categories, like stocks, bonds, and cash. This is a crucial part of a diversified investment strategy because it helps balance risk and return based on your financial goals and risk tolerance.
One common question that comes up in asset allocation discussions is, “What percent of my portfolio should be in cash?” This is an important consideration for investors at every stage of life. Keeping a portion of your portfolio in cash can offer stability and liquidity, but it’s also essential to understand the potential drawbacks of this strategy.
In this article, we’ll explore the optimal percentage of cash to hold in your portfolio, how much cash you should consider keeping, and what factors influence this decision. Whether you’re just starting to invest, planning for retirement, or reassessing your current strategy, understanding how much of your portfolio should be in cash is crucial for making informed investment decisions.
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Why keep cash in your portfolio?
When managing your investment portfolio, having a certain level of cash might seem counterintuitive in a world where returns are often sought through more aggressive investments. However, cash provides liquidity and flexibility, allowing you to address emergencies, seize short-term opportunities, or cover unexpected expenses without disrupting your investment strategy.
This liquidity ensures you’re not forced to sell investments at inopportune times, maintaining the integrity of your long-term financial goals. Additionally, cash serves as a stabilizing force during market volatility. It acts as a buffer against market downturns, preserving your portfolio’s value and enabling you to invest when opportunities arise during market dips.
Furthermore, cash provides psychological comfort, reducing stress and preventing emotional decision-making driven by market fluctuations.
Emergency fund vs. investment cash
An emergency fund is a safety net designed to cover unexpected expenses, such as medical bills or urgent repairs, and is typically recommended to be around three to six months' worth of living expenses.
You might also keep cash allocated for investment purposes—either for future investment opportunities or to cushion against market volatility. This allocation should be strategically managed based on your risk tolerance and investment goals.
So, how much of your portfolio should be cash?
When it comes to how much of your portfolio should be in cash, recommendations vary among financial experts. Some suggest a lower percentage, while others advocate for a higher allocation based on current market conditions.
“As a CPA and former fractional CFO, I’ve found 5-15% of total assets in cash provides stability without sacrificing growth,” says Russell Rosario, a certified public accountant (CPA) and innovative AI software engineer.
Oh the other hand, Ben Klesinger, co-founder and CEO of Reliant Insurance Group and Helping Hand Financial, recommends a higher percentage. “Right now, with economic uncertainty and market volatility, around 10-15% of a portfolio in cash seems prudent,” Klesinger says.
Determining the right amount of cash to hold in your portfolio also depends on various personal factors:
- Age and life stage: Younger investors typically need less cash compared to those nearing retirement. For those closer to retirement, having a larger cash reserve can be crucial for liquidity and stability.
- Risk tolerance: Your willingness to take on risk impacts your cash allocation. Aggressive investors might lean towards 5-10% cash, while conservative investors might hold 10-20% to buffer against market volatility.
- Investment goals and time horizon: Align your cash allocation with your specific financial goals. For instance, if you’re saving for a down payment on a house or planning for retirement, your cash needs will vary based on how soon you’ll need access to those funds.
Potential cons of holding cash in your portfolio
While holding cash in your portfolio brings certain benefits, it also comes with notable downsides. “The biggest mistake investors make is keeping too much cash on the sidelines,” Klesinger says. “While cash provides stability, inflation eats away at its value over time. Investors should review their cash allocation at least annually and rebalance as needed based on their financial situation and market conditions.”
Here are some of the primary cons of holding cash:
- Inflation risk: Cash loses purchasing power over time due to inflation. As prices rise, the value of your cash reserves reduces, meaning you get less for the same amount of money in the future.
- Opportunity cost: Keeping money in cash means missing out on potential returns that could be earned if those funds were invested in stocks, bonds, or other assets.
- Lower returns: Cash typically offers lower returns compared to other investment options like stocks and bonds. By keeping too much of your portfolio in cash, you may miss out on the growth potential offered by more aggressive investments.
Klesinger shares an example of a client that held over 50% of their portfolio in cash, paralyzed by fear of loss during a market downturn. “After discussing their financial goals and risk tolerance, we moved some of that cash into short-term bonds and dividend-paying stocks,” he says. “This improved their returns while still giving them stability, and they felt much more at ease. A year later, their returns have outpaced inflation and they only hold about 15% in cash.”
Different scenarios for cash allocation
When it comes to cash allocation, different scenarios call for varied approaches. Understanding these scenarios can help tailor your cash strategy to best fit your financial needs and goals.
High-interest-rate environments
In periods of high interest rates, cash allocation strategies might shift. Higher interest rates can make cash accounts more attractive, offering competitive returns compared to other periods. This environment provides a chance to earn better returns on cash reserves while keeping liquidity. Adjusting your cash allocation to take advantage of these rates can enhance your portfolio’s performance.
Retirement planning
For those nearing retirement or already retired, adjusting cash allocation becomes particularly important. “Nearing retirement, having enough cash to cover one to two years of expenses is typically sufficient,” Rosario says. Ensuring sufficient liquidity for living expenses in retirement helps keep financial stability and provides peace of mind without having to liquidate other investments under unfavorable conditions.
FAQs
How much cash should I have in my portfolio at different life stages?
Cash needs can vary significantly depending on your life stage. Those early in their careers may need less cash, around 5-10%, as they can afford more risk for higher returns. As you approach major financial goals like buying a home or funding education, increasing your cash reserve to 10-15% can be beneficial. If you’re nearing retirement, having enough cash to cover one to two years of living expenses is typically recommended to ensure liquidity and stability during retirement.
Is it better to hold cash or invest in bonds for short-term needs?
For short-term needs, cash and bonds both have their advantages. Cash provides immediate liquidity and safety, making it ideal for emergencies and imminent expenses. Bonds, especially short-term ones, offer slightly higher returns with minimal risk but may have less immediate liquidity. Your choice will depend on your need for access to funds versus the potential for earning returns.
What are the best cash-equivalent investments?
Cash-equivalent investments include high-yield savings accounts, money market funds, and short-term certificates of deposit (CDs). These options offer safety, liquidity, and competitive returns relative to traditional savings accounts. They are ideal for preserving capital while earning some interest.
Can holding too much cash hurt my long-term financial goals?
Yes, holding excessive amounts of cash can hinder long-term financial goals. Cash usually offers lower returns compared to investments in stocks, bonds, or mutual funds. Over time, inflation can erode the purchasing power of cash, making it less effective for achieving growth-oriented financial goals. Balancing cash with other investment opportunities is essential to maximizing your portfolio's performance and meeting your long-term objectives.