How much cash is enough?
Like so much else in life, investment decisions must recognise a trade-off between the present and the future. A robust investment portfolio may benefit from longer-term investment returns that should help to preserve or grow wealth, thereby improving the prospect a more secure financial future. However, holding too little cash can leave investors exposed to the shorter-term risks of investment markets. Achieving the right balance is key.
Net returns on cash are lower than the rate of inflation, meaning that holding cash can result in those funds being eroded in real terms over time. This means that as the costs of goods and services rise, cash buys less. This is discussed more in Simon’s article ‘Inflation, Cash and the Purpose of Investing’. By way of an example, after 25 years of inflation at 2.5% per year, £10,000 could buy £5,450 worth of goods and services. The perception of cash being a ‘safe’ investment is therefore open to challenge.
While interest rates remain below inflation, it may be tempting to hold less cash and invest more in growth assets (e.g. stocks and shares) to achieve a real rate of return, meaning a return above inflation.
However, investments are volatile
Whilst a well-constructed portfolio should beat inflation over the longer-term, its value and the income generated can fall as well as rise, especially in the shorter term. Over the medium to longer-term, such potential losses should recover and a real rate of return should be achieved if a prudent strategy is adopted.
Being forced to sell investments in adverse conditions could lock in losses which should therefore recover if given sufficient time. This can erode funds that could otherwise be relied upon over the longer-term. In more extreme conditions, there may be insufficient funds available for the given objective.
Holding cash is the chief mitigation of such investment risk
Cash can be drawn in place of investments, giving them more time to recover.
Paraphrasing Warren Buffett: cash is like oxygen—everyone needs it and takes it for granted when it’s abundant, but in an emergency, it’s the only thing that matters.
A balance therefore needs to be achieved between providing shorter-term financial security (i.e. cash) and longer-term financial security (i.e. investing to preserve or grow wealth by more than inflation).
There is no single answer to how much money should be kept accessible in cash. It will vary depending on each individual’s circumstances, the flexibility in their income and expenditure profile and the proportion of their income that is guaranteed. However, BpH adopts a prudent framework in considering how much might suitably be retained in cash and how much invested.
“Berkshire Hathaway always has $20 billion or more in cash. It sounds crazy, never need anything like it, but someday in the next 100 years when the world stops again, we will be ready. There will be some incident, it could be tomorrow. At that time, you need cash.
Cash at that time is like oxygen. When you don’t need it, you don’t notice it. When you do need it, it’s the only thing you need. We operate from a level of liquidity that no one else does. We don’t want to operate on bank lines.”
Warren Buffett, CEO, Berkshire Hathaway
The Basic BpH Framework
There are three main elements to the framework as follows:
- An emergency reserve based on a minimum of three to twelve months’ expenditure. This should provide cash that can be drawn on in an emergency or for unforeseen reasons. This could include death, incapacity or redundancy or unexpected costs that might otherwise require investments to be drawn (a new boiler or unexpected essential home repairs).
Those with surplus income and suitable protection in place who can easily replace such emergency reserves might be willing and able to hold nearer three months’ expenditure. Those drawing from their investments without such a surplus might be better placed to hold nearer 12 months’ expenditure.
- A capital reserve to cover any foreseeable items of capital expenditure within the next three to five years. This might include a new car, home maintenance or anything that might require investments to be drawn.
Where the term to an item of capital expenditure is less than five years, priority should be given to holding adequate cash reserves. Of course, some will be flexible in their objectives and might be able to defer the expenditure until their investments recover.
- An income reserve is needed if taking an income from investments. It should be based on 2 years of portfolio withdrawals. If a market correction or downturn has been experienced, then this should allow a reasonable amount of time for portfolio withdrawals to be reduced or suspended and income reinvested to improve the chances of a recovery.
In turn, this can depend on the nature of an individual’s expenditure and what can be foregone in adverse conditions. This is discussed further below.
Of course, some might feel more comfortable holding a higher level of cash reserve and this can then be a very personal decision. Maintaining good investor discipline, and not selling investments at inopportune times, in part, means having enough cash and being able to sleep at night.
The Role of Expenditure
Expenditure is an important basis of determining a suitable emergency, capital and income reserve and the following points should be considered in this regard.
- Essential Expenditure – The necessary level of expenditure for sustenance (rent/mortgage, utilities, food and drink, clothing, etc).
- Lifestyle Expenditure – The level of expenditure including essential expenditure needed to maintain a chosen lifestyle. This will vary from person to person, but it is essentially the quality of life that doesn’t want to be foregone. This might include eating out, one holiday a year, hobbies, Christmas and birthday presents and so on.
- Discretionary Expenditure – This is the aspirational level of expenditure that could be foregone in extreme market conditions (to allow investment withdrawals to be suspended and income reinvested). This might include a second annual holiday, or a more luxurious holiday with executive or first-class travel, substantial regular gifts or more expensive hobbies.
- Capital Expenditure – This refers to any foreseen capital expenditure within the next five years, meaning expenditure that might otherwise require investment capital to be drawn. This might include a new car, home maintenance or improvement or substantial one-off gifts (perhaps a wedding).
For example, total expenditure might prudently be used as a basis of determining a suitable emergency fund with this serving as a proxy for the amount of unexpected costs and also in considering how long funds might last in an emergency (especially in the event of death, incapacity or redundancy). However, where a high degree of discretionary expenditure exists, then the combination of lifestyle and essential expenditure alone might be considered a suitable basis provided discretionary expenditure, would be foregone in the event of an emergency.
Similarly, it may be possible to forego some discretionary expenditure in extreme market conditions and therefore be willing to hold a lower level of income reserve.
These considerations can help to finetune suitable levels of cash and therefore help to optimise the level of any investment.
Where to Hold Cash
The next natural question when a level of suitable cash reserves has been established is where these should be held. BpH does not provide advice on where to hold individual cash deposits. The costs involved would simply outweigh the benefits for most clients. However, we would suggest that some key points are considered in this regard.
- Emergency reserves should be held in joint names (where applicable) and in instant access accounts. This should allow each party to access the funds without delay or penalty if the other is unable to act (e.g., due to illness or even death).
- Term deposits can be considered to match the timescales for known capital expenditure included in the Capital Reserve to improve the potential return. However, this should be considered if and only if the funds would be available without any restrictions in good time for the intended purpose.
- One- and two-year term deposits could be considered for the Income Reserve if and only if this would provide unrestricted access at the necessary time. This will require more careful consideration and planning.
The key point to note is that security is paramount and the rate of return secondary. Investments should be working hard to achieve the necessary returns, meaning cash can adopt a defensive role.
The FSCS & NS&I
Savers should also be mindful of the Financial Services Compensation Scheme (FSCS) limits. If money is held with a UK-authorised bank, building society or credit union that fails, the FSCS will automatically compensate them subject to an upper limit of
- £85,000 per eligible person, per bank, building society or credit union.
- £170,000 for joint accounts.
The FSCS also protects certain qualifying temporary high balances up to £1 million for up to twelve months from when the amount was first deposited.
Therefore, if using UK authorised accounts, savers should consider holding this between a number of institutions such that each amount is within the limit. Some banks and building societies will share a banking licence as a subsidiary or brand (see here); so further care is needed as only one claim might be valid for more than one account.
The FSCS can take a significant time to pay compensation and should not be seen as adequate protection when considering an Emergency Reserve.
Further details can be found here.
Otherwise, most savers might consider National Savings and Investments for any funds in excess of their emergency reserve. National Savings and Investments are 100% backed by HM Treasury without any equivalent limit under the FSCS.
Further details can be found here.
Summary
The question of how much should be held in cash does not have an easy answer, but this article gives a useful framework of how to approach the question. It is critically important to know average monthly expenditure and whether there is willingness to reduce some of it to ensure longer-term financial health. Then the appropriate amount of money can be held to provide some protection against any expected or unforeseen eventualities that might come along.
Even once reserves are created, it is important that they are regularly reviewed and updated. It is advisable to ensure that reserves are dynamically adjusted to keep up with life’s twists and turns. For instance, starting to draw capital reserves for upcoming purchases, preparing income reserves when approaching retirement and changing the amount kept in reserve to reflect changing levels of expenditure. It is sensible to review the amount kept in cash reserves at least once a year to check they still meet objectives. It is also important to top up depleted reserves as a priority as they may be needed again at any time.
If you take care of your cash reserve your investments will take care of you.
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