Jun 18, 2021
When meeting with clients who have financial planning questions, one common area of concern is cash. Most investors have heard phrases such as “cash is king,” but few can confidently describe the cash levels that they should maintain. Fortunately, the guidelines for cash are simple and can quickly be understood through the lens of goals and risk tolerance. This article will cover the four major cash guidelines that we always communicate to our clients.
1. Build an intentional emergency fund.
There’s a reason that “cash is king” rings as a common refrain when markets are down. When your assets are placed into investment vehicles such as stocks and bonds, you sacrifice liquidity for the possibility of growth, income, or both. If disaster strikes and you need immediate access to funds for a car repair or hospital bill, you don’t want those funds tied up in an investment that has fluctuated in value, or that takes time to liquidate. Outside of short-term scenarios, there’s also the risk that your income flow becomes inconsistent or nonexistent. It’s not something that’s fun to think about, but building a contingency plan for income loss is critical for anyone that relies on a paycheck to sustain their lifestyle. Our general rule is that you should build a cash account equivalent to three months of household income. This three-month number is subjective, but it’s a solid starting point for thinking through each situation. For instance, a family of four might decide to build a five-month plan to account for the size of the group. Or a college student, looking to maximize long-term investing potential, might opt for two months of living expenses in cash and the rest in investments. Regardless of each individual situation, we always encourage our clients to err on the side of caution. Don’t push the limit with your emergency fund and opt for the amount of savings that provides you with maximum buffer. If you don’t know where to start, choose a small percentage from each paycheck that you place into a separate savings account until you reach your final balance goal. Some banks allow you to automate this process, which can make it all the easier. Even if it takes you months or years to build the emergency fund completely, it’s a wise financial decision that everyone should make.
2. Organize and de-clutter your accounts.
This isn’t just applicable to the cash conversation, it’s a general tip that helps to sharpen all aspects of an individual’s financial picture. When investors start juggling multiple accounts, including checking, saving, brokerage, 401k, and IRAs, sometimes assets can get lost in the shuffle. As it relates to cash, we often see prospective clients who have random cash amounts in multiple accounts, adding up to a significant balance that gets missed in the big picture. While the short-term downside to holding cash is limited, that’s capital that could be added to an emergency fund or invested in the market. Our recommendation is to choose specific allocations in each account and be disciplined in managing those allocations. For instance, if you prefer to keep your emergency fund in a separate savings account, choose your amount and keep that account at 100% cash, only spending from it when absolutely necessary. If you have a scheduled withdrawal from your brokerage account, determine the cash percentage you need to maintain for that amount to transfer, and don’t let your cash balance balloon in size unnecessarily. While this balancing act is easier said than done, you can set yourself up for success by structuring your accounts deliberately and creating guidelines along the way. Much of our work as professional advisors is this very process of setting allocation guidelines and remaining disciplined to them, on behalf of our clients.
3. Keep cash levels low in your pre-tax retirement accounts.
For investors that are not nearing retirement, keeping large amounts of cash in retirement accounts is counterproductive. This is particularly relevant for traditional IRA’s and 401(k)’s, where assets are “locked” until retirement age. While there are some workarounds to access your pre-tax assets before turning 59 ½, these accounts are generally designed to keep funds protected from use, and we recommend maximizing their benefits for as long as possible. If a 40-year-old investor has $200,000 in his pre-tax 401(k) account, with the assumption of 20 more years in the workforce, he has no need for cash in his 401(k). As cash is added to the account, it only reaches its full potential if it is invested, otherwise, it becomes a victim to depreciation by inflation over time. For our clients with pre-tax retirement accounts like Roth IRAs, we rarely build in a cash allocation, and we put new cash to work immediately. For Roth IRAs, there are no taxes paid on withdrawals in retirement, so it's in the investor's best interest to keep cash low and grow the portfolio to its full potential. However, Roth IRAs do allow for more flexible withdrawals pre-retirement, so a specific situation might call for a higher cash balance. For clients who are nearing (or in) retirement, cash comes back into the equation, as they begin the spending phase in their portfolio and start to take required minimum distributions (RMDs). Bottom line, if you have a retirement account, and are younger than 55, we recommend keeping your cash balance low and your invested capital high.
4. “Going to 100% cash” is rarely a good idea.
As political and economic climates change with various presidencies and global events, investors bounce between greed and fear. When times are good, and the market is performing well, it’s easy to keep your cash invested in order to participate fully. However, when times are bad (or look that way), many investors feel tempted to “go to cash” and sell their investments in order to protect themselves from further downside. Especially around election season, this is a conversation that we have with many clients and investors, and we have never encouraged a full-blown exit to a 100% cash position. While cash is undoubtedly the safest asset class if you are seeking short-term stability, pulling off the panic sell is much harder than it seems. First, you have to nail the timing of the sale, meaning that you have to avoid selling at the bottom of the downturn. Second, you have to nail the timing of the re-invest, meaning that you can’t be too late to reenter the recovering market. Most often, we see investors miss the timing on both. Less often, we see investors get the timing right on one, but miss the other. Extremely rare is the instance where an investor sells at the top and buys back in at the bottom, and when it does happen, there's usually more luck than skill involved. With that in mind, our recommendation is to avoid the “go to cash” urge by establishing discipline early. Determining allocation target percentages between equity, fixed income, alternatives, and cash is key to setting up boundaries that match your risk tolerance. Another golden rule to keep in mind is that making massive portfolio changes (ex. moving from 100% equity to 100% cash) is usually an indicator of desperation or greed, and should be avoided. If you feel convicted about changing course in a dramatic fashion, consider building a game plan to move at a slower, steadier pace. Seek advice, sleep on it, and remember the importance of your time horizon.
As you consider your own portfolio, remember that cash is just a tool. It is glorified by some, underappreciated by others, but every investor should consider the role of discipline in maintaining appropriate cash levels. Set yourself up for success by organizing your accounts, setting allocation targets, and placing cash aside intentionally. If you have any questions regarding your portfolio or the topic of cash, please reach out to me at [email protected].
Director of 401(k) Services
Luke joined Narwhal’s client services team in the spring of 2019 after working as a wrangler on a West Colorado guest ranch. He holds a B.S. in psychology from Davidson College and competed for four years on the Davidson men’s swim team. His role at Narwhal focuses on serving 401(k) clients and their employees. In his own time, Luke enjoys all things related to fitness and the great outdoors.
At Narwhal Capital Management, you’re more than just a portfolio, and it’s not all about the numbers. Let’s start with a meeting about your needs and future goals.