Is it possible to have too much cash? Every time I log into personal capital I see a pop up indicating I am holding too much cash. How do they know how much cash I feel comfortable holding, especially in the current environment? Many family and friends have asked me recently about how much cash to hold and I think this a great question to ponder.
Is it possible to have too much cash? Too much cash can be a real drag, on your portfolio that is. If you’ve got enough cash saved for emergencies (3-6 months,) then the rest isn’t ideally working for you. Take a look at your overall cash position and invest the excess to grow your net worth. – Personal Capital
Many intelligent investors hold cash. They hold it for a variety of reasons. Why would someone chose to hold cash instead of invest? Lets take a look.
There are two obvious reasons why cash is held.
The most obvious reason is to fund a lifestyle. You want to make sure you have enough cash in your account to pay for life’s daily expenses. You may have a mortgage, car payment, groceries, utilities, student loans and want to take a trip every now and again. Most people want to have enough in a primary account to cover such expenses until they receive their paycheck. We typically put everything on a credit card and then use our cash to settle up at the end of the month.
The second part of this cash is typically an emergency fund. This usually holds between six months to a year of living expenses. For the TPM household, nine months of cash while two parents are working is a great margin of safety. When we retire early we will likely hold even more. For these funds, we typically place our cash investments in one of these places.
Well that sounds reasonable, why is Personal Capital dinging us for holding too much cash?
This is where things get more interesting. Many experienced investors know that cash is king. Look at Berkshire Hathaway, they are holding record levels of cash with $100 billion ready to be deployed. Warren Buffet is comfortable allowing the cash build up while scouting the marketplace for companies to gobble up. Many value investors do this.
In the TPM household, the cash builds up from regular contributions from our day jobs, stock sales and dividends. Not to mention I recently sold stock as part of my tax loss harvesting strategy.
Here are some reasons you may consider holding cash in your portfolio:
- Cash lowers your portfolio’s downside risk
- Cash reduces portfolio volatility
- Cash provides “dry powder” to invest on the spot.
- Cash allows you to ride out downturns. You will not need to sell investments to fund lifestyle should a long downturn occur and we lose our job.
Minimize Downside Risk
Downside risk in a portfolio is the risk that your portfolio takes a nosedive. You may have heard investors use the saying that they want to “sleep well at night.” Many people have been forecasting that the next recession is imminent. This might encourage people to allocate a higher cash position than usual. Everyone knows its coming, but nobody knows exactly when and how large of a downturn it will be.
Holding cash can help minimize the downturns in your portfolio as cash is a relatively stable asset class.
By holding cash in an investment portofolio, this portion of the portfolio will not fluctuate with the market. It will not disappear in a market correction. It is relatively stable.
Just take a look at one of my favorite value investors, Seth Klarman over Baupost Group. He has a staggering 42% of his hedge fund in cash, making it the largest position. As a hedge fund manager, he also has to think about redemptions, but still this is a lot of cash to be sitting on.
Ample Dry Powder
The cash portion of your investment portfolio provides ample resources to load up when an opportunity is found. No-one enjoys having to sell investments to fund the purchase of other investments, unless the opportunity cost is so great even after paying taxes on gains.
You may have heard Warren Buffet make this comment:
I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.
If you only had 20 investments over a lifetime, you would think hard about where you invested your dollars. You would also require patience to find the right time to invest. I am not recommending market timing here, just waiting to purchase a great company when there is a discount to its intrinsic value.
Funding Lifestyle During Downturns
If you are reading this, you probably already have a substantial amount of cash in your emergency fund. Imagine a 2008 scenario, your home loses 25% of its value, maybe you get laid off and you are still trying to make ends meet. Good thing you have that emergency fund. After 6 months of looking for a job you burn through that emergency fund.
Where do you look next? Selling investments or taking on debt? Well, luckily you allocated an additional double digit percentage to withdrawal without needing to sell investments that have lost value. That extra 10% you would have loved to invest at bargain prices, but alas you needed to fund your lifestyle until you found a job 9 months later.
Yes cash is an asset class. Generally it will lose its value over time to inflation. In a downturn however, you will be very happy with how your cash holds up.
Are you holding more cash than usual? What are your reasons for holding cash?