Portfolio Dilemma: how much cash should I hold?

Faye asks:How much cash should I hold at a given time? I worry about the possibility of a market crash and see the appeal of having cash to invest if markets do fall. But I know that holding cash is not a good strategy for the longer term. 

Cash has been a controversial topic in recent times, what with the government limiting how much of the ISA allowance can be used for it each year – and then looking to tax interest on cash held in a stocks and shares ISA. 

That itself has caused plenty of debate, and we covered that in a dedicated podcast earlier this year. But for this piece we will look at some of the factors that influence how much cash you might hold at a given time. 

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Whether it’s in a stocks and shares ISA or elsewhere, it can make sense to have a decent level of cash purely to cover emergencies, and to prevent you from being a forced seller when it comes to your investments. 

A commonly cited rule of thumb is to have enough cash to cover six months of outgoings – although this is no small amount. 

Rainy day money aside, it’s better in the long term to have most of your money invested.

But certain factors might drive an uptick on this front. An investor might commonly want somewhere between 2% and 5% in cash, just to deploy when needed. 

That’s because sell-offs can be fleeting, and it can be good to take advantage of them without having to disturb your existing investments.  

Broad sell-offs (like that of early 2020) can be relatively short-lived, and when it comes to individual companies investors might want to pounce on a sell-off as it happens.  

One example might be some of the big tech stocks in the US and now the emerging markets, where a company can see its share price tumble even after a highly positive trading update. 

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Cash as an offset? 

Investors sometimes opt to run a high level of cash to offset the fact that their investments are pretty racy. That can happen with professional investors but also in the DIY space. 

That much was apparent in a discussion on our social trading network ii Community.  

In a discussion about income investing, one member, Deakus, noted: “I invest solely in high-growth exchange-traded funds (ETFs) and stocks on a 60/40% split (in tech, biogen, space, robotics, etc) but I keep about 12 months’ income outside my self-invested personal pension (SIPP) for immediate income needs. 

“This ensures that I will never be a distressed seller during a market crash and in addition the cash ETF yielding about 4% gives me risk capital to deploy and purchase value stocks during a market fall to benefit from any bounce.” 

This is admittedly a risky approach, and one that requires plenty of monitoring. An investor who has a more diversified portfolio would likely have much less use for cash. 

The risk factor 

It’s not unusual for investors to worry about valuations, especially after some incredibly strong recent performance.  

Emerging market equities were sitting on returns of almost 40% over 12 months at the time of writing, with Japanese shares up by around 28% and all major equity regions on double-digit gains. 

While it should be stressed that worries about valuations have been common over the last decade, investors who fear an impending crash might want to hold a higher level of cash. But there are big issues with this approach. 

First, markets could continue to motor ahead, leaving you with a cash allocation producing little in the way of gains. 

Second, investors who are waiting for markets to tank before they put that cash to work need to be pretty nimble, and pretty alert to any big moves. 

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It’s also worth holding cash efficiently where possible, using the likes of money market funds, so that you at least get some return from it. 

Note, also, that you can attempt to make your investing experience less rocky via other means than holding lots of cash.  

Defensive assets from bonds to absolute return and the wealth preservation investment trusts can help here, although as we recently discussed, the outcomes from using such funds and assets are pretty unpredictable. 

Cash might ultimately be best viewed as a tactical tool, and something you can use in the short term. 

But having a big cash position in the long run will fare poorly against inflation, and potentially deprive you of the opportunity to compound gains.

If you have a question you’d like to be considered in our Portfolio Dilemma series, we’d love to hear from you. Please contact: editorial@ii.co.uk