Should your investment portfolio have 90% in stocks and bonds and 10% in cash? Or should it have 60% in stocks and bonds and 30% in cash?
The commonly recommended percentage for portfolio cash is ten to fifteen percent based on an age appropriate asset allocation model. Tactical investors and financial advisors, however, adjust cash percentages from five to forty percent or more based on opportunities at any given time. Therefore, the investing method affects the percentage of portfolio cash held.
We all love for our money to feel safe. This makes it hard to know the best cash allocation in our portfolios because cash types of investments feel safe.
The emotional thinking tied to safety, however, can lead to avoiding investing, which can result in not having enough money to retire comfortably when and how you want. Our money has to grow considerably more than inflation for us to be able to retire, assuming there isn’t some sort of windfall or inheritance. Such needed growth simply doesn’t happen in cash.
Few “one size fits all” solutions will be found here at Retire Certain since financial goals and situations are vastly different among individuals. Therefore, this post presents both traditional and more tactical strategies for portfolio cash allocations so you can assess how much cash you should keep in your own portfolio.
The information here is based on my AFC® (Accredited Financial Counselor) credentials, but, more so, from almost 40 years of experience as an individual investor in all types of markets both alone and with financial advisors at times.
Is Cash Considered An Investment?
Some financial professionals don’t consider cash an investment, period, because cash loses value to inflation. The question we have to ask with this approach is whether stocks or bonds that decrease in value after they are purchased are still considered an investment.
The answer is, of course, assets that decrease in price after we buy them are still assets; it would be silly to suggest otherwise.
Cash has other characteristics of investments, such as being a risk management vehicle. There is also the fact that the value of cash rises during the rare times of disinflation.
Therefore, I define portfolio cash as money that has been put aside specifically for investing. While you may change the percent of cash in your portfolio as explained below, think of this cash as being out of reach. I like to call this available investment capital.
Net Worth Cash Percentage Vs Cash Allocation in Portfolio
It’s important to note here that the percentage of net worth in cash is different but closely related to the cash allocation in a portfolio.
Here’s why: Net worth includes your home and other assets while a traditional investment portfolio typically includes stocks, bonds, and cash.
Also, net worth cash includes money to be used for out of the ordinary or nonrecurring expenses. This cash is often more accessible than portfolio cash for convenience and structure. Many financial planners call this an Emergency Fund.
Portfolio cash is money you are investing for present and future financial security. The line and the rules can get a bit blurry, however, between investment cash and emergency cash. In fact, many asset allocation models don’t even consider cash in a portfolio nowadays. Instead, they allocate money between stocks and bonds, assuming an investor has kept cash available in an Emergency Fund elsewhere, perhaps at the bank.
More tactical investors and wealth managers, however, increase portfolio cash to have funds available for better opportunities as explained in Method 2 ahead. In other words, cash is an integral part of the portfolio for tactical investors.
There’s one more important thing about portfolio cash to note before getting into the cash allocation percentages.
What Is Portfolio Cash?
When we hear the word cash we envision piles of cash hidden under the mattress. While having a good stash of cash in a safe at home might make good sense nowadays, keeping money under the mattress doesn’t.
Ideally, however, portfolio cash is not really cash. What is referred to as portfolio cash is usually money that’s put into a money market account or similar fund that pays interest, albeit minimal.
The financial lingo that is used for portfolio cash is “cash equivalents”. That sounds really complicated so we’ll just call it cash in this post to keep things simple and lingo free.
With interest rates so low, many investors wonder if it is worth the very minimal risk to put cash in a money market account so let’s go there next.
Where to Keep Cash
It’s important to make sure that wherever your “portfolio cash” is held, the value does not fluctuate. Otherwise, it is not really “portfolio cash” at all since it could lose value.
A money market fund is like cash because it does not change in value but it does pay interest, unlike true cash. Ignoring inflation temporarily, the value of money in a money market stays at $1, though, just like paper cash.
Don’t make assumptions that the money in your brokerage or investment account is automatically in the best money market. There are thousands of money markets so do some research.
Let’s look at a few factors to consider as they relate to keeping portfolio cash sensible and safe as you research the best place for your portfolio cash.
Are Short Term Bond Funds As Safe As Money Markets?
Many investors use short term bond funds today instead of money market accounts while stretching for a little more interest, however, this may not be ideal for portfolio cash. An example is Vanguard’s Short Term Bond Fund ETF, BSV, which hold one to five year debt.
Ultrashort bond funds and short term bond funds (officially comprised of “notes” or “bills” or “bonds”) fluctuate in value when interest rates change, even though they react much less to changes in interest rates than intermediate and longer term bonds.
Remember, however, the main goal with portfolio cash is no change in value. Therefore, investors must decide if it is worth a minimal yield for some fluctuation in value, and that even short term bond funds don’t truly qualify as portfolio cash since they fluctuate in value.
Comparing Interest Rates on Portfolio Cash
Check to see if there is a money market that pays a higher interest rate with lower fees than what you are currently in, even though it may seem futile given low interest rates nowadays.
For convenience, I seek the best money market available at the brokerage firms we already use so I don’t have to move money to a new brokerage firm just to get another .05% in interest.
Beware: While interest rates are always changing, look out for gimmicks and promotions with temporarily higher rates that go away shortly after you’ve moved your money into such funds.
Portfolio Cash Fees
We can’t control money market interest rates, but we can control fees. Fees are particularly important given the negative real return on portfolio cash.
Fees add insult to injury to already paltry interest rates that money market accounts pay investors. Definitely check the fees you are paying on the cash in your portfolio if you have it in a fund of any type.
Could you also be paying wealth management fees to a financial advisor or retirement fund administrator on your cash like investments? If so, you’re suffering a serious negative return, especially after considering inflation depletion as well. The only time it could make sense to pay wealth management fees on portfolio cash is if you’re working with a wealth manager who uses tactical asset allocation and moves your investments in and out of cash regularly; the wealth manager should also get better investment returns as a result of such initiatives.
Insurance on Portfolio Cash
Quickly check the insurance levels (published online) to make sure your “cash” is insured. If you’re a very high net worth investor with a high cash allocation, you might possibly exceed insured levels.
Loss of insured funds from default is highly unlikely and seems unfathomable, but since it has previously happened investors are smart to check the amount for which their money market is insured per account. This was a common practice in 2008 that has since been forgotten.
Money Market Returns After Inflation
Be realistic about how much you’re making from your portfolio cash that’s sitting in a money market account. Even if there is an annual yield of .5%, this equates to a negative 3.5% real (after inflation) return after the loss to average historical inflation of 3% is considered.
Portfolio cash suddenly feels less secure after this reality check.
Portfolio Cash in Retirement
The negative real return on portfolio cash is usually compounded in retirement so retirees need to be especially careful with portfolio cash levels.
First, an annual negative return on even a small percentage of a portfolio can hurt even the best retirement plans.
Second, investors often have excessive portfolio cash as they get older, too, because it feels safe.
Third, retirees’ entire financial situation is worsened when ceased career earnings aren’t increasing with inflation. It just feels safer with higher percentages of portfolio cash, but this may not be the case.
Is Cash Really Trash?
I can’t bash cash too much, though; it has been much, much safer in the past to have had higher portfolio cash percentages at certain times. Such times become long forgotten, however; they include 2000 and 2007, as horrific and extended bear markets began.
Remember, however, a rigid asset allocation model would have led investors to have had very little portfolio cash in 2000 and 2007 so they would have not been prepared for those bear markets. Bond investors, and many tactical investors and financial advisors certainly had the edge during those turbulent times with higher cash levels.
Cash has recently become more popular as a risk management tool, however, given the low interest rates and potential volatility in bond investments.
There’s the ongoing challenge of balancing reduced risk with higher portfolio cash against investment returns drained by too much cash. This fact is what makes it hard for investors who aren’t using a rigid asset allocation model to determine the best percentage of portfolio cash. And this is what makes having the right amount of portfolio cash super important so keep reading.
How Much of Your Portfolio Should Be in Cash?
Now that we have addressed the importance of portfolio cash, the difference between net worth cash and portfolio cash, defined portfolio cash, and revealed the pros and cons of portfolio cash, let’s address how much portfolio cash to have.
Like many things here at Retire Certain, you’ll start with a decision because there is no cash allocation formula that works for everyone. This is because everyone must choose how they want to invest based on their own investing style, assets, and financial goals.
Investing is personal; it’s about what you want your money to do for you, and being at peace with your investment decisions while your money does its’ work.
Choose an Investing Method
The first step to determine your portfolio cash percentage is to make one of two decisions. Neither decision is wrong, but they will get different outcomes as to how much portfolio cash you’ll want to have.
Making this decision will keep you from worrying about having enough cash in your portfolio because you will have evaluated all the facts and made a decision from a place of clarity.
Here’s the decision: Make a conscious choice to be a passive “asset allocation” based investor OR a more tactical investor that prefers to sell stocks (or other assets) as they become expensive and buy stocks when they are cheap, as explained more in Method 2 below.
We begin with this initial decision because it is a determining factor in how much cash you should have in your portfolio as explained below.
Method 1 – Portfolio Percentage for Cash, Stocks, and Bonds Using Asset Allocation
Traditional investing uses a standard asset allocation model based on your age and risk tolerance to determine how much of your portfolio should be in cash, stocks, and bonds as explained earlier.
This is the most common portfolio cash allocation method among financial advisors, retirement investing institutions, and individual investors.
More experienced and tactical investors and financial advisors, however, use a different strategy to determine how much cash to keep in a portfolio as explained in method 2 below. First, let’s look at a traditional investing method for determining the percentage of portfolio cash.
Asset Allocation Example
A common portfolio asset allocation for a moderate to low risk 50 year old investor is 50% in stocks, 35% in bonds and 15% in cash (money market), for example, as explained more in my post How to Understand Your Investments.
The Goal of Asset Allocation Among Cash, Stocks, and Bonds
The goal with asset allocation among stocks and bonds is to lower risk and reduce the need for increased portfolio cash, thereby allowing an investor to maximize portfolio returns. No one can argue that this makes sense.
For standard asset allocation to work for lowering risk, bonds must go up when stocks go down.
Historically, this has almost always happened but there have been occasions when it didn’t happen as explained more below. Also, there is the twofold problem with bonds having such low interest rates.
This also helps reduce the risk of bonds now that the forty plus year bond bull market from declining interest rates is over. Even billionaire investor Ray Dalio warned of bonds in his cash is trash video despite his popular All Weather Portfolio which is heavily weighted in bonds.
Regardless, asset allocation investors tend to use bonds or cash in their portfolios to mitigate stock market risk.
Rebalancing to Desired Cash Allocation
With asset allocation investing, keeping the percentage of portfolio cash, stocks, and bonds consistent over time doesn’t happen on its’ own, however.
Here is how it works: The portfolio is rebalanced with the desired asset allocation percentages at least once a year. This must be done since asset values in the portfolio, other than cash, are ever changing.
At the chosen time, stocks and bonds are bought or sold so that the portfolio allocation to cash and other investments is restored to the desired level.
This portfolio cash allocation model is incredibly simple and it will show you the exact percentage of portfolio cash to have in any given year.
An asset allocation investing method can work well for passive investors who have decades to invest in stocks and bonds before retirement. Many investors don’t realize, however, the overall financial markets affect the success of asset allocation investing over any given time frame.
Problems with Asset Allocation for Cash Portfolio Percentages
There are some problems with using asset allocation for cash portfolio percentages despite the appealing simplicity.
Remember, asset allocation keeps investors in the same percentage of investment types no matter how expensive or cheap stocks or other assets get.
One problem with the standard asset allocation model, then, is that it keeps investors with a very low percentage of portfolio cash at all times. While a low cash percentage helps returns most of the time, it leaves investors vulnerable with a large allocation in overpriced stocks when stocks become overvalued during extended bull markets.
This increases investment risk even though annual portfolio rebalancing helps manage risk somewhat.
A subsequent problem is that investors don’t have investment capital available to buy undervalued stocks after the inevitable yet occasional bear market if they always keep a small percentage of portfolio cash.
Good News and Bad News
The good news for asset allocation method investors is that eventually stocks return to the value they were before the bear market, and another bull market resumes.
Unfortunately, this process can take several years, which can be problematic, especially for those preparing for retirement who were close to their retirement savings goal before the bear market began.
An alternative to passive long term investing is more tactical investing as explained in the very next section.
I don’t want to TMI (Too Much Information) you when all you wanted to know what how much cash should be in your portfolio but the answers here aren’t usually a simple formula.
it’s worth the time because having enough cash in your portfolio is crucial to reduce risk while also building wealth so stay with me while I share the next investing method that strongly affects portfolio cash percentages.
Method 2 is how the truly great investors invest; they invest based on opportunities at various times, not using asset allocation models even though asset allocation models can work well for passive investors during most long time frames.
Method 2 –Portfolio Cash Allocation for Value Investors
Tactical investors adjust their portfolio cash allocation based on opportunities in stocks, bonds, and other asset classes.
This method suits investors who want to apply other investing models besides asset allocation.
One popular more tactical investing approach is value based investing. The goal with value investing is buying assets when they are cheap and selling assets as they become overpriced.
Buying low cost assets is a hallmark of wealth building based on the timeless investing principle that money is made on the purchase side.
My Big Epiphany about Raising Portfolio Cash
After investing through a few painful bear markets, both alone and with financial advisors, I had a big epiphany after seeing the abundant opportunities after bear markets had ended: If you increase portfolio cash when markets get expensive you have the cash to buy assets when they are cheap later on.
So, at this point in my life, I’ve been through too many bear markets and recessions to ignore expensive stock markets that have always been followed by undervalued stocks, so I like to increase the ratio of cash to investments as markets get riskier (more expensive).
With value investing, overall markets, the economy, and asset valuations relative to historical prices are all considered before deciding how much of your portfolio should be in cash rather than using a set percentage for cash allocation.
This method naturally provides portfolio cash to buy undervalued assets when they are plentiful after bear markets which have pushed stock prices back below long term average valuations.
Alternatively, an asset allocation investing model tends to result in having almost all your portfolio cash invested when stocks and other assets present exceptional opportunities.
Investors must, however, either have portfolio cash available to purchase assets when they do swing under the mean valuation, OR be able to sell other assets to fund such purchases, ideally with a profit. While it is impossible to Know if the Stock Market Will Go Up or Down for sure at any given time, stock markets revert to the mean (average) over time with wild swings on the way.
Disadvantages of Value Investing
The disadvantage of investing based on valuations is investors inevitably miss some of the upside near the end of bull markets as assets become more overpriced.
Value investing requires a trade off between missing out near the top or having portfolio cash to take advantage of lower stock valuations after bear markets.
It is worth noting that even Warren Buffett has increased cash levels when he couldn’t find fairly valued stocks to buy.
Buffett’s investment advice to be fearful when others are greedy and greedy when others are fearful certainly speaks to a value investing approach despite more recent suggestions for investors to only buy the S&P 500 and hold it forever.
It’s also worth noting that in 2018, cash was the top performing asset class from among US and international stocks and bonds, commodities and real estate (REIT’s) with a 1.86% return as shown in this MFS asset class quilt.
Why Doesn’t Everyone Keep Enough Portfolio Cash to Sell High and Buy Low?
While it may sound great to sell stocks to lock in profits when they are expensive, and buy stocks when they are cheap, you must increase portfolio cash as stocks get more and more expensive for this to work unless you plan to sell other assets to raise cash.
This can be hard to do unless you have made a conscious decision to do so and accepted that you will miss some of the upside as stocks continue to climb because no one can time market perfectly.
That’s why it is suggested to first make a clear decision about whether to invest with a standard asset allocation in cash, stocks, and bonds no matter what valuations are, OR to be more of a tactical investor who invests based on opportunities. Once this decision is made, you’ll know whether or not to vary the amount of portfolio cash you hold.
Many individual investors avoid considering valuations when determining their portfolio cash allocation for several valid reasons as outlined below.
It’s Hard to Think Differently
One reason investors ignore valuations is that conventional wisdom says investors can’t figure out how to allocate investments among cash, stocks, and bonds based on valuations.
It does, undoubtedly, require some discipline and attention to be a more tactical investor. It’s my opinion, however, investors who choose can understand this basic financial concept as explained more in my post Ways to Reduce Investment Risk.
Too Much Cash Hurts Returns
It is worth repeating that if you invest based on market valuations, you can be wrong about when the stock market will decline and present better opportunities.
This usually results in having too much cash in your portfolio and missing out on some of the profits from bull (increasing) market trends. Even though you’re sitting pretty when bear markets do happen, you’ve got to make up for missing out on extended bull markets.
Passive Investing Is Easier
It’s easier to “buy and hold” stocks and bonds using a standard asset allocation than it is to alter the percentage you keep in cash, stocks, and bonds based on valuations.
The standard asset allocation model is simple for anyone to do.
There’s also less stress and little need to pay attention to the economy or stock market valuations. I do think, however, that all investors should pay attention because it affects one of the most important things in their life: their money.
Investors Are Encouraged to Use Fixed Asset Percentages
Investors are often discouraged from anything other than asset allocation based investing. While there are some more tactical financial advisors, passive investing with set asset allocation models is how most financial advisors invest for their clients.
Investors are often led to believe it’s riskier to raise cash levels when markets become overvalued, but this really makes no sense because buying assets at lower, fair costs naturally lowers risk. Also, for investors who have raised portfolio cash in response to expensive markets, buying less risky, lower valuation stocks is possible since investors will have the cash to buy them.
Even If You Have Portfolio Cash It Can Be Hard to Buy
Even when you have cash in your portfolio available to undervalued cheap stocks after bear markets, it’s very hard to do so. During such times, everyone hates stocks and many swear they’ll never invest in stocks again.
The disdain increases selling and drives the valuations even lower. This is when undervalued investments are abundant, yet many investors understandably don’t invest due to all the fear and uncertainty.
Most people like to follow commonly accepted practices rather than question them and consider being contrarian investors; we are herd beings.
This is when investing with facts, data, and historical information instead of emotions can help make smart investing decisions.
Imagine that if dividend stocks are bought during such times, for example, investors can be well positioned for retirement since yields are considerably higher when stocks are undervalued.
How Much Cash Should Tactical Investors Have in a Portfolio?
There is no set rule for the best cash allocation in portfolios for more tactical investors but there are some factors to consider.
One factor which will affect portfolio cash allocations is the amount you have in Treasury bonds as addressed more below.
Risk tolerance, level of confidence about a change in the economy, and net worth are other factors that affect the percent of portfolio cash tactical investors hold.
High Net Worth Wealth Managers
When stock markets become expensive, many tactical financial advisors, particularly high net worth wealth managers, increase portfolio cash to 50% or more.
High net worth investors are often savvier about economic cycles, market trends, and valuations. As a result, they demand more from their wealth managers.
Also, many more experienced individual investors employ similar risk reducing strategies as stock markets become expensive.
Are Bonds or Cash Better to Lower Portfolio Risk?
The percentage of your portfolio in Treasury bonds is also a huge factor in deciding how much of your portfolio should be in cash since Treasury bonds usually rise when stocks fall as explained above.
Is cash in a money market or Treasury bonds better a better risk management tool for investors?
Pros for Bonds Vs Cash to Manage Portfolio Risk
First, Treasury bonds are subject to price fluctuation and cash isn’t. This allows investors to experience a potential (and typical) increase in the bond portion of their portfolio when stocks go down. Since cash does not increase or decrease in value investors have no chance of it increasing to offset stock losses in the way that bonds do.
Second, bonds also pay higher interest than cash, unless perhaps there is an inverted yield curve.
Cons for Bonds Vs Cash to Manage Portfolio Risk
Unlike cash, bonds are subject to price fluctuation. This can be a good and a bad thing.
Investors tend to flee Treasury bonds after bear markets end as they put their money back into the stock market. As a result, the value of bonds goes down so investors must be prepared for this swing. Ideally, the bond decline will be offset by the portfolio benefitting from increasing stock prices.
Also, when interest rates rise, bonds decrease in value since investors can get higher interest from other or newer investments.
Summary for How Much Cash to Keep in Your Portfolio
One of the biggest challenges for investors is balancing the risk of holding too little portfolio cash against holding too much portfolio cash and thereby hurting returns. Deciding how much cash to keep in a portfolio becomes easier after an investor has chosen their primary investment method of asset allocation vs a more tactical investment approach.