The case for cash: How much do I really need for a healthy portfolio?

Well-versed investors are apt to make a case for cash being part of a healthy investment portfolio. A cash reserve may be used in the case of unexpected life events or gaps in your cash flow, while giving you the liquidity to pursue investment opportunities.

“If you have a portfolio of a million dollars and you’re fully invested … and you spot an investment opportunity, you don’t have any powder left to deploy,” says Eric Edstrom, director of cash management at RBC Wealth Management-U.S. “You’re stuck; you lose that opportunity.”

But in the current interest-rate environment, it can also be important to understand the tools at your disposal to help you get the most out of an asset like cash.

“The current low interest-rate environment is challenging investors who are maintaining larger cash allocations as a percentage of assets,” Edstrom says. “Historically, clients held approximately six percent of cash in their investment portfolio; today that number is closer to 11. Anyone sitting on the sidelines like that unfortunately may have missed the market’s momentum.” 

Edstrom advises clients not to keep the majority of their portfolios in cash, but to instead understand the different types of cash and the roles that they play. These include operating cash, which clients need to live on; cash reserves, for using within 6 to 12 months; and investable cash, used to meet the long-term objectives for clients’ cash needs, such as cash needed in retirement. 

“Understanding your objectives, short- or long-term, and working with your financial advisor can help you attain your life’s goals with a well-thought-out plan,” Edstrom says.

Knowing how much is enough

One of the most common questions that arises is how much cash to keep in the reserves.

“Three to six months of cash is what you always want to have on hand,” says Fred Rose, head of Credit & Liquidity Solutions at RBC Wealth Management-U.S. “Sometimes you could go up to twelve months if you feel like you have more risk in your life.”

The exact amount varies from family-to-family and lifestyle-to-lifestyle, so Rose recommends sitting down and having a frank and honest discussion about your budget.

“We tend to do this a lot in life, we go with the most aggressive income assumptions and the most conservative expense assumptions … we don’t factor in the true things that come up,” he says. “People are not (always) honest with themselves when they’re budgeting.”

While it’s important to have an idea of what you’re spending monthly, your expenses can vary significantly from quarter-to-quarter.

“Your expenses in June, July, and August are different than September, October, November,” says Rose. “You have down months and up months and you need to smooth those things out and be honest about your budgeting expectations.”

Liquidity can come from credit too

Having a line of credit can also give you some agility in your cash flow management. There’s no cost to having a line of credit in place — no ongoing fee or report that goes back to your credit bureau, says Rose.

“You never know when you’re going to need liquidity fast,” he adds. ”It’s there when you need it.”

You can leverage current assets to set up a line of credit.

Angie O’Leary, head of Wealth Planning at RBC Wealth Management-U.S., says her line of credit came in handy for putting her three kids through college, allowing them to cover costs up front without having to tap into their savings, and giving them the time to slowly pay it back.

“Usually, interest rates are low because it is a secured loan against either your portfolio or your home,” says O’Leary. And some of the interest on a home equity line of credit may be tax deductible if it’s used to substantially improve your home.

While there are stipulations you need to look into based on your unique case, she says, a line of credit may be an effective backup as well as a tool for retaining liquidity.

Optimizing your cash

One of the major pain-points investors have with cash is being at the mercy of the current interest rate environment.

“Short-term interest rates (are) what drives yields on cash, so it’s all about maximizing what you’re earning on your cash within the current interest rate environment without taking on too much risk,” says Edstrom.

He breaks down the cash reserve into several tiers: zero-to-six-months, six-months-to-a-year and beyond-a-year, all of which center around maximizing yield while maintaining liquidity.

Tier one (zero-to-six-months) is operating cash and should be in an agile vehicle like an interest-bearing secure savings account.

“That’s going to meet your daily needs, pay bills, living expenses and be there immediately … there’s really no delay; it’s like a checking account,” Edstrom says.

When the cash reserve that might be needed after the zero-to-six-month stash is burnt through, he recommends investing in something stable but with a more competitive interest yield such as treasury bills, certificates of deposit (CDs) or money market funds — all of which typically are deposited for a fixed time with penalties if withdrawn before that commitment. Beyond a year, Edstrom starts to look at fixed income, investments that pose less risk and return income at reliable intervals.

“If there’s the very low probability that you’re going to need the cash, you’re probably going to keep more of it in that second bucket, where you’re really seeking to keep it safe but also generate a competitive yield,” he says. “Over time it’s probably going to shift more into that operating cash – that zero-to-six where it’s highly liquid and available for your needs.”

An ongoing discussion

How much you set aside in cash should change as your needs and lifestyle evolves. The important thing, says Edstrom, is to ensure your cash reserves are on the agenda whenever you’re revising your overall investment strategy.

Often, he says, the conversation doesn’t happen as much as it probably should.

“A general rule about ‘how much cash do I need’ does not exist,” Edstrom says. “Our lives are fluid, and circumstances often dictate the ebb and flow of our cash needs.”

However, cash requirements should be a continuous topic of discussion with your financial advisor and wealth manager.

“Cash, like life, is a strategy that should not be left to chance,” he adds.