How much cash should you hold in your portfolio?
By Barry Ritholtz,
Washington Post December 13, 10:19 AM

 

When people discuss their investing portfolios, they typically refer to the stocks, bonds, commodities and real estate they hold. The conversation might also include model weightings, tilt toward and away from different asset classes, and rebalancing. What we rarely hear about is cash.

Much of the traditional thinking about cash is well intentioned but unrealistic. Should you have six months of living expenses in the bank for emergencies? Sure. Do you? Probably not. In over 20 years of working in finance, I simply never see that sort of cash cushion among average investors of ordinary means. It is a luxury that only the wealthiest can afford.

We looked at a related issue earlier this year when discussing “How to get back into the market after you missed a big rally.” That also involved the issue of cash being a drag on portfolio returns. The context there was investors who had gotten skittish, had sold out of various positions and then found themselves unable to muster the discipline to redeploy cash back into risk assets.

That is not the cash matter I want to discuss today. It’s this: How much cash should there be in your investment portfolios? You may not have given it much thought. It seems to be coming up a lot among the ultra-wealthy. As mentioned before, many of the investment firms that service the wealthy have discovered that these folks are sitting on mountains of cash. Broad surveys from the likes of U.S. Trust, BlackRock, UBS, even American Express have shown that their high-net-worth clients are cash-heavy and, in many cases, asset-light.

Why the ultra-wealthy have decided to sit in an asset class that loses value by the second with even modest inflation can most likely be explained by psychology. Call it the “recency effect” — investors are still shellshocked by the four asset crashes in a decade. From their peak years, we had technology/dot-coms fall about 80 percent (2000-02). Housing dropped 35 percent (2005-09), including the related falls in home builders, banks and investment firms of 75 percent. Equity markets crashed 57 percent (2007-09). And, lastly, commodities are off their highs anywhere from 30 to 50 percent (2011-13). Is it any surprise that investors are skittish?

Perhaps the financial media bear some blame. There has been nonstop bubble talk. We read that stocks are over-valued. We are told they carry high cyclically adjusted price-earnings valuations relative to GDP. Earnings are at record highs, which is somehow a bad thing. The Dow, the Standard & Poor’s 500-stock index and the Russell 2000 keep making record highs, which also is somehow portrayed as bearish. As a side note, let me point out that markets averaged 30 all-time highs per year from 1982 to 2000. Although none of these issues is new, it has been a persistent condition among the commentariat since this bull market began in March 2009. I called this the most hated rally in Wall Street history that year; the vitriol has only gotten worse since.

Back to cash and how much to hold in a portfolio. It really depends on who you are, how you are investing and your investment horizon. A hedge fund manager whose clients demand monthly performance reports has different needs than any individual investors with a 20-year time horizon. The needs of that long-term investor differ markedly from someone who is retiring in three years.

Warren Buffett has patiently held as much as $20 billion to $40 billion in cash. He thinks of cash not just as an “asset class that is returning next to nothing,” but rather as “a call option that can be priced, relative to the ability of cash to buy assets.” He put that to good use during the financial crisis, scooping up deeply discounted bargains.

Most investors lack Buffett’s discipline. When markets are rallying, cash in the portfolio is a drag on performance, returning about zero. The argument I hear for cash in the portfolio is it doesn’t go down during market crashes, and it allows the purchases of cheap assets a la Buffett at attractive prices. But investors rarely can make that buy when markets are crashing. They are simply too scared, lacking the fortitude or the nerve to pull the trigger. Even those who managed to avoid the 2008 crash found themselves stuck with way too much cash in their portfolios as markets recovered. Up more than 150 percent since the 2009 lows, many are wondering what to do.

Exactly how much cash are we talking? BlackRock President Rob Kapito noted in a Wall Street Journal interview last month that “on average, more than half of portfolios are in cash, earning negative real returns . . . 48 percent of U.S. respondents’ investible assets are in cash deposit and savings accounts, and an additional 12 percent are in money-market accounts and certificates of deposit.”

About 60 percent is a shocking figure — and when we put this in dollar terms, it’s even more astounding. American Express’s survey of affluent Americans — those folks with at least $100,000 in disposable income — discovered $6 trillion in cash savings. Again, that is a stunningly large number.

The alternative to stocks for the skittish is, obviously, fixed income. Given the inevitable increase in rates, many investors have liquidated bonds, further raising their cash balances. Rather than try to time the bond market, the solution here is to hold a ladder of individual A-rated bonds — not a fund subject to redemptions — that will mature over the next three to seven years. As this paper reaches its maturity over time, you simply roll into a similar bond at what is likely to be a higher yield. That is a better strategy than holding cash for the next seven years.

The bottom line is this: Cash, in modest increments, has a role in any portfolio. But unless you are Warren Buffett, you should limit it to 2 or 3 percent. Otherwise, you are likely to miss the next bull market. Too many people have already missed this one.

~~~

Ritholtz is chief investment officer of Ritholtz Wealth Management. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. Twitter: @Ritholtz.

Category: Asset Allocation, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

32 Responses to “How Much Cash Should You Hold In A Portfolio?”

  1. foosion says:

    I hold cash to reduce the average duration of my bond holdings. I hold Vanguard’s NY muni fund in taxable and it’s too long for me, so I hold a NY money market to bring the average duration down to the level I want.

    What major practical difference do you see between a rolling ladder and a bond fund?

    • Bond funds suffer redemptions — usually at the worst possible time.

      Ladders are held to maturity

      ENORMOUS DIFFERENCE

      • mockware says:

        Thank you for bringing this up. I basically tell people that a bond fund effectively turns bonds into stocks with a huge problem. There is a limit to how much a bond can appreciate in price. You will get run over by the crowd in the fund when bonds drop in price and they run screaming for the exits. I simply list my bonds in my assets at 100 and ignore whatever price they are selling at at any time. I made a huge killing in 2007 when I scooped up a boatload of high quality bonds. I love Short View on FT. I saw a video where he pointed out that in order to lose money on corporate bonds compared to Treasuries, 50% of companies would have to go bankrupt. It’s an easy call to make to load up and diversify. If 50% of the companies did go bankrupt, I’m sure losing money would be the least of my worries at that time. I would worry about the value of the money left instead.

  2. sdpost5 says:

    “Earnings are at record highs, which is somehow a bad thing.” Well, only if you look at historical data that shows that profit margins revert to the mean — with no exceptions.

    • Please provide the following:

      1) A link to a chart showing that
      2) An indicator that informs you that THESE record profits are the sell signal, as opposed to 2012 2011 or 2010

      • elliottw says:

        Barry, I recognize many of my own mistakes in your description. I could add another — getting whipsawed by tactical asset allocation with moving averages in 2011 and 2012, then giving up and waiting for a correction to get back in just as the rally got going in 2013.

        Just to play devil’s advocate, the first chart in John Hussman’s latest post illustrates the mean reversion of corporate profits: http://www.hussmanfunds.com/wmc/wmc131216.htm
        He seems like a smart guy, but I’m not sure if he’s using his analytical skills to inform his investing or confirm his hunches.

        ~~~

        BR: John is a very nice, really smart guy.

        Unfortunately, his methodology has led to severe under-investment and under-performance for 4 years

  3. GeorgeBurnsWasRight says:

    I don’t know how much money these people have to invest, but I note that public sites such as MarketWatch are filled with people posting about how “the markets are rigged”, the US is doomed and is about to enter financial collapse worse than anything the world has ever seen, and espousing various conspiracies, particularly around gold.

    For people stuck in this mindset, a rising market isn’t a reason to invest, it just represents the final blowoff top that will end in disaster for everyone “foolish” enough to believe any government or non-government economic reports which contradict these people’s version of reality. Given research showing how people faced with evidence contrary to their strongly-held beliefs mostly just believe even more strongly, I doubt that much of this money will be coming into the market.

  4. constantnormal says:

    “Why the ultra-wealthy have decided to sit in an asset class that loses value by the second …”

    … perhaps they are “doing God’s work”, redistribution of assets to others who are more deserving of them …

  5. MinskyMinded says:

    Unfortunately I am one of those who has sat on too much cash as a result of listening to GMO, Hussman and others who have repeated argued that record earnings are a function of record government deficits. Earnings justified stock prices in 2007 as well, but they too were artificially and unsustainable.

    But this time is different (really), the Fed has changed all dynamics and broken historical cycles. How this ultimately plays out is pure speculation, we are in totally uncharted waters.

    Fooled me once, fooled me twice, but can I really live with myself thrice? My fear of being a greater fool once again is higher than my fear of missing a rally. I could probably live with the capital loss, but not the fact that I was sucker once again.

  6. S Brennan says:

    Good read Barry..thanks.

  7. FrankInTheFalls says:

    I just read the June 14 Post column about missing the rally. As one who missed a good portion of the rally, I cannot believe the comments made in that column. The rationalizations are spelled out & I really believe they are mostly guilt trips by people like me who missed a bunch of the rally. A little history and a little math are really constructive here. Rather than whine and make my mind more twisted about the whole thing than it already is, I am developing a plan. People need to admit it and move on. I, for one, am sick of all this cash.

  8. rd says:

    I think that one of the key issues that is over-looked is the scale of holdings. A Warren Buffet or Pimco can’t simply access cash overnight to make a transaction by selling 5% of their holdings. Their simple action of doing that would move the market given the magnitude of their holdings, so they need to have cash in order to make something happen on relatively short notice. However, I could convert my entire 401k or IRA to cash overnight and the markets wouldn’t even be aware that I did it.

    Since I can sell my bond funds and re-invest in equities in 24 hours or less, I don’t need cash in order to provide opportunities. If anything, the bond funds may actually even increase in value during the stock market panic giving me more investable funds.

    Bond bear markets tend to play out much more slowly than stock bear markets, There were three major declines and subsequent rises in the stock market from the mid-60s to the early 80s. The bond market was simply in a massive bear but the annual declines were relatively small compared to the stock market during that period. We have had both a massive bull market and a bear market in stocks during the current bond bull market. So the real key seems to be in simply using the rebalancing process to use the slower bond moves to reduce overall portfolio risk by using the more volatile stock market to lock in gains during stock bulls and re-invest in stocks during the bears.

    CAPE and mumerous other long-term valuation measures say that this is not a time to go all in with stocks, but with -2% real yields on cash, then cash is no better than stocks looking out 7 years or more. I think the bond market move this spring and summer gave us back a more rational set of medium and long-term yields that are more likely to move in response to economic and inflation concerns than over the past few years.

    • “bond funds may actually even increase in value during the stock market panic giving me more investable funds”

      Exactly the idea behind rebalancing

      And its not like I am saying “go all in” here. I am saying question why you have too much cash in your portfolio, and how you can avoid making bad decisions that rely on market timing.

      • rd says:

        I was simply pointing out my reasons for not holding much cash right now in a small investors account. Usually, money market funds will keep pace with inflation, especially in a tax-deferred account. The Fed is ensuring that cash will lose 2% a year to inflation and have said they will maintain this policy for at least a couple of years. So, at this juncture a portfolio of high quality bonds and diversified stocks (including international) looks like the best approach to staying even with or ahead of inflation over the next few years. This is obviously subject to revision over time, especially when stock or bond markets make major moves.

        A very large investor needs to have cash on hand already to take advantage of opportunities as they will either move the market with sales or inform the world they have weakness in their accounts disrupting their credibility in deals. Small investors don’t have these liquidity concerns.

  9. Imspartacus says:

    If you purchase MUAD-G series I-Shares and invest the redemptions into the latest date series ETF you could create a muni-bond ladder with ETF’s. Am I missing something? Thanks

    • Anytime you deal with a fund, even ETFs, you are relying to some degree on your fellow shareholders.

      The risk is they panic and do something stupid

      • Imspartacus says:

        Thanks I get it now, What could possibly go wrong with relying on people to be rational? BTW I really do look forward to reading your blog each day. You are providing an Ivy league level education for investors at a much more affordable price. It is great to see someone
        in finance doing the right thing and looking out for investors interests instead of taking advantage of their ignorance.

  10. Imspartacus says:

    If I invest MUAD-G I-shares target maturity ETF’s an roll the redemptions into the longest maturity fund, would I not be creating a Muni-Bond ETF with ETF’s? Am I missing something here Thanks

  11. Imspartacus says:

    Sorry I meant to say Muni-Bond Ladder with ETF’s Thanks

  12. DiggidyDan says:

    This is not a cut and dried answer really. It depends on many factors, such as interest rate environment, inflation, overall equity valuation, prospects for future “safe” returns, when you will need the money, etc. Personally, I have built my emergency fund to 12 months cash-like holdings. But in my retirement account, it’s fully invested in stocks right now. This is mainly because of 3 things: I can’t touch my retirement account for 30 years, so may as well just let it ride in equities right now, bonds and safe return vehicles like CDs are particularly unfavorable in this interest rate and FED policy environment, and I have uncertainty in my near future job prospects and may need the money, so I have more cash on hand than a person normally would.

    In an ideal economy and bull market, with job security, I would probably have only 6 months living expenses (not salary) in a high yield MM account, and the rest in long term equities given my age.

  13. DiggidyDan says:

    Also, BR, I think you need to do a new post on the investor sentiment cycle: http://www.ritholtz.com/blog/2011/12/psy-cycle-updated/

    but update it with things on the upswing that correspond to “regret”, “jealousy”, “fear of missing out”, and “self pugilism” as the bears and cash holders capitulate approaching the top.

  14. Berkeley Maven says:

    For those holding significant cash, for whatever reason: don’t leave it in a money market fund earning 0%, probably where you hold your stocks and bonds and mutual funds, just for convenience. Don’t let your money manager do that, either.

    Find yourself one or more internet savings accounts, the best of which pay 0.90% to 1.00%, with deposit insurance up to FDIC and NCUA limits. That will reduce the negative real yield on cash. This is a great place to shop:

    http://www.depositaccounts.com/

  15. TheDailyGold says:

    What media is Barry talking about? No one is talking about a bubble. Every guest on every show is bullish and saying stocks are the only game in town. This is not the most hated rally. Equity inflows have been at records this year. Investors intelligence bears and bulls/bears ratio are at 1987 levels.

    Also, its very dangerous to assume all-time highs are always bullish. Just look at the S&P from 1966-1982. It made many all-time highs yet had 5 20% drawdowns or 3 of 27% or higher. Go look at the Dow from 1900-1920. Numerous false breakouts. With profit margins at all time highs and the trailing pe at 18.4 (tops ex 2000 are at 23-25), the market is most certainly not at a 1982 or 1942 (or even 1949) position. Stay invested and get low returns for the next 3-5 years? Not a good idea. Most will but then sell out at the wrong time. Seems like a wise idea to hold cash when things get frothy rather than to stay 100% invested.

    By the way, the CCI, the broadest and most balanced measure of commodities is down 27%. Its retraced a normal 50% of the 08-11 run. Not exactly a crash. Its a cyclical bear in a secular bull. That trailing PE needs to come down again and inflation is what will cause that. When stocks suck wind again, you’d be better off in commodities, not cash. I guess in that case you could also be in emerging markets.

  16. elliottw says:

    Good points, but I’m not sure that 2-3% is the optimal cash allocation if we are entering a rising rate environment.

    This table (http://pages.stern.nyu.edu/~%20adamodar/New_Home_Page/datafile/histretSP.html) shows plenty of years from 1966 up through even 1994 when 3-month T-bills outperformed both stocks and bonds.

    I don’t expect T-bills to return 14% again anytime soon, but it would be interesting to do the analysis and see if maybe a 10% allocation would reduce draw-downs and improve the risk-adjusted return during those decades.

    But this is not the 70s. I like your idea of a bond ladder, and I’m using Bulletshares and iShares corporate term ETFs to diversify the credit risk. I’m not sure whether a roll-your-own ladder is technically any different than an open-end bond fund, but it helps me to sleep at night knowing I’ll get my investment plus interest back when they mature, less fees and any defaults.

    • This is not a market call — The issue is not “what is optimal if you are an algorithm,” its for the typical human.

      The key question is when you pull out of markets, what is the basis for getting bsck in? This is not a market call, its an observation about process.

      To (once again) quote Peter Lynch, Peter Lynch. “”Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

  17. Aaron says:

    Hi Barry.

    I really enjoyed this post, as the issue of having cash in my 401k account was a spirited yet friendly topic of discussion recently between my financial advisor and I. After discussing my age/time horizon to retirement, risk tolerance, and other factors regarding my portfolio, he suggested that I should be mostly in equities with the remainder in bonds only with no cash holdings. I, on the other hand, felt there is a reason to hold some portion of the holdings in cash as well as bonds only because I wanted to take off some gains from the domestic equity portion of my holdings this year to rebalance my portfolio and increase my holdings in under invested international equities as opposed to increasing my allocation to a bond fund, given my concern(s) about interest rates going into the new year. I have a process down of the types of funds I will invest in, limited as they may be in my 401k, as well as what assets I intend to invest in (bonds/stocks/cash). I know that cash is a drag on any portfolio, yet putting cash back to work in equities if/when they go down is a difficult process that I am all too familiar with. Again, great post to end the year with, really appreciated this.

  18. Keith R says:

    The 2-3% guidance is based on history, but the Fed’s intervention is a material difference here. Given the Fed’s success at inflating those asset prices, is it really so unreasonable for some to want to hold a higher level of cash than “normal”? Advocating a “normal” 2-3% cash is akin to ignoring the affect of the Fed on current environment.

    I take your point about “how will you know when to get back in?”. I don’t want to be all out of the market in 1982, but I also don’t want to be all in the market in 1973.

  19. howardoark says:

    I’ve been getting crushed the last three years, but I also went 100% long during the 2008 unpleasantness (I went in gradually over the spring investing my last investable funds in 2000 shares of GE on the day the S&P hit 666 – my feeling was that if it was the end of the world, money in a retirement account wasn’t going to do much for me). And that was after getting a pretty steady return in bonds over the 1998-2008 period while missing 2 stock market crashes. So, not unlike the WWI generals (always fighting the last war) I’m waiting for stocks to go on blue-light special again before I put all my cash to work. If I have to wait until I die, then I screwed up even worse than I did when I got out again in 2010 (missing the bulk of the current run-up). But 1999 – 2001 was also a pretty bleak period for me too so I think it’s too early to start kicking myself.