Count the Cash

Jonathan Clements

WHEN WE THINK about portfolio building, we tend to think first about stocks. They’re our engine of investment growth—and the source of endless anxiety. Indeed, to make stock market investing palatable, we take all kinds of precautionary measures, including diversifying broadly, adding bonds, throwing in cash, purchasing gold and goodness knows what else.

But maybe we have this all wrong. Perhaps, instead, we should start with cash: how much we currently have in safe, liquid investments, how much we expect to receive in the years ahead and how much we’ll need in the near future. Once we have a handle on our cash situation, we’re free to invest the rest of our portfolio as we wish—including potentially stashing much or all of our money in stocks.

Sitting pretty. How much cash should we hold? In addition to a modest sum in our checking account to cover the next month’s bills, we should all hold some cash or cash-like investments, whether we’re in our 20s or our 80s. This money might sit in a savings account, certificates of deposit or a high-quality short-term bond fund.

Think of it as comfort cash. It can ease our worries, knowing we have a backstop if we have a surprisingly expensive month—and it can help us avoid the financial anxiety suffered by four out of 10 Americans, who apparently either couldn’t cover a $400 unexpected expense or, to do so, would need to borrow or sell possessions.

How much comfort cash should we keep? It’s partly about sleeping at night, but also partly about being prepared for financial emergencies. That’s an especially big issue for those in the workforce, because the big financial emergency is getting laid off.

What about retirees? Because losing their job is no longer a risk, arguably they need little or no emergency money. But they may still need a heap of cash for another reason: to cover their spending needs in the years ahead.

Coming in. As a rule of thumb, money we’ll spend over the next five years should be out of stocks and riskier bonds. Instead, it should be invested in nothing more daring than a short-term bond fund. So how much cash do you need from your portfolio over the next five years?

For many folks, the answer will be zero—because they have enough cash coming in from elsewhere. If you’re in the workforce, your spending over the next five years will likely be more than covered by your paycheck, and thus there’s no need to hold anything more than comfort cash. Ditto for retirees who can cover their entire living costs with Social Security, plus any pension, annuity and rental income. For both these groups, investing heavily in stocks could make sense, provided they have the tenacity to stick with their holdings through the inevitable market turmoil.

The case for investing heavily in stocks is especially strong for those in their 20s and 30s, and not just because they have a long investment time horizon. A digression: There was a rather tedious debate in the 1990s about whether stock market returns are mean reverting. If they are, periods of bad returns will be followed by stretches of good performance, and thus long-term stock investors with diversified portfolios should eventually get rewarded. But if markets aren’t mean reverting and instead performance is totally random, there’s no assurance stocks will deliver the highest return, no matter how long we hang on.

So if young adults shouldn’t invest heavily in stocks simply because they have a long time horizon, why should they? In a nutshell: Because they don’t need to hold cash. In fact, if you’re in your 20s or 30s, your portfolio will likely be the net recipient of cash over the next three or four decades.

Suppose you’re age 30 with $50,000 saved. You make $80,000 a year, save 12% of income and plan to retire at 65. Ignoring inflation and future pay raises, you’ll add $336,000 in new cash to your portfolio over the next 35 years. In other words, even if your $50,000 is entirely in stocks, your portfolio is arguably super-conservative, given the $336,000 in cash still to be invested.

Going out. What if you’re retired and, over the next five years, will need to take regular annual withdrawals from your portfolio? You should calculate the total dollar amount you’ll need and then move that sum into cash investments and high-quality short-term bonds.

Let’s say you’re withdrawing 4% of your portfolio each year. You might keep 20% of your money in cash investments, to cover the next five years of portfolio withdrawals, and then invest the other 80% in stocks and riskier bonds.

Each year, part of that 4% withdrawal would be covered by the dividends and interest kicked off by your investments. Suppose your portfolio’s overall income yield is 2%. If you have a strong stomach for risk, you might keep less than 20% of your portfolio in conservative investments, knowing that your portfolio’s yield will cover half your withdrawals in the years ahead.

What if you’re withdrawing not 4% each year, but just 3% or even 2%? In retirement, the stronger your stomach for risk and the lower your withdrawal rate, the less cash you need to hold—and the more you could potentially allocate to stocks. That would be rational.

But it might also be rational to dial down risk. In the past, I’ve mentioned the comment from friend and fellow financial author Bill Bernstein that, “When you’ve won the game, stop playing with money you really need.” If you have more than enough saved for retirement, you might opt to keep less in stocks, thus ensuring there’s scant risk your lifestyle will be derailed by terrible markets.

So should you take more risk or dial it down? It all depends on your appetite for risk: You need to decide whether you care more about upside potential or downside protection.

That said, if you have money that you know you’ll never spend during your lifetime, and instead plan to leave it to your heirs or to charity, I’d be inclined to invest that money largely or entirely in stocks. Assuming neither your heirs nor the charity are banking on the money, it’s going to be gravy to them—so you might as well aim for as much gravy as possible.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Signal FailureCash Back and Crazy Like a Fox. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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Sunil Sharma
Sunil Sharma
2 years ago

Under normal circumstances, a retiree would raise funds for annual living expenses (beyond Social Security and other non-wage income) via portfolio rebalancing transactions. What are the specific circumstances or triggers that would cause the retiree to draw upon the five-year reserves in order to fund annual living expenses? When would the retiree stop drawing from these reserves and return to using rebalancing transactions? How and when should the reserves be replenished? Could you please provide specific guidance? Thanks very much.

Peter Blanchette
Peter Blanchette
3 years ago

Great article…except for the last paragraph. Prior to the last paragraph you are essentially saying that you can dial it down once you get to a point where you feel the income from investments, pension, SS, annuities is a good match with expected expenses to come. In the last paragraph you seem to assume that potential catastrophic health care expenses, possible long term expenses, and expenses for those of us who are of the of the sandwich generation who potentially have to support the generation before us and the generation after us are off the table. It seems to me that you are making some unreasonable assumptions. In addition, do you tell someone with a $1Million portfolio and a 2% withdrawal rate that they should invest 60/40 in equities and face the potential of a 2008 event? First off, you are addressing a situation that applies to a very small part of the population in this country. And I have yet to talk to a CFA who would tell someone to do what you are suggesting. Risk tolerance means not just how you feel about risk but about what level of risk is necessary to meet your goals.

Roboticus Aquarius
Roboticus Aquarius
3 years ago

Interesting example. In that situation, I don’t think I’d have any issue with the 60/40 allocation, though of course we all have unique situations and perhaps even my sense of risk is out of spec. The way I think about that situation, is that $1M at 2% provides a big buffer, since most people would turn out fine with a 4% withdrawal of $500K in savings for 30 years or so (leaving aside whether the future will be like the past when it comes to the Trinity study.)

Therefore, a 50% loss against a $1M portfolio would leave you withdrawing 4% against a $500K portfolio, which should still sustain a reasonable retirement in most cases. Still, that’s not quite accurate. A 50% loss on the entire portfolio is unlikely I think – but a 50% loss on the equity portion of the portfolio is an event that takes place once every decade or so, and should be part of our planning process. So, if I lose 50% of the 60% of my AA that is in Equities, I lose 30% of my portfolio, so I still have around 70% or $700K. I still have a 20% buffer vs my true base needs ($500K). Plus, equities are then on sale. As a worst case scenario, that seems acceptable to me, since my core goals are met.

Perhaps you have a different reading of how that plays out, or just have a different sense of acceptable risk. Clearly, not everyone would be happy in that situation – but for some folks who understood the risks, it may be just fine.

Market Map
Market Map
3 years ago

And yet, inflation and taxes are a couple of the biggest threats to saved assets.
The use of a Roth IRA as a tax sheltered savings vehicle can provide great benefit to an investor, with benefit of tax free withdrawals after age 591/2, thus relieving the tax piece.

Investing “mainly” in equity based assets during positive economic and market trends and duration assets during negative economic and market periods ( see Part 2 in links below ) may alleviate the inflation piece ( by maximizing asset accumulation above the rate of inflation through “strategic” and “tactical” use of bonds ).

If an investor is so inclined, they may build a “safe money” bucket during positive trends through a regular percentage “asset harvesting” from the equity portfolio ( see Part 5 * ).
. . . .

Rick Connor
Rick Connor
3 years ago

Great article Jonathan. This approach worked really well for my mother-in-law. After she sold her home and moved into assisted living, we set aside 5 years of expenses in cash, and put the rest in low cost bond and stock index funds. Because of medical diagnosis we were able to deduct her assisted living expenses as medical deductions. This allowed us to move IRA funds to cash tax free and fill her cash accounts. She was able to live safely and comfortably for many years, and her portfolio grew to leave a nice legacy her 5 children.

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