Keeping too much cash in your portfolio means you lose money due to inflation. How much should you keep, to cope with different situations?
There are plenty of suggestions out there, on which unit trusts to buy, or which bonds are best. But few people talk about good old cash. How much should you leave lying around uninvested, and how much should go to work for you?
Understanding “Cash Drag”
It’s debatable how much of your portfolio should be kept in cash. The main worry is “cash drag”. When your money isn’t put to work, it’s stagnating due to inflation. For example, a typical fixed deposit has an interest rate of under one per cent, whereas Singapore’s inflation rate is around three per cent (excluding private housing and transport; it’s much higher if you aim for either of those).
At the same time however, cash is the safest asset. It’s not likely that the Singapore dollar will suddenly devalue in a few months, whereas that’s quite possible with, say, equities or Bitcoin.
As such, deciding how much cash to keep is problematic. Here are a few rules of thumb that can help.
If Your Financial Situation is Uncertain
Keep six months’ of your expenses, or double that if your financial situation is uncertain.
You should always keep at least six months’ of your expenses on hand, to deal with any emergencies. This minimises your reliance on loans, which come with an interest rate.
If your financial situation is uncertain (e.g. you are self-employed and in your first year of business), then you may want to ramp this up to a years’ worth of expenses.
In any situation, try to avoid keeping more than 12 months’ of your expenses in cash. Remember the problem of cash drag (see above), in which you have large sums of money eroding due to inflation.
If Markets are too Volatile to Make an Investment Decision
Financial markets are prone to collapses and periods of uncertainty, every few decades. In the immediate aftermath of such crises (such as the bursting of the dot com bubble in the ‘90s, or the Global Financial Crisis of ‘08), the markets are volatile in the extreme.
In these situations, it may be best to do nothing until the dust settles. Consider keeping your cash safely in a bank account.
One common strategy, in such times, is to switch to 50 per cent cash (and put the other 50 per cent of your portfolio in low risk investments, such as blue chip stocks).
You can invest more cash later, when markets are in a less confused state.
If You’re Trying to Time the Market
We advise against speculating – but that said, this is one reason to hold a large part of your portfolio in cash. You may be waiting to take advantage of a perceived opportunity.
For example, say you believe housing prices are about to drop, and you want to buy a property as an investment (to rent out). You may decide to hold on to sufficient cash for the down payment, in the year or so preceding your purchase.
When the time comes to buy, you can either go ahead with it quickly, or change your mind and invest the cash elsewhere.
If You’re Nearing 70 years old
As you grow older, you should focus more on preserving your accumulated wealth, rather than growing it. As such, retirees may want to consider holding as much as 20 to 30 per cent of their portfolio in cash (speak to a financial adviser for more specific advice, pertaining your situation).
Inflation is less of a worry to the elderly. The main worry is losing the wealth you already have – as you probably aren’t working (or are at least earning less), there’s no easy way to replace your losses.
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By Ryan Ong
Ryan has been writing about finance for the last 10 years. He also has his fingers in a lot of other pies, having written for publications such as Men’s Health, Her World, Esquire, and Yahoo! Finance.