You may have heard stories of people in past generations storing cash in a coffee can in the backyard. Perhaps they didn’t trust banks, or perhaps they just wanted easy access to their cash in an emergency.
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Fortunately, today we have easier and more secure ways of stashing cash, including money market accounts, high-yield savings accounts and certificates of deposit (CDs).
But the question remains: How much should you hold in cash, rather than investing the money in assets like stocks, bonds or real estate?
“In the short term, cash is king, but over the long term, cash is trash,” says Andy Moran, founder and financial planner at Ad Astra Financial Planning in Henderson, Nevada.
While interest rates are higher and investors have high-yield, low-risk cash-like options, it can be tempting to lean more on cash allocation, Moran explains.
However, it’s not ideal to make long-term investment decisions based on short-term conditions. Here are some considerations when allocating a portion of your portfolio to cash:
— Cash allocation differs by situation.
— Consider your age when allocating cash.
— Holding cash to pursue new work opportunities.
— Options in a high-interest-rate environment.
Cash Allocation Differs by Situation
“An ideal cash allocation will vary tremendously depending on one’s goals and circumstances, including one’s risk tolerance and capacity,” Moran says.
On the plus side, holding a significant cash allocation in a portfolio offers immediate liquidity, which can be advantageous not only for an emergency, but it can help investors weather a market downturn.
However, the downside is missing out on market gains if you have too much parked in cash when the market turns higher.
Additionally, the erosion of purchasing power due to inflation could diminish the real value of cash over time.
“Striking the right balance should be done through the lens of whether or not your current investment strategy will meet your financial plan’s required rate of return,” says Eric Amzalag, owner of Peak Financial Planning in Woodland Hills, California.
The required rate of return, he adds, tells you what return target you need to hit to meet your financial goals.
“If you are meeting that or exceeding that, you will have more wiggle room to hold more or less cash depending on your personal preferences,” he says.
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Consider Your Age When Allocating Cash
While cash plays a role in smoothing volatility and preserving capital in a market downturn, consider your age when deciding the amount of cash to hold.
“We typically would advise younger investors not (to hold) too much cash because they have a much longer time horizon,” says Carman Kubanda, financial planner at Innovative Wealth Building in Fort Worth, Texas.
Younger investors have a longer runway to weather market corrections, and they can even take advantage of down markets to dollar-cost average to add more shares.
There are some situations where a larger-than-average cash holding makes sense. For example, if you know you have a large expense coming up in the near future, such as a car, or if you’re buying a house with cash, then it’s unwise to put that at risk of short-term market fluctuations.
Your own personal and career goals may mean holding more cash than the average investor.
Holding Cash to Pursue New Work Opportunities
Moran counts tech workers among his clientele. Many are interested in exploring various job opportunities in a nontraditional way.
Moran says central to planning for those scenarios is maintaining sufficient liquidity, usually in the form of cash and stable investments like short-term U.S. Treasurys. Investors should balance the effect of short-term cash allocations against investments for the future.
He adds that entrepreneurs may also want to maintain large cash positions to allow for future self-funding of a startup or to make an angel investment. The potential for those returns, Moran says, “far exceeds that of the broader stock market.”
Investors who are concerned about sequence of returns risk, or the impact of market timing on investment outcomes, may want a substantial holding in cash. That allows them to take distributions from cash rather than from declining investment portfolios, says Amzalag.
“Or, if the investor believes great discounts will be available in certain markets or sectors, they may want to keep larger amounts of cash available as dry powder,” he adds.
Options in a High-Interest-Rate Environment
In the current interest rate environment, savers have various tools at their disposal for optimizing the return on their cash.
One option is in a money market fund, which you can purchase through brokerage accounts, mutual fund companies, or directly from banks and credit unions.
“Right now because of interest rates it is easy to earn 5% in a money market fund,” says Kubanda.
“This is a great cash equivalent that won’t tie up the funds like a CD,” he adds. “If you are trying to maximize your cash returns, then a CD may be a good option but you have to remember the interest rate is set for the duration of the term and won’t adjust with interest rates like the money market funds will.”
Another option is a high-yield savings account, which Moran says is a good option for shorter-term cash needs.
These accounts, he says, “can provide reasonable interest in today’s environment with no additional effort required, unlike laddering Treasury bills, which involves a little more active maintenance.”
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How Much of an Investing Portfolio Should Be in Cash? originally appeared on usnews.com
Update 11/01/23: This story was previously published at an earlier date and has been updated with new information.
