*Articles and content provided by SigFig Wealth Management, LLC.
Determining whether you have too much or too little cash in your portfolio is an important part of your overall investment strategy. It might even teach you a little something about the role your emotions might play in the way you make investing decisions.
The three steps below may help you arrive at a cash allocation that works for your risk tolerance, goals and time horizon:
- Distinguish between household cash and portfolio cash.
First things first: Don’t mix up (or lump together) portfolio cash and the cash you hold in bank accounts as an emergency fund. “There’s a huge difference between someone who invests their portfolio 50% in cash, versus someone who has a $50,000 401(k) and a $50,000 savings account,” says Michael Kitces, partner and director of planning research at Columbia, Maryland-based Pinnacle Advisory Group. Although that second investor may have 50% of their assets in cash, their 401(k) is fully invested, he explains.
Although there isn’t a lot of benefit to having a large cash holding in your portfolio, Kitces says there are a lot of good reasons to have a “relatively sizable household cash holding.” The rule of thumb is to have at least six months’ worth of living expenses saved up in an emergency fund, which could be a large percentage of net worth for investors in the accumulation stage.
- What percentage of your portfolio holdings is cash?
If you completed the exercise in step one and determined you have enough emergency savings, it’s time to determine what proportion of your investable assets is in cash. In industry speak, having too much cash in a brokerage account is called “cash drag,” simply because that cash doesn’t produce any yield.
A quick look at the asset allocation of your brokerage accounts will give you the answer. If you have multiple brokerage accounts with different brokerages, you’ll need to do some math or sync your accounts with a portfolio tracking app, such as SigFig, which will do the math for you.
As of March 2015, 27% of investors who track their portfolios with SigFig hold 10% or more of their portfolios in cash. Is 10 percent too high? What percentage is ideal? No single answer fits everyone’s circumstances, but moving on to step three may help you figure it out.
- The million-dollar question: Why?
You’ll have to dig deep into your emotions with this one. Why is that money in cash? Did you panic and sell a certain stock or fund during the market crash and leave that money sitting on the sidelines? Are you afraid the markets have peaked? Do you have a compelling reason for keeping a portion of your assets in cash, such as being ready to jump into the next investment opportunity?
When the answer involves an investor’s emotions, chances are that the cash allocation may be too large.
“I look at cash in a portfolio as a measure of an investor’s emotional level,” says Barry L. Ritholtz, chairman and chief investment officer of Ritholtz Wealth Management. “It’s a sign of fear and an indication of emotional concern.”
Granted, Ritholtz doesn’t often meet with investors concerned that their 5% cash holding is too large. Usually, it’s people who have 10%, 20% or 30% of their portfolios in cash, he says. “If you want less money exposed to stocks, then set up six months worth of expenses in a savings account and occasionally put money in there to keep up with inflation,” he says. Keeping cash because you’re afraid of the future or are trying to time the market, however, is a mistake. “History tells us that the average investor is bad at timing the market, and professionals aren’t better,” Ritholtz says.
One solution to cash drag is to divide that extra cash into six or 12 equal parts and deploy the money monthly, Ritholtz says. “That’s just one way to overcome those emotions. And that’s really what this is about. Keep your emotions in check,” he says.