When it comes to financial security, it’s comforting to know you have adequate cash reserves to tap into when you need them.
But there’s also a downside to hoarding cash: It can lower your portfolio’s returns in the long run.
Sure, having an emergency fund can help you survive financial troubles, like an unexpected car repair or job loss. But cash really shouldn’t play a big role in investment accounts meant to fund long-term goals like retirement.
“Cash becomes a drag on returns very quickly,” said Kristin McKenna, CEO of Darrow Wealth Management.
Weigh short-term needs against long-term goals to find an optimal cash position. Personal finance professionals recommend a “bucket” approach that allocates cash in three different time frames.
A zero cash allocation is not crazy. Once you’ve funded buckets one and two and can survive financial Armageddon, you’ll likely have enough protection to invest aggressively with bucket three.
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- Emergency fund. You need cash savings for emergencies, like an unexpected health care bill.
Think of your emergency bucket “as your personal safety net when life throws you a curveball,” said Judith Ward, senior financial planner at T. Rowe Price.
Single-income households should set aside six to 12 months of regular expenses. For dual income families, three to six months should be enough.
It makes sense for retirees to build a cash cushion of a year or two of living expenses so they can tap into their emergency fund to ride out a market downturn without having to sell retirement savings at depressed prices.
“It’s about protecting your assets for the long term,” Ward said, adding that research shows that the most balanced portfolios (60% stocks, 40% bonds) fully recovered from the 2000 and 2008 bear markets in one or two years.
- Larger expenses or medium-term goals. If a major purchase, like a new car, college tuition, or a down payment on a new house, is on the horizon, you should have the money set aside for it, too.
You can’t afford to risk the money you’ll need a few years from now on the stock market. High-yield or money market savings accounts, or even conservative short- or medium-term bond funds, are good options for this goal-based segment.
- Investments. For long-term money, the less cash the better.
“We don’t think cash has a place in an investment portfolio,” said McKenna, who recommends no more than 2%. Even a 5% to 10% cash weighting can act as a headwind. To maximize long-term returns, mimic the low cash holdings preferred by fund managers.
The seven nations with the largest government pension funds (a group that includes the US) had average cash positions of 4% in 2019, UBS data shows.
Vanguard’s target-date funds, which become more conservative as retirement approaches, have only about 1% of cash in portfolios targeting retirement in as little as five years.