What's the right amount of cash?
For a while now, I have been wondering how much cash is appropriate to hold. Given the seemingly-permanent low interest rate environment, and the inflation numbers, this topic has weighed on my mind a lot over the past few months.
Financial planners say that 3-6 months of expenses should be kept in reserve as an emergency fund for unforeseen expenses, or as a buffer for a job loss. This is probably the right advice, but I have kept a larger proportion of my overall assets in cash than the baseline recommendations suggest.
I like keeping a health cash position because it allows for optionality. While I don’t claim to be able to time the market, if there’s a significant market dislocation, I feel like having excess cash allows me to take advantage of buying opportunities. “But that’s just a form of market timing,” I hear you say. And you’re right. My rejoinder to this argument is that I am still pursuing my investment plan of regular asset purchases in my retirement account, taxable accounts, and college savings account. Absent a compelling reason, I do not sell assets simply because they have appreciated or declined in price. So, while maintaining a cash position that lets me take advantage of temporary dislocations is a form of market timing, I tend to discount that because I am continually investing income regularly, and I am not trying to time the market in selling assets. Imagine that something you really want goes on sale unexpectedly. Wouldn’t it be nice to have the cash to buy it? I look at investments the same way.
On the other hand, I know that keeping a significant cash position may be creating a drag on my overall returns. This is certainly the case in a market like the one we have been experiencing this year. I would be far better off today if all my excess cash had been invested in the market this year. My response to this is that consistently rising markets won’t persist forever. When we experience another bear market, a healthy cash position will act as a buffer for my overall portfolio, and again, provide optionality to add to investments as they decline in price.
The return of inflation has come as a surprise to many, especially the speed with which it returned. In July, the inflation rate was at 5.4%, a level previously seen 13 years ago. The swift increase in inflation rates brought on by various pandemic-related factors, coupled with the persistently low-yield environment, has certainly caused me to question the wisdom of holding so much cash. A few years ago, I opened a “high-yield” savings account online. The stated APR for that account was 1.8% at the time I opened it. Over the past few years, that rate has steadily declined to where it is now, 0.5%. So, with inflation where it is, and rates on bank deposits where they are, I am effectively losing purchasing power all the time.
Ultimately, I believe that the increase in the inflation rate will prove to be transitory as factors related to the pandemic such as pent up demand, and supply chain challenges normalize. So, unless you are in urgent need of a new car, hopefully most people will be able to wait out the current inflationary environment.
There is something reassuring about having a decently sized cash buffer, even if it creates a slight drag on our household’s overall performance in the current market environment. Hopefully it wouldn’t come to this, but our cash position means that my wife and I are relatively insulated from a period of unemployment. The optionality of cash is also attractive. It gives me the freedom to make tactical portfolio additions if sudden opportunities arise (such as March 2020). Similarly, if real-estate prices become more attractive in coming years, our cash balance will give us more flexibility in coming up with a down payment without liquidating a portion of our portfolio and the attendant tax consequences.
Ultimately, cash helps me to sleep at night. That’s reason enough to have it around.