How Much Cash Should You Have In Your Portfolio?

How Much Cash Should You Have In Your Portfolio?
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Where were you on May 10, 2021? Stocks hit an all-time high after a weak U.S. jobs report led investors to believe that the Federal Reserve would not change its dovish policy of low interest rates and quantitative easing (QE).

Just two days later, the April consumer price index (CPI) report showed inflation was rising at its fastest rate in 13 years. It kicked off 18 months (and counting) of ever-worse inflation readings, which drove the Fed to raise interest rates and abandon QE.

This dynamic has been responsible for stocks and bonds delivering their worst annual performance since the Great Recession, and maybe longer.

How bad has it been? As an investment, cash has outperformed both stocks and bonds by wide margins.

Cash was a sucker’s bet for years as ultra-low interest rates helped markets soar after the Great Recession. Those days are gone, and nearly every other asset class besides cash is struggling.

Does it suddenly make sense to own more cash? How much cash should you have in your portfolio?

The Case for Holding Cash

The decade and a half leading up to 2022 was tough on cash. Low interest rates and negligible inflation meant that investors couldn’t earn much yield on fixed income, so they flocked to stocks with high growth potential.

For many, it seemed like this historical abnormality was the new normal. They had good reasons for their belief: When the Fed actually tried to raise interest rates from 2015 to 2018, unsettled markets forced the central bank to cut them again in 2019.

The cuts resumed in early 2020 due to the Covid-19 pandemic. Despite a severe but brief recession, stocks soared thanks to trillions in federal fiscal stimulus and a dovish monetary policy.

Always eager to avoid past mistakes, the Fed was slow to respond in 2021. The upshot has been the worst prolonged bout of U.S. inflation in four decades—and that’s part of the reason why cash looks so good right now.

How Much Has Cash Outperformed?

How good? Let’s say you had a chunk of change to invest in early May 2021.

With lots of startups going public, meme stocks soaring and special-purpose acquisition companies (SPACs) on the rise, you might have been drawn to equities. With Bitcoin (BTC) going to the moon, you might even have dabbled in cryptocurrency.

More conservative investors might have been more interested in bonds, especially after the banner years of 2019 and 2020.

These impulses would have been mistaken, however. Over the past 18 months, investors who put $10,000 into stocks would have about $9,350 as of late October, per Morningstar Direct, while bond investors would only have around $8,420.

If you simply held your money in cash—in the form of Treasury bills—you’d have more than $10,080.

Put another way: Cash is up about 0.6% over the last 18 months, compared to declines of 4.5% in stocks and 11.2% in bonds.

Bitcoin, which you might define as the polar opposite of cash, is down 67% over the same period.

The Case Against Cash

The question that’s top of mind among anxious investors is how long this dynamic might go on. It could take quite a while.

The Fed expects core PCE inflation, which strips out volatile food and energy prices, to remain above its 2% target until 2024, which would require the central bank to keep the fed funds rate near 4%. To put that into perspective, the fed funds rate hasn’t been above 4% since December 2007.

But that doesn’t mean stocks and bonds will automatically go down for the next two years.

Stocks could pop once market participants see that the Fed begins pivoting away from rate hikes. That’s what happened for six weeks into the summer of 2022 when traders convinced themselves that the Fed was shifting to a more dovish policy.

What About Bonds?

Bonds, meanwhile, are finally in a position to deliver better yields.

“To us, fixed income has been attractive since 10-year Treasurys hit 4%,” said Vishal Khanduja, a bond analyst at Morgan Stanley Investment Management. “It’s an attractive entry point.”

The yield on 10-year Treasurys neared 4% at the end of September and has remained around there ever since.

That’s just the near-term reality. Long-term investors need to stay in an asset allocation that will allow their portfolio to grow large enough to fund their retirement later in life.

When stocks and bonds finally recover, as they surely will, you don’t want to be left on the sidelines.

How Much Cash Should You Hold Now?

So how much cash should you hold now? Talk to any financial advisor worth their salt and you’ll get a version of the following answer: Not any more than you otherwise would.

“The role for cash in a portfolio is to fund short-term and near-term goals, as well as immediate spending needs,” said Maria Bruno, head of U.S. wealth planning research at Vanguard. “Principal protection is important.”

How much principal you need for protection depends on where you are in your life. Retirees, for instance, should consider having a year or two worth of spending in a savings account.

“You don’t want to be selling investments to fund your lifestyle,” said Nick Foulks of Great Waters Financial.

Those further away from their golden years might want to avoid cash in their portfolio altogether. “If you’re trying to accumulate wealth, cash is irrelevant,” said Foulks.

To put that point another way: The only role of cash for today’s investors is to protect you during emergencies.

“If I need my emergency rainy day to be safe and accessible, I’ll trade some level of growth to achieve that,” said Morgan Hill of Hill and Hill Financial.

The typical rule of thumb for an emergency fund is three to six months’ worth of expenses, though your particular level of need, and where you actually put the cash, depends on your circumstances.

That’s why Foulks recommends folks hire a fee-only financial planner to develop a financial plan that takes into account the totality of your situation. If nothing else, a plan will help you psychologically weather the market’s ups and downs.

“Our clients are calling us because of the headlines, and they’re worried about their overall balance,” said Foulks. “We remind them that your plan was not built on massive returns, it was built for good, bad and ugly times.”

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