Last week we looked at how we can build a perfectly suitable investment portfolio using “just” bonds and equities.
But we somewhat neglected the third pillar of any asset allocation - our cash sleeve. Cash savings fulfil a couple of key roles during our financial lives:
They provide funds for planned short term expenses and living costs.
They act as our “financial bulletproof vest”, shielding us from the impact of unforeseen costs.
Cash provides a hefty psychological dividend, in terms of a sense of wellbeing and security.
Having a good cash buffer simultaneously allows us to target a higher return from our investments and better endure periods of drawdown, and;
Liquid cash provides the oxygen of optionality, meaning that you are less forced to endure a job that you despise just for the pay cheque.
But, as we know, holding too much in cash can be a danger to our long term wealth due to the corrosive impact of inflation. So it is worth taking the time to establish how much cash we should have to hand as we move through the two stages of our financial lives - the saving phase, and the spending phase.
The saving phase
When we are working, our day to day living expenses are funded from our ongoing earnings and we are left with an income surplus that we can either divert towards building up our cash reserves (saving), or buying financial assets to meet the needs of our future selves (investing).
At this stage of life having an emergency cash fund of three months’ regular expenses set aside to cover any nasty financial surprises is perfectly fine. In addition, if you have any big capital expenditures planned for the next three years (say a house purchase or a wedding) these funds should be held in cash as well.
Having only three months’ expenses set aside for emergencies might strike some as being a little low. And if that’s you, there is nothing illegal about building up more in savings, say six or twelve months’ - have at it.
But even building up six months’ expenses may seem unattainable to some, so there is the danger that they give up - “what’s the point?”. That doesn’t help anyone.
Three months’ expenses is enough of a base to build off. It doesn’t constantly need to be in the bank paying the highest rate either, it just needs to be safe and it needs to be there when you need it. For what it is worth, I use Marcus.
The spending phase
As we move into the spending phase of our lives (also known as retirement), we lose the safety net of knowing that we have a future earnings stream to rely upon. Our human capital, to a large extent, has been exhausted.
Negotiating the spending phase of our lives demands an ongoing financial balancing act. And one of the key questions that we have to answer is how much cash we should hold versus how much we should invest for the future.
In beginning to answer this question, I have looked at how two simple investment strategies, a 100% global equity strategy and a 60% global equity/40% bond portfolio have behaved during periods of past drawdown.
Source: YCharts. The chart shows total returns, with all portfolio income reinvested. Returns are shown in Dollar terms, and do not include any investment or advice costs.
Over the past twenty five years, global stock markets fell by over 20% on four different occasions - the Dot Com Crash, the Great Financial Crisis, COVID and during the inflationary shock that we have just been through over the past couple of years.
The below table sets out how long the two strategies spent below their previous high on each of these four occasions.
Source: YCharts.
During periods of drawdown, the all-equity strategy not only fell by more (unsurprising), but it also took longer to recover its previous highs.
So, for retirees, having some diversification within their invested portfolio would appear sensible.
However, the compromise of course is that less equity content means less growth. Nothing is ever a slam dunk.
Source: YCharts. The chart shows total returns, with all portfolio income reinvested. Returns are shown in Dollar terms, and do not include any investment or advice costs.
If we want to completely avoid having to sell investments during any period of drawdown, then the evidence of the past twenty five years would suggest that we need to hold just under five years’ of cash aside (assuming a 60% equity/40% bond allocation).
However, take a look at the first drawdown chart again - what do we notice? Being in drawdown off the highs is the rule, not the exception. It is relatively rare for stock markets to trade at new highs.
Therefore only being prepared to sell down our investments at all time high values to “top up” our cash allocation is, I believe, an unrealistic objective.
If instead of only selling at all-time highs, we only wanted to avoid selling down our investments when they are in a 10% of greater drawdown from their highs - what do the figures look like then?
Source: YCharts.
These numbers show that we should be prepared to hold three years’ expenses of cash aside as a buffer if we are invested into a 60/40 allocation, and just over four years if we are invested into an all-equity strategy.
Having these levels of cash set aside represents a sensible compromise between having enough cash to avoid being a “forced seller” of your investments at an inopportune moment, while being aggressive enough with your allocation to financial assets to give you a good chance of protecting the value of your assets against inflation.
Twenty five years of data isn’t loads, and the future may very well look different to the past, but this exercise at least gives us a starting framework when we are building a suitable strategy for retirement. And we do need a strategy, the potential consequences of going in blind are just too significant.
By establishing the rules in advance, at a time of low emotion, we have a framework to stick to when the tough times arrive and emotions are running high.
Fail to prepare and all that.
None of the above is intended to constitute advice to any individual. If you have any specific questions about your situation, please consult a regulated financial adviser. Past performance is no guarantee of future returns.
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