How Much Cash Do I Need?

People often ask " how much cash should I keep in my investment portfolio?" 

This is a difficult question, because the answer will differ depending on each person's unique & personal, existing financial situation, and their ongoing cost of living requirements.

Having some cash in an investment portfolio is beneficial, at the very least to enable the investor to purchase a really good company stock when it is offered "on sale".  See the related post: "How to make money on blue-chip stocks".  A cash allocation of 10-15% (of the total investment portfolio) may make sense to an average investor.

Financial planners usually suggest, and most would probably agree, that the average salaried employee should have enough cash on hand (or other liquid instrument that can be turned into cash quickly e.g. stocks that can be sold), to cover ongoing household expenses for at least 6 months.  Of course, 12 months may be better, or preferred, as a safety net!

But, too much cash on hand is not a good thing, because the opportunity cost of losing investment returns on cash deposits in a bank account (or under your mattress) is high.  Cash deposits that exceed the suggested safety net of 6-12 months above represent a lost opportunity to earn passive income, or may deliver a 'net negative' return on investment (e.g. when adjusted for inflation)!

In a previous posting I had remarked that even relatively safe investments (safe investments often deliver lower returns) - e.g. in a basket Dow stocks - could easily average about 7% annually.  For more detailed information about the Dow Jones Industrial Index performance during the past century, you can view this blog site: Observations.

In reality, my positioning is conservative. According to Observations (presenting data easily verified elsewhere): "from ’33 to ’65 the average return was about 7% per year and with reinvested dividends, approximately 10%. From ’82 to ’99 the average return was about 15% per year."

At a glance then, you can see that cash in the bank earning interest at e.g. 0.1% represents investment opportunity lost, as mentioned and described above vs. a relatively safe investment in a basket of Dow stocks.  

Note, I suggested "a basket" of Dow stocks and not a Dow stock (as in singular).

If we review the Dow 2012 YTD change, you will notice that performance of the entire index of 30 stocks for this year, to date, is 7.67%.  No big news, because it matches the 100-year average performance mentioned previously.  But, pay special attention to the outliers: Bank of America (NYSE:BAC) is up 91% YTD, but Hewlett-Packard (NYSE:HPQ) is down 46% YTD.  Clearly, an investor who only bought Bank of America stock would be delighted... but the HPQ stock investor... not so much!

In the next post we'll explore the follow-up question: "How much will I need to be able to retire?"

Now of course, this question is even more difficult to attempt to answer, because the variable components to this question include for example where you live (country, city, etc.), ownership/rent of your current home, ongoing expenses, whether you are willing to reduce your spending, current saving and spending habits, debt (you're not thinking of retirement while you have debt, right?), and so much more.

There are many professional, licensed financial planners who have the ability to work diligently with investors to arrive at a detailed analysis and attempted answer to this question.  We'll review a high-level attempt at answering this question, in the next post.

Later, we'll explore the philosophical question: "What is retirement anyway?"