We all know the expression that cash is king. But with rates on savings, checking accounts, and CDs in the low single digits, the question is, how much of a king? How much money should an individual hold in cash?
I spoke with Marc Freedman, President of Freedman Financial in Peabody, MA who said that individuals should "never use their investment account as their emergency fund." In general, he recommends that individuals hold enough money in cash to handle six to nine months of fixed expenses. While it's nice to get interest on your money, he said the main goal of your emergency fund is that it be safe and accessible. For this reason he recommends savings accounts or money market accounts.
Good advice. I personally also like to hold cash if I have an impending big expense. If I am making a major purchase within one to two years, then I'll generally switch the funds to cash to be prudent. We've all heard stories about friends, or friends of friends who planned to buy a home and the down payment evaporated along with the stock market. In this case, a savings or money market account, or a certificate of deposit might be the right fit.
Warren Buffett keeps an enormous amount of cash on hand to be ready and liquid should the right investment opportunities arise. Becauase Buffett had cash-on-hand, he was able to loan Goldman Sachs and Bank of America money at very advantageous terms. Having cash when others don't can be a big advantage.
Contrarian View of Cash
There are some that argue that cash can even be part of an overall investment portfolio. Marketwatch reported last year about investor Charles Almon advisory service called Growth Stock Outlook. In 1986, Almon moved the bulk of his portfolio to cash and has kept it there ever since. His portfolio is 76% cash and holds just four stocks: Altria Group, Bristol-Myers Squib, Newmont Mining, and Phillip Morris. Despite the fact that he has held mostly cash for one of the largest bull markets in U.S. history, as of September 2011, his portfolio registered an annualized gain of 8.6% versus an annualized gain for the Dow of 8.4%. This is not a truly fair comparison since the Dow annualized gain does not include dividends. But it's still interesting that Almon's cash-rich portfolio came out ahead when just comparing prices.
Two things contributed to this. Great stock selection. Almon's stocks outperformed the overall stock market. And the volatility of the stock market. During the Internet boom and the housing bubble, Almon was well behind. But the stock market fell back to a mean growth level. While there have been some big negative years for the stock market, Almon's cash holdings have never lost money. Instead, they grow and compound every year.
Is this saying that an investor should put all of their money in a 2% 5-year CD? No. But having an emergency fund in cash isn't necessarily the worst investment either.
Building a Cash Fund
Here's how I think about how much cash I should hold. I add:
- Emergency Fund: Six to nine months of fixed living expenses.
- Major Purchase Fund: Any major purchases I plan to make over the next one to two years (I like to pay out of savings instead of taking on debt via a home equity loan, mortgage refinance, etc.). This could include paying for a wedding, paying for college tuition, putting a down payment on a home, house renovation costs, etc.
- Opportunity Fund: A small portion of my investable portfolio that I keep in reserve should a good investment opportunity arise quickly.
- Peace of Mind Fund: A portion of my funds that I set aside for peace of mind. The older the investor, the larger this might be. Remember, the purchasing power of this fund may shrink over time if inflation exceeds the savings rate so this peace of mind may comes with a price.
For other opinions and to determine your specific cash allocation, speak to a qualified financial advisor.
No matter what percent you put in cash, make sure to get the best rate on the money in the bank. As Charles Almon showed, by being prudent, a cash investment can still grow. The best bank rates are often 1% higher than the average rates.