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 Nick LaPlante, director of cash management at RBC Wealth Management-U.S. in Minneapolis. “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 past eight years, keeping your assets in cash has given you nothing in return," says LaPlante. Contributing to this is the combination of low interest rates and major gains in the stock market from the lows of the recession. “Clients sitting on cash kind of got burned in a big way by that."
LaPlante suggests clients shouldn't keep the majority of their portfolios in cash. However, that doesn't negate using cash within your overall strategy.
“It's just being mindful about where you're at in your life — having a well-thought-out plan," LaPlante 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 the 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 LaPlante.
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," LaPlante 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, LaPlante 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 LaPlante, 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.
“There's no real general rule about this … it's a continual key discussion item that financial advisors and wealth managers should be having with their clients," says LaPlante. “It's an evolving thing."
RBC Credit Access Line is a securities-based, demand line of credit offered by Royal Bank of Canada, an Equal Opportunity Lender and a bank affiliate of RBC Capital Markets, LLC. Securities-based loans involve special risks and are not suitable for everyone. To review more details pertaining to the risks and considerations, please visit: https://www.rbcwealthmanagement.com/us/en/legal/rbc-credit-access-line