In this low-interest rate and post-financial crisis world, cash has been cast in a new light. Investors who once thought little of the cash in their portfolios are now wondering:
- Is cash king or is it trash?
- Can it be used as a security blanket?
- Is it an investment?
- Does holding cash cost investors?
But before we address those ultimate questions and offer cash management strategies that make sense, it’s important to understand what role it plays in your portfolio. To figure that out, we need to consider three key questions:
- How much cash is enough?
- What’s the cost of cash? and
- Where should I invest it?
How much cash is enough?
The answer depends on why you’re holding cash. Is the cash for an immediate short term need (within the next 3 years) or is it for a long-term need? Do you need it to pay current living expenses, to provide a cash cushion for emergencies, or do you want it to take advantage of investment opportunities?
As a starting point, investors could consider keeping enough cash to cover 12-36 months of living expenses in case an emergency arises. If you have other sources of income, that could reduce your allocation to cash in your portfolio.
Your risk tolerance level is also important − if you want to be ultra-conservative or tend to be a nervous nelly, you may want to keep as much as 60 months of cash. If you have anticipated needing cash for a big expense in the near term (buying a vacation home, paying college tuition, etc.), you should increase your cash holdings above the amount you’ve set aside for emergencies. Your advisor may recommend you hold more or less cash, depending on your situation.
To help you determine how much cash you need to set aside, we’ve created a quick 5-Step Checklist (you can find it at the bottom of this article). You can also contact GV or your advisor to discuss your cash needs in more detail.
What’s the cost of holding cash?
People often perceive cash as a security blanket, and when viewed through that lens, investors may increase their cash holdings to enhance their sense of security. Many investors accumulate piles of cash in their portfolios so that they can feel safer, sleep well at night and feel free from the chains of having debt.
This retrenchment behavior is especially common in volatile markets. Market downturns make us nervous, and moving more of our money from stocks to cash or choosing not to invest excess income can provide some temporary relief from our anxiety—but at what cost?
There’s a fine line between setting aside an appropriate amount of cash and stockpiling cash because it makes you feel more secure. There’s a significant opportunity cost to holding more cash than you need, and the more cash you hold, the higher the cost. The opportunity costs include:
- Inflation risk – Cash cannot keep pace with rising inflation, especially when interest rates are low. So keeping more money in cash than you need often means sacrificing purchasing power over time. As prices go up, today’s dollar will buy you less tomorrow.
- Missed investment opportunities – The yield on cash is low, but fairly secure. Conversely, the yield on stocks is typically higher, but there are no guarantees. Cash typically offers lower returns than a diversified portfolio. Cash does have a place in a diversified portfolio and it makes sense to sacrifice return for greater security of having sufficient emergency reserves, but holding excessive cash means missing out on potentially higher returns. Most investors wouldn’t willingly accept subpar returns on their investments—why limit your portfolio’s potential by holding more cash than you need?
- Taxes – Today’s meager returns on cash investments are taxed as ordinary income, which means investors’ after-tax net returns are near zero.
It’s important to remember that cash is not security or control. Money is only a tool to help you create the life you want—nothing more and nothing less. Scientific research confirms that stress and decisions don’t mix well. Stress dampens our brain’s executive functions and augments our flight-or-fight behavior. Under stress, our brains work to justify decisions that relieve our anxiety rather than responding rationally—even when those decisions can hurt us financially.
We created Behavioral Wealth Management to help investors uncover and address these behavioral biases so that you can live more confidently and make decisions based on reason, not emotion.
Where should I invest the cash?
Once you determine the amount of cash you need, the next step is to determine where to invest the cash. The national rate for savings accounts and money market funds was 0.11% as of July 31, 2016. With yields at historically low levels, it’s important to understand your options for achieving better yields.
The options vary from one extreme to the other—you can put dollar bills under your mattress or invest in a variety of bond funds. Choosing the option that’s right for you depends on your tolerance for risk, your liquidity needs and when you will need the cash. We have outlined many of the more typical choices in Options for Investing Cash—The Pros & Cons (you can find this at the bottom of the article).
To better understand cash management strategies, let’s look at a hypothetical example of how the various choices would work for Mr. John who is 55 years old and has $40 million portfolio with spending needs of $750,000 per year to maintain his current lifestyle. Let’s assume he’s currently keeping $5 million in cash as that amount makes him feel secure. (Please see disclaimers below.)
Option 1: Mr. John finds multiple banks offering high interest rates (say 1%) on their savings accounts and deposits $250,000 in each bank account.
- Pros – He would earn higher rates, assuming all the banks Mr. John found are in fact paying the higher rate and there are no hidden fees. Also $250,000 of his deposits in each bank account will be FDIC insured. He would have daily liquidity.
- Cons – Mr. John will have to manage balances at multiple bank accounts which would a time-consuming endeavor. The banks might end the teaser rates or charge other account fees at a later time. John will have to actively monitor these accounts. Net of taxes and inflation, Mr. John will be earning a negative return.
Option 2: John invests $5 million in a money market fund. Currently, the national rate for money market funds is 0.11% (as of July 31, 2016).
- Pros – Mr. John would have his money invested in a liquid instrument earning some yield. The principal he invested would be safe unless the money market fund “breaks a buck,” that is, reports its value less than a dollar. (You may recall that in 2008, the Reserve Money Market fund briefly froze its fund, preventing withdrawals by shareholders of the fund.)
- Cons – The yield is really low, roughly earning him only $5,500 in a year on his $5 million (0.11%). Net of taxes and inflation, Mr. John would be earning a negative return.
Option 3: Mr. John creates a bond portfolio to manage the cash. He decides to keep only 2 years of living expenses or $1.5 million ($750k times 2) in cash; he invests the next $1.5 million in short-term bond funds and the remainder in total return bond funds.
Mr. John’s income on such a set up using indexes and current yields to represent each tranche would be substantially higher than the options discussed above:
|Hypothetical Investment of $5M||Dollars Invested||Current Yield|
|Cash/Money Market Fund (Using National Rate)||$1,500,000||0.11%|
|iShares 103 Year Treasury Bond (SHY)||$1,500,000||0.61%|
|iShares Core U.S. Aggregate Bond (AGG)||$2,000,000||2.31%|
Data as of July 31, 2016. Source: Bank Rate and ishares.com
- Pros – Mr. John would earn a higher yield with daily liquidity and have a diversified approach to managing cash. He would have the potential to participate in capital appreciation of the investments. Higher yields also would offer some protection against rising rates, as he could reinvest the income. How does that happen?
As rates rise, income can be reinvested at higher rates, thereby reducing the potential for extended periods of negative price returns from bonds. Remember, over time, interest income—and reinvestment of that income—has accounted for the largest portion of total returns for many bond funds. Over time, the impact of falling market value of the bonds might be offset somewhat by income and reinvesting at higher coupon rates.
In the chart below, you see that over 2-year rolling periods, most of the indexes have returned a positive return due to the reinvestment of income. The “Options for Investing Cash” chart at the end of the article has more information on the impact of rising rates on the performance of the different bond choices.
2-Year Rolling Annual Periods – Worst Returns
|Bond Market Sector||Total Number of Negative Years (1983-2012)||Worst 2-Year Return||Worst 2-Year Period|
|BC Agency Index||0||2.83%||2004-2005|
|BC Treasury Index||0||1.04%||2009-2010|
|BC Mortgage Index||0||2.53%||1993-1994|
|BC High Grade Corporate Index||1||-0.30%||2007-2008|
|BC Aggregate Index||0||3.22%||1993-1994|
|BC 10-Year Municipal Bond Index||0||2.68%||1998-1999|
Source: GW&K Investment Management, BC is Barclays Capital
- Cons – There might be principal fluctuation in the short term if rates rise. However, over the rate rising cycle, most of the choices would give him a positive return due to the reinvestment of bond income at a higher rate.In this hypothetical example, we believe Option 3 provides Mr. John with cash when he needs it, higher yield, potential for capital appreciation and liquidity.
To effectively manage your cash, the key is to balance risk and reward. Develop an understanding of (1) your investment needs, (2) investment time horizon, and (3) your ability to take risk, then choose investments that can help improve your cash return without taking any unnecessary risk. Periodically monitor your cash management strategies as not only can your investments needs and time horizon change, the economic and regulatory environments can change as well.
At GV, we use a 3 tier bucket approach when approaching portfolio construction. We separate your short-term cash needs from your core diversified long-term portfolio. We design short-term portfolios to meet your immediate and potential emergency needs so you can have the cash you need when you need it, without worrying about market risk, liquidity risk and reasonable principal risk.
Our core diversified model portfolios may also use cash as a part of the allocation. Here, cash is for long term needs and acts solely as a diversifier to the other investments in the portfolio. To learn more, please contact GV or your advisor.
5-Step Cash Checklist
Here’s a 5-step checklist to help you determine the amount of cash you need:
Step 1: Make a list of your specific cash needs and when you anticipate needing the cash for each.
Step 2: Write down all the income you anticipate earning that can help you meet your cash needs.
Step 3: Develop a working budget that estimates all your living expenses (include monthly, quarterly and annual expenses).
Step 4: Decide how many months of cash you want to set aside for emergencies. Remember the rule of thumb is to set aside at least 6 months of living expenses, depending upon your situation and risk tolerance.
Step 5: Compare your cash needs to the percentage of cash currently in your investment portfolio and adjust accordingly. Repeat these steps every few years or when circumstances change.
If you need assistance or have questions about this exercise, please contact GV or your advisor.
Options for Investing Cash – The Pros & Cons
|Short-Term Needs (Less than 1 year)||Pros and Cons|
|Bank Account- Savings & Checking||Smaller banks or online banks might offer higher yielding savings accounts. However, as you evaluate the higher yield than the national average, be aware of any hidden account fees, limited or no access to ATMs, required account minimums, etc. FDIC insured bank accounts provide safety to depositors’ cash and interest up to $250,000 in case the bank defaults. Learn more here.|
|Short-Term CDs (Certificates of Deposit)||Direct CDs from banks or Brokered CDs of various maturities are available. One can ladder the maturities based on needs or buy one targeted to a specific need. Laddered CDs bear reinvestment risk should investors not use the cash at maturity. CD rates vary and a sample of the CDs available can be found here.|
|Money Market Funds||These offer easy, daily liquid access, and active management of your funds. However, in the stubbornly low interest rate world, they earn very low yield. The national average is around 0.11%. Given the new regulations, also beware of the money funds you own as some might control withdrawals during market volatility and might having floating NAV based on its assets. Know what you own. Generally, fund providers have been reimbursing the fund fees as the yields are so low. Also, you have options that vary based on your tax bracket.|
|T-Bills||These are safe given the backing of the government and so offer really low rates.|
|Intermediate & Long-Term Needs||Pros and Cons|
|-Short Term Bonds, Longer Duration CDs, Treasury Notes||If principal protection and immediate liquidity are not a concern, these options can offer a higher yield than the readily available options above. They generally have lower credit risk when compared to high yield bonds, total return bond funds. However, understand the duration risk, interest rate risk, fees and access to these funds and bonds as you invest in them.|
|-Total Return Bond Fund, Municipal Bonds and Funds, High Yield Bonds and Funds, Dividend-Paying Stocks||Many look at these options in the chase for yield and higher income. These come with principal risk, interest rate risk, fees and potential for loss. Be aware of what you own as the higher yield comes at a price.|
To examine the interest rate risk on cash investing tools, we examined the last three interest rate rising periods and have outlined the rate of return over each period below. We have used indexes to represent the offerings available:
Federal Reserve Tightening Cycles
|Feb 4, 1994||Feb 1, 1995||3.00%-6.00%|
|Jun 30, 1999||May 16, 2000||4.75%-6.50%|
|Jun 30, 2004||Jun 29, 2006||1.00%-5.25%|
Source: BoA Merrill Lynch, Federal Reserve Board
|3-Month Citi T-Bill||4.45||4.69||2.83|
|Barclays 1-3 Year Treasury||1.24||3.5||1.86|
|Barclays US Treasury 5-10 Year||-4.46||2.00||2.85|
|Barclays 7-10 Year Treasury||-5.21||1.78||2.42|
|Barclays US Aggregate Bond||-2.04||2.02||2.99|
|BoA Merrill High Yield||-1.71||-1.84||7.4|
|DJ US Select Dividend||0.89||-13.34||10.94|
Source: Morningstar Direct
The above table shows:
- Not all rate rising cycles are created equal. Rate increases differ in magnitude and in their impact on various parts of the market.
- Risk and reward are inextricably connected. Those instruments that give you higher yield/income than pure cash also bear higher risk, meaning they have a higher likelihood of earning negative returns.
Disclosures and Disclaimers:
The information provided herein is for general educational and entertainment purposes only, and should not be considered an individualized recommendation or personalized investment or financial advice; nor should the information provided herein be considered legal, tax, accounting, counseling or therapeutic advice of any kind. Any examples or characters mentioned herein are hypothetical in nature, purely fictitious, and do not reflect any actual persons living or dead. GV Financial Advisors, Inc. (“GV Financial”), together with its affiliated companies, directors, officers and employees, make no representations, whether express or implied, as to any expected outcome based on any of the information presented herein. Users assume all responsibilities or the use of these materials, including the responsibility of protecting the privacy of their responses. GV Financial, its affiliated companies, directors, officers or employees of GV Financial or its affiliated companies accept any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this document or its contents. Please refer to complete terms and conditions, which are incorporated herein by reference, on our website, gvfinancial.com/.
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This foregoing exercise is one in a series of exercises. If you would like to see additional exercises or have any questions about this exercise or Behavioral Wealth Management, please contact us at gvfinancial.com/contact/ or telephone us at 770-295-5600.