How much cash should you keep in your portfolio?

Accumulating

If you are in the accumulation phase, new deposits should result in new cash to be invested on a regular basis. This is also an opportunity to scoop up any cash that has accumulated from dividends, interest, and other distributions to invest as well. 

Whether you should maintain an intentional cash allocation depends. If the account is a registered retirement savings plan (RRSP) or similar retirement plan for many years from now, there may be no reason to hold a cash allocation.

One exception might be if you intend to use the Home Buyer’s Plan (HBP) and take an RRSP withdrawal for the purchase of an eligible first home. But barring that, you should probably keep an account meant for the long term fully invested. 

Some people argue that you should have some “dry powder,” so to speak, to buy stocks if markets fall. Since stocks rise more often than they fall, the odds of being better off keeping cash on the sidelines to invest when markets tank are low. You would generally be better off being fully invested.

Besides, as stocks fall, you should probably be rebalancing and selling bonds to buy stocks, and can benefit from this as a result. At least the bonds are earning a higher return than cash in the meantime, and may even rise when stocks fall. 

Decumulating

If you are drawing down your investments in retirement, having some cash or near-cash investments becomes more beneficial. You may need to have cash for monthly or quarterly withdrawals from an account. 

I wish I could provide a smart rule of thumb, like a 10% cash allocation or one-sixth of your stock allocation or something cute, but it may not be so simple. You could use your monthly expenses to come up with a certain number of months and a dollar amount to keep in cash, but again, how many? I do not think there is a “right” answer. What one person is comfortable with may be too much or too little for someone else. 

Some people promote a concept called a cash wedge, where you keep a large allocation in cash to use when stocks fall. It sounds smart, but is it?

Stocks go up slightly more than half of the time from day to day. But over a one-year period, it is more like three-quarters of the time. So, if stocks generally go up, and bonds pay a higher return than cash, an investor would generally be better off fully invested. 

The argument in favour of a cash wedge is that you can use the cash when stocks fall to avoid selling them. When is the right time to use the cash, though? As an example, if stocks fall 10%, is that when you use the cash? What if you do and stocks continue to fall and bottom out after a 30% decline? You may have used up all your cash and then must begin to sell stocks at the bottom. Had you been fully invested all along, you would have sold stocks at a higher price on the way down and been better off overall. 

This type of scenario is exactly the one that a cash wedge tries to avoid—selling after a large decline. The problem is identifying the end of the decline and the ideal time to turn to cash. Market timing is not a successful strategy for the average professional, so to think that it may be for a non-professional is even less likely. 

As a matter of interest, based on past peak-to-trough downturns for the S&P 500, a retiree can expect two to three 30% declines in stocks during their retirement.

Dividend reinvestment

Some investments allow you to automatically reinvest cash dividends into new units of the underlying investment. This dividend reinvestment plan (DRIP) can easily reinvest cash rather than an investor needing to do so manually. 

A DRIP can be useful when you have an account that is not getting new deposits nor funding withdrawals. If you are depositing new cash regularly, you can invest deposits plus dividends quite easily. And if you are drawing down your investments, you may actually prefer having the distributions accumulate in cash to fund withdrawals. 

Summary

Like many parts of portfolio construction and financial planning, how much cash to hold in a specific account or across your portfolio is really a personal decision. There are a number of considerations that can help guide a cash allocation strategy that is right for you.

About Jason Heath, CFP

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. and Objective Tax & Accounting Inc. in Toronto. He does not sell any financial products whatsoever.