Cash — we all love it, and we all want more of it. But when it comes to investing, cash is not necessarily your best friend. Right now, cash will barely generate a 1% return, and actually loses value when there's inflation.
Don't get me wrong, cash can provide some stability to a portfolio — it doesn't lose value quickly like stocks sometimes do — so it's helpful for older investors who have stopped working or who are close to retirement. And younger investors should have some cash on hand for emergencies and general flexibility.
So how much cash should you have in your portfolio?
1. Do You Have an Emergency Fund?
Everyone needs some cash available in their lives to pay for day-to-day expenses, but also to protect themselves against disaster. Your furnace breaks. Your car is totaled. You're laid off. Most financial advisors recommend setting aside at least three months worth of expenses in case these scenarios pop up, and some recommend much more, especially for those with low or unpredictable incomes.
This type of cash is not really an "investment," per se, as it's unlikely to generate much return, especially with interest rates as low as they currently are. But you can still make it work for you by placing cash in flexible CDs, money market accounts, or online savings accounts that offer a yield of 1% or more. And by having this cash available, it will prevent you from dipping into stocks and other higher performing investments just to take care of emergencies.
Recommendation: Keep a minimum of three to six months of living expenses in an easily accessible emergency fund. If you have unstable income or higher financial needs, consider keeping up to 12 months of living expense funds in cash. More than that, and you may risk diminishing returns.
2. How Close Are You to Retirement?
As long as they have an emergency fund, someone who is 30 years from retiring probably doesn't need a mountain of cash. Put that money to work by putting as much as you can in retirement accounts and investing in mutual funds, ETFs, and stocks to build that nest egg. If you are within a few years of retirement, it makes sense to move into more conservative investments, and that's when cash can play a role.
Discount brokerage Charles Schwab suggests having 5% of your investment portfolio in cash or cash equivalents like CDs if you are between 60 and 69 years old, ramping that up to 10% for those in their 70s and 30% for those over 80. Generally speaking, advisors suggest using fixed income investments like bonds to bring stability to a portfolio, but a small percentage of cash can also be useful for retirees, especially if interest rates rise.
Recommendation: Aside from your emergency fund, people aged 60-69 should consider keeping up to 5% of their portfolio in cash. If you expect significant portfolio volatility or are otherwise risk-averse, a somewhat higher percentage can make sense.
3. Have You Maxed Out Your Retirement Funds?
Most people can contribute up to $18,000 into a 401K plan annually and $5,500 into a Roth or traditional IRA. And if you're not close to retirement, this money should be placed in growth stocks and investments that will help you build wealth over time.
If you're maxing out your contributions, then you are on the right path for a great retirement, and shouldn't stress much about having too much cash on hand. But there are still many tax-advantaged ways to invest, including real estate and college savings accounts. And even if you buy stocks in a taxable brokerage account, your returns will be much higher than cash alone, even after taxes.
4. Are You a Passive or Active Investor?
If you're the type of person who makes steady contributions into your retirement accounts and likes to leave the investments alone and watch them grow, you probably don't need a lot of cash on hand. But for active investors who like to pounce at every good opportunity, it helps to have some money available in your brokerage account.
I'm personally not an advocate of trying to "time" the market, but if you see shares of a great company trading at good value and want to take advantage, go for it. The catch is that you'll need money on hand to buy right away. Otherwise, you'll have to sell other securities to make the purchase, or borrow money from your broker. Your ideal cash holdings will vary depending on how often you buy and the number of shares you want, but having at least a few thousand dollars on hand is useful in these cases.
Recommendation: If you invest actively, keep on hand only as much cash as you believe you'll need for exploiting investment opportunities.
This article first appeared at Wise Bread.