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For some, holding cash in a portfolio is seen as a lost opportunity, as one can invest it in the market right away. For others, it is viewed as an important tool for providing stability and liquidity. For both beginner investors and veterans alike, achieving a balance between risk and reward is crucial, and determining how much cash to hold is one of the questions that should be answered.

Cash serves multiple purposes within an investment portfolio, and its allocation plays a significant role in risk management. It provides liquidity, allowing you to take action on opportunities or access funds for unforeseen emergencies without having to sell other assets, which could result in losses due to poor market timing. In other words, it serves as a safety net during volatile market conditions and enables you to capitalize on market corrections. As demonstrated in last week’s post, whether you invest a lump sum or make weighted average contributions doesn’t create a major difference in the long term, and holding some cash in your portfolio gives you flexibility.

Of course, this doesn’t imply that you should hold only cash. There are certain factors you should consider to determine what makes sense for you, and the answer is highly subjective.

a. Risk Tolerance: If you’re a risk-averse investor, you may choose to hold more cash than other assets in your portfolio. This can provide peace of mind and is still preferable to holding only cash, as your assets have the potential for growth in the future. Conversely, if you’re a risk-taker, you may allocate much less cash and bet on higher returns in financial markets. It’s essential to understand where you stand on this spectrum before making any decisions.

b. Future Expenses: It’s advisable to create a forecast for your future cash flow, ideally looking ahead 12 months. Estimate how much money you expect to receive during this period and anticipate your expenses, always erring on the side of caution by overestimating expenses. It’s better to have a surplus of cash than to face a shortfall. If you’re planning a significant expense, ensure you allocate a higher cash allocation to maintain liquidity. Additionally, always maintain some cash as an emergency fund, and incorporate this into your financial planning. Using tools like Excel or online spreadsheets can help you visualize and manage this effectively.

c. Market Conditions: Predicting market movements is challenging, and even seasoned fund managers can get it wrong. This blog aims to discourage speculative bets based on market valuations. However, there are indicators that can inform your decisions. For instance, if central banks hint at reducing interest rates, investing in assets may yield higher returns than keeping cash in a savings account. Similarly, historically high price-earnings ratios for funds/stocks may suggest overvaluation, prompting you to hold more cash than usual to capitalize on potential market corrections.

• P/E ratio, or price-earnings ratio, is a metric used to evaluate the valuation of a company’s stock (or an index / fund based on its holdings) relative to its earnings per share and it can be easily checked online.

By considering the above factors and periodically reassessing them, you can determine the right cash allocation for your portfolio. Remember, markets can remain irrational longer than you can remain solvent*, a cautionary reminder to approach cash allocation thoughtfully and pragmatically.

* It’s commonly believed that John Maynard Keynes is credited with this quote, but its true origin is uncertain. Nevertheless, the message behind it perfectly captures the essence of cash allocation.