Key takeaways
Cash and cash equivalents can provide liquidity, portfolio stability and emergency funds.
Cash equivalent vehicles include savings, checking and money market accounts, and short-term investments.
A general rule of thumb is that cash and cash equivalents should comprise between 2% and 10% of your portfolio.
Cash and cash equivalents play a variety of roles in your investment portfolio and financial plan, including providing liquidity, portfolio stability and emergency funds for unexpected events. Cash equivalent vehicles are typically defined as money held in different types of accounts, such as savings, checking and money markets, as well as short-term investments with maturities less than 90 days, such as CDs, bonds and treasuries.
For many people, especially retirees who are no longer generating a paycheck, cash can help provide peace of mind that they have sufficient liquid reserves to weather periods of uncertainty or a downturn in the economy.
For investors who are willing to take on more risk, cash and cash equivalents also offer liquidity that can allow them to move quickly to take advantage of investment opportunities, particularly when there is disruption or fluctuation in the market.
Rightsizing investment portfolio cash allocations
Determining how much cash is enough is a common question, and the answer varies depending on your unique circ*mstances and current market conditions. Some factors that help to determine how much cash and cash equivalents to hold include:
- Your financial goals and objectives
- Your time horizon for investing
- Your spending needs
- Your risk tolerance
A general rule of thumb for how much of your investment portfolio should be cash or cash equivalents range from 2% to 10%, although this very much depends on your individual circ*mstances.
Cases where you might want to hold more cash include if you’re planning on a big purchase or expense within the next few years, such as buying a home or paying for college tuition. In addition, some people might carry a lower amount of cash based on their leverage opportunities. “In a low-interest rate environment, for example, you might have equity built up in your home that you can tap into, such as through a home equity line of credit, versus holding extra cash,” says D.J. Verhaalen, Wealth Management Advisor for U.S. Bancorp Investments.
Income and net worth are two additional considerations. For example, people with a steady income can often count on liquidity from a paycheck or annual bonus and may need to hold less cash. Others who work as independent contractors or hold commission-based jobs may want to hold more in cash reserves if their income is uneven or less predictable throughout the year, notes Verhaalen.
How much cash should I have in my portfolio? Weighing the pros & cons
It can be challenging to find the right balance of cash and cash equivalent holdings. A common mistake people make is carrying too much or too little cash for their situation, as well as putting cash in the wrong investments.
As an example, with the market volatility that occurred in 2022 and the allure of higher interest rates, investors increased and held higher cash positions. ”In some cases, this cash was kept out of equities and participation of the positive market performance so far in 2023," Verhaalen says.
Carrying too much or too little cash in your investment portfolio can offer both pros and cons that differ depending on an individual’s situation.
- Too much cash in portfolio: One of the advantages of too much cash is that liquidity gives you a lot of flexibility to take advantage of new investment opportunities. Peace of mind is another advantage of having a lot of money on the sidelines. The number one negative of having too much cash is that you’re getting a flat or very low rate of return. “Inflation is a hot topic, and when we look at return, it’s important to look at the real rate of return,” says Verhaalen. “If inflation is at 9% and you’re only earning 1% on your money, your real rate of return is –8%.”
- Too little cash in portfolio: One advantage of not holding much cash is that you have the potential to get a higher rate of return. On the downside, you don’t have the liquidity to take advantage of new investments and it could limit your opportunities, especially when you need to move quickly.
Cash and cash equivalents in a financial plan
Cash equivalents should be part of a regular discussion when it comes to a holistic financial plan. “When we build a financial plan for clients, we tend to be a little bit more conservative, because we believe managing risk is important,” says Verhaalen.
Verhaalen often recommends clients hold, at a minimum, the equivalent of six months of income. In addition, he’ll run a financial plan to determine an ideal amount of cash to hold based on an individual’s unique circ*mstances, as well as how to ladder it into different types of cash equivalents depending on the time horizon and when cash might be needed.
- Shorter-term cash needs of 0-6 months should be kept in very liquid accounts, such as savings, checking or money market accounts.
- A mid-term cash vehicle, such as a 12-month CD, is typically used for cash needs between six months and three years.
- Longer-term cash equivalents often involve short-term, low-risk investments between three and five years, such as a CD or bond with a fixed maturity.
“Laddering cash into short-, mid- and longer-term investment vehicles is very important because it provides liquidity and backup and is a good way to diversify your fixed-income portfolio,” says Verhaalen. For example, if your child is going to college, you might decide to set aside cash in a checking or money market account to cover the first semester’s tuition, put the second semester’s tuition in a six-month CD, the following year in a 12-month CD and so on.
In a rising rate environment, Verhaalen notes that he may also recommend that clients ladder cash equivalents in fixed-income assets with maturities on a regular basis, allowing them to reinvest and capture yield as rates go up.
Investors should review the percentage of cash positions in their investment portfolio periodically as part of their holistic approach to financial planning. Consider reviewing your financial plan with your financial professional on an annual basis, at minimum, or as needed as circ*mstances change.
Just as your life evolves, so should your financial plan. Learn how we can help you design a plan that fits your life.
Expert Introduction: I am an experienced financial advisor and wealth management expert, well-versed in the intricacies of investment portfolios and financial planning. With a solid background in the field, I have navigated various market conditions, helping clients optimize their portfolios and achieve their financial goals. My expertise extends to the nuanced aspects of cash and cash equivalents, providing clients with sound advice on liquidity, risk management, and maximizing returns in both stable and volatile markets.
Key Concepts in the Article:
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Role of Cash and Cash Equivalents:
- Cash and cash equivalents serve multiple purposes in an investment portfolio and financial plan.
- They provide liquidity, ensuring quick access to funds.
- Offer portfolio stability during market fluctuations.
- Act as emergency funds for unexpected events.
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Cash Equivalent Vehicles:
- Savings, checking, and money market accounts.
- Short-term investments with maturities less than 90 days, such as CDs, bonds, and treasuries.
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Portfolio Allocation Guidelines:
- A general rule of thumb suggests that cash and cash equivalents should comprise between 2% and 10% of an investment portfolio.
- Allocation varies based on individual circ*mstances, financial goals, time horizon, spending needs, and risk tolerance.
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Factors Influencing Cash Holdings:
- Financial goals and objectives.
- Time horizon for investing.
- Spending needs.
- Risk tolerance.
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Determining Adequate Cash Levels:
- The ideal amount of cash depends on individual circ*mstances and current market conditions.
- Considerations include upcoming expenses (e.g., home purchase or college tuition) and leverage opportunities.
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Pros and Cons of Cash Allocation:
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Too Much Cash:
- Advantages: Flexibility for new investments, peace of mind.
- Disadvantages: Low rate of return, potential negative real rate of return in high inflation scenarios.
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Too Little Cash:
- Advantages: Potential for higher returns.
- Disadvantages: Limited liquidity, reduced flexibility.
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Cash Equivalents in Financial Planning:
- Cash equivalents should be a regular topic in holistic financial plans.
- Recommendation to hold a minimum of six months' worth of income in cash.
- Laddering cash into short-, mid-, and longer-term investment vehicles for diversification and liquidity.
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Laddering Cash Equivalents:
- Shorter-term needs (0-6 months) in liquid accounts (savings, checking, money market).
- Mid-term needs (6 months to 3 years) in 12-month CDs.
- Longer-term needs (3-5 years) in short-term, low-risk investments like CDs or bonds with fixed maturity.
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Adapting to Market Conditions:
- Adjusting cash equivalent positions in response to market conditions, such as rising interest rates.
- Regularly reviewing and updating the percentage of cash positions in the portfolio.
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Periodic Financial Plan Review:
- Recommending annual or more frequent reviews of financial plans with a professional.
- Emphasizing the importance of adapting the financial plan to changing circ*mstances.
In conclusion, the article underscores the crucial role of cash and cash equivalents in a well-rounded financial strategy, providing insights into allocation strategies, risk management, and the dynamic nature of financial planning.