(U.S. News & World Report) - Retirement savers have long heard the axiom "cash is king." Certainly, managing cash flow is a key tenet of retirement planning.
In addition, it's prudent to hold some cash in an investment portfolio. That allows an investor the flexibility to add to a position if an opportunity arises, gives some wiggle room while trades settle, and can offer a psychological buffer for investors with lower risk tolerance.
Typically, financial advisors allocate no less than 5% to cash, and often an amount closer to 10% or even 15% or 20%.
But during volatile market conditions, does it make sense to use a higher-than-normal cash allocation to preserve capital? Here are some factors to consider when determining how much cash to hold in your investment portfolio:
- Cash can be a drag on performance.
- Cash holdings in actively managed funds.
- Cash equivalents are your friend.
- Risk tolerance can affect cash balances.
Cash Can Be a Drag on Performance
While there are valid reasons to hold a certain proportion of cash, cash is also a drag on performance. That's particularly true during bull markets, but even during a downturn, investors run the risk of losing buying power.
"One of the biggest money myths is cash is king," says Robert Johnson, professor of finance at the Heider College of Business, Creighton University, in Omaha, Nebraska.
"Over the long run, holding significant amounts of cash ensures that one will suffer significant opportunity losses," he adds. "When it comes to building wealth, one can either sleep well or eat well. Investing conservatively allows one to sleep well, as there isn't much volatility. But, it doesn't allow you to eat well in the long run because your account won't grow much.”
Johnson cites data compiled by Ibbotson Associates, which found that large-capitalization stocks, such as those tracked by the S&P 500 index, returned 10.3% compounded annually from 1926 to 2020. Over that same time period, long-term government bonds returned 5.7% annually and Treasury bills returned 3.3% annually.
Johnson puts those data in perspective, pointing out that $1 invested in the S&P 500 at the start of 1926 would have grown to $10,944.66, including dividend reinvestment, by the end of 2020. That same dollar invested in Treasury bills would have grown to $21.71.
"The surest way to build wealth over long time horizons is to invest in a diversified portfolio of common stocks. Someone with a long time horizon should not have exposure to money market instruments, yet many investors do because they fear the volatility of the stock market," Johnson says.
Cash Holdings in Actively Managed Funds
Many investment advisors and financial planners favor index funds or passively managed vehicles over active management. The latter entails managers who choose investments in a fund or portfolio, rather than simply tracking an index, such as the S&P 500 or the MSCI All Country World Index.
"The two biggest reasons that index funds beat the majority of active managers are the fees of active managers and cash drag," Johnson says. "Cash drag refers to the fact that active money managers often keep a portion of funds in cash, say, 5% to 10%, to pay out redemptions and to be able to take advantage of investment opportunities that arise."
When cash or a Treasury bill has an average return of 3.3% over the long term and stocks have an average return of 10.3% over time, holding cash reduces these active managers' return, Johnson says.
Cash Equivalents Are Your Friend
If an investor knows he or she has a specific short-term need, such as a new roof or a new vehicle, it's often prudent to hold cash to cover that expense, rather than risk those funds in the market.
"We're risk-averse when it comes to our cash liabilities," says Buddy Amis, CEO of Cardinal Retirement Planning in Chapel Hill, North Carolina. "There is no need to tie up money needed for purchases in anything but a cash equivalent with a matching time horizon. It's too risky when Treasury bills are paying such attractive rates."
Amis explains why he prefers shorter-term Treasury bills over actual cash in accounts.
"When we work with clients, we tend to minimize the level of cash they carry in favor in increasing the income they can earn," he says. "You can't spend a 13-week Treasury bill at the pizza parlor, but it is as good as cash to a bank."
The math makes sense, he points out. "Treasury bills can earn 4% and have no intermediary, while most cash in a client's account is held in digital dollars; it's their bank or financial institution making 4% and giving the client 2%," Amis says.
Risk Tolerance Can Affect Cash Balances
Jamie Ebersole, CEO of Ebersole Financial in Wellesley, Massachusetts, typically allocates no cash or a 5% holding in client accounts.
"This cash level usually follows the type of investor, their level of risk tolerance, and what stage of their life they are in," he says. "For younger clients with tax-advantaged accounts, we usually like to be more aggressive and remain fully invested. For clients in retirement, we like to have more cash on hand to pay daily expenses and any unexpected one-time costs.
Ebersole says cash allocations tend to fluctuate depending on the market cycle, with cash balances going up as the stock market rises.
"This happens as we take gains when valuations are high and then the cash will fall as we re-allocate when valuations are lower," he explains. "Of course, every investor is different in terms of their goals and risk tolerance levels, so it may not play out this way for everyone, but it is the general rule we see."
By Kate Stalter
Reviewed by Rachel McVearry
November 9, 2022
