This might be the most important question in personal finance.
It’s a query your editor fields frequently. But it’s one that most people don’t ask when it should be on their mind.
‘How much cash should I hold?’ asks the private investor.
The odds are strong that you’re holding the wrong amount of cash. An imbalance that’s simple to redress now could be disastrous for your portfolio if you leave it unchecked.
The Saturday of a long weekend — if you live in Victoria, Tasmania, South Australia or the ACT, at least! — is the perfect time to fix this common problem.
By cash, we don’t just mean plastic notes in your sock drawer. We’re talking about money you can get your hands on quickly with minimal transaction fees…the kind with a value that doesn’t swing wildly day by day.
This includes savings accounts and certain short-term investment products that banks sell, like certificates of deposit. Basically, cash is the money you can use to pay for things in a hurry without a worry.
With that in mind, when we talk about how much cash you need to hold, we’re talking about two different ‘buckets’…
- Your emergency fund
- The cash allocation of your portfolio
Your emergency fund is like the airbag in your steering wheel. It gives you a safety cushion in case of emergency. One could save your life in a car crash, and the other performs a similar role if you lose your primary source of income. Going without either is deeply unwise.
You’d be amazed how many people galumph through life with no emergency fund — especially those with high incomes. These kinds of people tend to tune into the movements of the stock market, so you’d think they could manage their personal finances.
But these types look at a chart like the one below — which shows the 40% rise in the S&P/ASX 200 [ASX:XJO] over the three years to today — and conclude that their high-octane lifestyle is bulletproof. If there’s one thing the stock market teaches us, it’s that pride usually comes before a fall.
Click to enlarge
That stock market performance is why not nearly enough investors are asking the ‘cash question’ today. Cash is unfashionable in a bull market. But times like this can be some of the best to lock in some ‘emergency’ profits and sling them away for a rainy day.
On the flipside, this time three years ago — the point we’ve highlighted on the chart above — risk and gloom were the popular themes of the day. After two years of stock market losses, most investors waved the white flag and craved the certainty of cash. But in hindsight, ‘how much cash’ was the wrong question to ask. It was a great time to buy cheap stocks.
(By the way, large-cap stocks may have rallied 40% over the past three years…but several small stocks are poised to burst out of the blocks for even stronger potential gains. Go here to find out more about our favourite small-cap investment ideas for 2015.)
The amount of cushion in your emergency fund is ultimately a personal question. It depends on how safe you want to be. You should think about this in terms of living expenses for you and your dependents. Here’s your editor’s view — in the absence of any rich and generous uncles, keep six to 12 months of living expenses in your emergency fund.
If you work in a cyclical industry, like banking or mining, you need a larger cushion than somebody with a ‘job for life’ (if such a thing still exists!). And if you’re of a nervous disposition, make sure you keep enough in there to sleep well at night. That’s a handy rule of thumb with financial matters.
A full year of expenses is a lot of money for most people. If you’re just starting to save, don’t let that figure discourage you. Two months of expenses saved is better than no months…much like a weak airbag is better than none at all.
Once your cushion is sorted, it’s time to look at your longer-term cash allocation in your portfolio…
But as you move closer to retirement, you should start trading off some of the potential upside from your stockholdings for the security of cash.
Your cash allocation won’t bring you great wealth — particularly not if interest rates continue heading south, as your editor believes they will. But that’s not the point. Winning the game of investing is about minimising the potential fallout if risks blow up. In this case, the risk you face is that the stock market tumbles and because of your life phase, you have to liquidate shareholdings cheaply to meet your obligations. If you stagger your exposure to shares and property, ramping it down slowly over several years, you should enjoy a more comfortable and less stressful retirement.
How big you should grow your cash allocation up to you. Our fellow editor, Kris Sayce, has told you that at certain times it can make sense to have as much as half of your portfolio in cash…alongside an allocation to gold, silver, and large and small-cap shares .
Your editor views a 50% cash allocation as far more than most people should need to sleep at night. Some people live happily, healthily and wealthily well into their dotage holding as little as 10% of their assets in cash. You’ll often find that a good chunk of that happiness comes from well-chosen and long-held dividend-paying stocks.
But because of our emotions, people tend to skew either too cautious — and hold too much cash — or too aggressive, holding too little.
Step back and take a sensible look at your cash needs. It only takes a little effort to determine what you need to provide for emergencies without sacrificing the potential for long-term gains.