Building Wealth When thinking about the role cash plays in your portfolio, the first questions you should ask is: How much do I need?
By cash, we don't mean actual dollar bills stacked up in your sock drawer. We mean money you can access quickly, with no loss of capital and few transaction fees.
This includes checking accounts, savings accounts, and a few short-term investment accounts, like money-market mutual funds.
Basically, cash is the money you can use to pay for things with no worry or hassle.
With that in mind, when we talk about how much cash you need to hold, we're really talking about two different things:
- Your emergency fund
- The cash allocation of your portfolio
Your emergency cash fund is there to provide a safety cushion in the event of unforeseen emergencies, especially the loss of your source of income.
In many ways, the dollar amount of your comfortable emergency fund is a personal question. It depends on how safe you want to be.
You can find experts saying that you should have between three and 36 months of living expenses in your emergency fund. I'd narrow that range to between six and 12 months.
To measure where you fall in that range, think about the risks that affect your life...
If your job is in a cyclical industry, you need more savings than someone whose job is recession-proof. If you only have one income-earner in the family, you need more than if you have two. If you have a large mortgage payment, you should keep more on hand than if you rent an apartment, since missing mortgage payments is more painful than skipping out on rent.
It also depends on how nervous a person you are. You should keep enough to sleep well at night. That's the central tenet to all of my investment advice.
Another thing to remember, six to 12 months of expenses is a lot of money for nearly anyone. For those just starting to save, it seems like an insurmountable number. Don't be discouraged. Three months of expenses saved is better than two months. And two months is better than no months.
A small cushion is better than having nothing at all.
After you've got your cushion – and we'll show you where to hold it in a minute – you have to look at the longer-term cash allocation in your portfolio.
For a young person with 30 years to retirement, there is little reason to have any cash holdings in your portfolio after you set aside your emergency fund.
As you get closer to retirement, you should start moving some of your investments over to cash. You should start this phase five or 10 years before retirement. And you could gradually grow your cash allocation from, say, 5% to as high as 20%, depending on your goals.
When figuring out how to scale into this cash amount, you need to think about the safety cash provides as well as the hidden risk it carries...
Investment returns fluctuate. Cash doesn't.
That matters as you approach retirement – or whenever you start to withdraw from your savings.
If you are loaded up in stocks and bonds just ahead of a bear market, when the market collapses and you have to sell assets to generate cash for day-to-day expenses, you end up selling at just the wrong time.
However, if you give yourself a five-year runway to start building up your cash reserves, that's long enough to span a typical business cycle. While the market's performance at the time you retire is unpredictable, the market is more consistent over a five-year window. So even if your portfolio isn't doing well, you have your cash reserves to fall back on.
Cash is a good safety net in a volatile market. That's the upside of cash.
The downside of cash is inflation.
Inflation is the true enemy of those investing for income and living off savings. Aside from rare bouts of deflation, the value of cash consistently declines. This destroys your purchasing power.
Let's say you plan to live off your retirement for 30 years. Well, one dollar in 1991 – 30 years ago – is worth about $0.42 today.
Inflation averages about 2% a year, and as you'll see, with today's low interest rates, few of the cash accounts available will outpace that.
This means that holding cash is almost certainly a losing proposition. Every dollar you hang on to is actually decreasing in value, rather than earning a positive return in stocks or bonds.
So what can you do about it?
There's no perfect portfolio for everyone.
Portfolios have different goals. Some are designed to build wealth, some to protect it. Most have some combination of the two.
And based on your age, appetite for risk, and desired level of involvement, your ideal portfolio could have different components and asset allocations.
But not many people have a portfolio that's properly prepped for inflation.
That's where my Retirement Millionaire team and I come in...
We have created a perfect portfolio allocation with a singular purpose: to protect your purchasing power when inflation roars upward.
In other words, some portfolios are designed to grow your wealth... but still have a little bit of a hedge against inflation.
This portfolio is designed specifically to keep your purchasing power.
That means, if you have a long time until retirement and want to keep your assets growing with traditional investment, you can put a portion of your assets into the Inflation-Era Portfolio as your hedge.
Or, if you're close to retirement and worry that inflation presents a major risk to your lifestyle, you can use this portfolio as a broader segment of your portfolio.
I recently began warning folks that inflation is one of the biggest risks to your retirement right now.
If you want to learn how to protect your portfolio, click here.
What We're Reading...
- The truth about cash.
- Something different: Why does this watch cost $450,000?
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
August 12, 2021