Stocks, bonds, real estate, currencies…your allocation decisions involve trying to determine the right mix of asset classes for your goals, risk tolerance and other issues. But there’s another asset that’s a critical part of the mix, though it lacks the cache of frontier market stocks or currency swaps. What is it? Good old fashioned cash!
How much cash do you need to keep on hand in your portfolio? We will answer this question in two parts: we’ll discuss operational cash and strategic cash.
Operational Cash
Like it or not, investing costs money. You’ll need to pay commissions, advisor fees (if you use an investment advisor), and other sundry expenses related to the services you use to manage your portfolio. (By the way, let me make a quick note: if you have no idea how much you’re paying, take a close look at your next portfolio statement. You may be paying more than you need for the level of service you are getting.)
To deal with these periodic expenses, you need to keep a part of your portfolio in cash. How much? Well, if you use an investment advisor you’ll pay a cash charge – typically somewhere around 1% of total assets under management annually. So if you have a $100,000 portfolio you would need to have cash on hand of at least $1,000 when the advisor’s invoice comes due. If you don’t use an advisor, the cash outlay will be less – broker’s commissions are normally deducted directly from the trades that the broker makes on your behalf. If you sell 50 shares of Coca-Cola stock, you’ll pay a trading fee directly from that trade.
You’ll also pay management fees for the mutual funds in which you are invested – but again, these fees are deducted directly from your returns, so they don’t constitute an expense for which you have to write a check. But don’t be fooled – those fees are still coming out of your pocket and they add up over time!
Strategic Cash
There’s a second use for cash in your portfolio, beyond whatever reserve is necessary to pay fees and expenses. This is cash as a strategic asset class. Think of cash (or more specifically cash equivalents = like money market funds or short term Treasury bills) as the safest of the safe harbor assets that you keep on hand to hedge against volatility.
How much you allocate to cash depends on your overall strategy. If you are a growth-oriented investor with a very long time horizon to retirement or other goal, your cash component should be very small, probably no more than 5% maximum of total assets. If you are closer to a major liquidity event or if you are a more risk-averse investor, the cash component may need to be higher.
In the current market environment, cash is a poor choice for income generation. You will find that almost all cash equivalent alternatives pay next-to-zero interest, even to their most creditworthy investors. Long gone are the days of 6% money market funds. On an inflation-adjusted basis you actually come out net-negative with cash.
Where it can play a role, though, is as a way to reduce the exposure of your safe harbor portfolio to interest rate risk, which is especially important today. When interest rates go up, the market value of fixed interest investments will go down – and instruments with longer maturity dates bear the lion’s share of the pain. Cash and other short-duration instruments offer some protection against this.
Cash is a basic feature of investment portfolios. Make sure you have the right amount of both operational and strategic cash for your own particular situation.
How much cash do you keep on hand in your portfolio? Tell us what you think.
For advice and tools to manage diverse assets from cash equivalents to equities and beyond, visit Jemstep.com.