Cash and cash equivalents can provide liquidity, portfolio stability and emergency funds.
Cash equivalent vehicles include savings, checking and money market accounts, and short-term investments.
A general rule of thumb is that cash and cash equivalents should comprise between 2% and 10% of your portfolio.
Cash and cash equivalents play a variety of roles in your investment portfolio and financial plan, including providing liquidity, portfolio stability and emergency funds for unexpected events. Cash equivalent vehicles are typically defined as money held in different types of accounts, such as savings, checking and money markets, as well as short-term investments with maturities less than 90 days, such as CDs, bonds and treasuries.
“Laddering cash equivalents into short-, mid- and longer-term investment vehicles is very important because it provides liquidity and backup and is a good way to diversify your fixed-income portfolio.”
D.J. Verhaalen, Wealth Management Advisor for U.S. Bancorp Investments
For many people, especially retirees who are no longer generating a paycheck, cash can help provide peace of mind that they have sufficient liquid reserves to weather periods of uncertainty or a downturn in the economy.
For investors who are willing to take on more risk, cash and cash equivalents also offer liquidity that can allow them to move quickly to take advantage of investment opportunities, particularly when there is disruption or fluctuation in the market.
Determining how much cash is enough is a common question, and the answer varies depending on your unique circumstances and current market conditions. Some factors that help to determine how much cash and cash equivalents to hold include:
A general rule of thumb for how much of your investment portfolio should be cash or cash equivalents range from 2% to 10%, although this very much depends on your individual circumstances.
Cases where you might want to hold more cash include if you’re planning on a big purchase or expense within the next few years, such as buying a home or paying for college tuition. In addition, some people might carry a lower amount of cash based on their leverage opportunities. “In a low-interest rate environment, for example, you might have equity built up in your home that you can tap into, such as through a home equity line of credit, versus holding extra cash,” says D.J. Verhaalen, Wealth Management Advisor for U.S. Bancorp Investments.
Income and net worth are two additional considerations. For example, people with a steady income can often count on liquidity from a paycheck or annual bonus and may need to hold less cash. Others who work as independent contractors or hold commission-based jobs may want to hold more in cash reserves if their income is uneven or less predictable throughout the year, notes Verhaalen.
It can be challenging to find the right balance of cash and cash equivalent holdings. A common mistake people make is carrying too much or too little cash for their situation, as well as putting cash in the wrong investments.
As an example, with the market volatility that occurred in 2022 and the allure of higher interest rates, investors increased and held higher cash positions. ”In some cases, this cash was kept out of equities and participation of the positive market performance so far in 2023," Verhaalen says.
Carrying too much or too little cash in your investment portfolio can offer both pros and cons that differ depending on an individual’s situation.
Cash equivalents should be part of a regular discussion when it comes to a holistic financial plan. “When we build a financial plan for clients, we tend to be a little bit more conservative, because we believe managing risk is important,” says Verhaalen.
Verhaalen often recommends clients hold, at a minimum, the equivalent of six months of income. In addition, he’ll run a financial plan to determine an ideal amount of cash to hold based on an individual’s unique circumstances, as well as how to ladder it into different types of cash equivalents depending on the time horizon and when cash might be needed.
“Laddering cash into short-, mid- and longer-term investment vehicles is very important because it provides liquidity and backup and is a good way to diversify your fixed-income portfolio,” says Verhaalen. For example, if your child is going to college, you might decide to set aside cash in a checking or money market account to cover the first semester’s tuition, put the second semester’s tuition in a six-month CD, the following year in a 12-month CD and so on.
In a rising rate environment, Verhaalen notes that he may also recommend that clients ladder cash equivalents in fixed-income assets with maturities on a regular basis, allowing them to reinvest and capture yield as rates go up.
Investors should review the percentage of cash positions in their investment portfolio periodically as part of their holistic approach to financial planning. Consider reviewing your financial plan with your financial professional on an annual basis, at minimum, or as needed as circumstances change.
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