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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