Dubai: While it’s often viewed as the ‘safe’ option, there are potential dangers in holding too much or not enough cash in hand.
Knowing how much of your wealth you currently hold in cash, and how much of your wealth you should be holding in cash, are two questions with often different answers.
This is why it is vital to weigh the perks and risks of holding cash and what money planners and investment experts consider is the sweet spot in how much you should hold in cash.
First, the risk of not enough cash. If you don’t hold sufficient cash, you can create cash flow stresses when unexpected expenses arise. The amount you should hold is dependent on your circumstances.
Subject to your situation, less than 3 months of living expenses is often not enough. On the other hand, any more than 6 months’ worth of your cost of living expenses or net income is often advised to not be kept in cash.
Exceptions to the rule
There are obviously exceptions to this and some cases where it is prudent to hold even 12 months’ worth, however, the norm is 3 to 6 months. So, if you need Dh7,500 to survive every month, save Dh45,000.
US-based renowned personal finance guru Suze Orman advises an eight-month emergency fund because that’s about how long it takes the average person to find a job.
Other experts say four months, while some say none at all if you have little debt, already have a lot of money saved in liquid investments, and have quality insurance.
Some of those same experts will advise you to keep your five-figure emergency fund in an investment account with relatively safe allocations to earn more than the interest you will receive in a savings account. On the other hand, the recent months may have reshaped your thoughts on what feels “safe.”
The dangers of too much cash
When markets are volatile, it is easy to see why people might choose to hold large sums in cash. As it’s something we handle every day, whether physically or digitally, it can seem more tangible than other assets. However, cash does lose value and this is particularly true in the current low-interest climate.
Interest rates have been at a historic low for more than a decade following the 2008 financial crisis, and the pandemic-induced economic crisis has exasperated this trend.
A low interest rate is good news for borrowers, but the low interest rate environment is not positive for savers. It means your savings likely will not deliver the returns they once did, especially if you compare the current rates to the pre-2008 or pre-pandemic rates of return on cash.
If you hold too much of your wealth in cash, you won’t be able to keep pace with inflation, meaning your purchasing power will go down and it will be more difficult for you to achieve your goals.
Inflation: Affecting the value of savings
The reason the value of cash savings falls in real terms is inflation. Each year the cost of living rises and if interest rates fail to keep pace with this, your savings are gradually able to purchase less and less.
Governments globally have always aimed to keep inflation between 2-3 per cent and in recent times have kept it at the lower end of that range.
However, with the increase of cash injected into markets to stimulate the economies in response to the coronavirus pandemic, there is a risk that inflation could increase in the short to medium term, and there are indications of it rising in several parts of the world.
If inflation goes up, your spending power goes down. Year-to-year, the impact of inflation can seem relatively small. Yet, when you look at the impact over a longer period, it highlights the danger of holding too much in cash.
If you hold excess cash in your bank account at say 0.1 per cent per annum interest and inflation is 2.5 per cent, you are in fact losing 2.4 per cent every year. If you look at inflation in terms of your long-term or retirement goals you can really see the impact.
Here’s an example: if you are planning on retiring in 25 years and think you need Dh15,000 income per month in retirement, when you take inflation into account, you will actually need double that, Dh30,000 per month!
When is cash right?
While inflation does affect the spending power of cash savings, there are times when it’s appropriate.
If you need ready access to savings cash accounts are often suitable, for example, as we mentioned above, having an emergency fund.
When you’re saving for short-term goals (those less than five years), a savings account should also be considered. Over short saving periods, inflation won’t have as much of an impact and can preserve your wealth for when you need it.
However, when setting money aside for long-term goals, investing in diversified growth focused assets aligned to your goals, your risk profile and other impacting factors may be a better option that’s worth considering.
Investing: When should it be considered?
Investing savings means you have an opportunity to beat the pace of inflation with returns over the long term, thereby, preserving or increasing your spending power.
However, investment returns can’t be guaranteed and short-term volatility can reduce values, as recent markets have demonstrated.
For this reason, investing as an alternative to cash should only be considered if your goals are more than five years away. This provides an opportunity for investments to recover from potential dips in the market.
A common-sense strategy
A common-sense strategy may be to allocate no less than 5 per cent of your portfolio to cash, and many prudent professionals may prefer to keep between 10 per cent and 20 per cent on hand at a minimum.
Evidence indicates that the maximum risk/return trade-off occurs somewhere around this level of cash allocation.
If you combine cash with fixed income securities, the maximum risk/reward level is slightly higher, somewhere along the lines of 30 per cent. For a portfolio of Dh5 million, that could mean anywhere from Dh250,000 to Dh1.5 million.
You should always try to keep at least six month’s living expenses in cash to avoid running out of money if something happens.
Of course, some hire portfolio managers and instruct them to remain fully vested. For example, if you approached a niche asset manager and told them you were handling your liquidity requirements, it would be perfectly reasonable for them to keep no funds on hand.
Top investors know cash in a portfolio has multiple roles
The best investors in history are known for keeping large amounts of cash on hand. They know through first-hand experience how terrible things can get from time to time – often without warning.
In August 2019, top billionaire Warren Buffett and his US-based firm Berkshire Hathaway held a record $122 billion ($448 billion) in cash.
US billionaire investor Charlie Munger would go years building up huge cash reserves until he felt like he found something low-risk and highly intelligent.
Privately, wealthy people like to hoard cash, as well. A 2019 Capgemini World Wealth report released found that people with at least $1 million (Dh3.67 million) in investable assets kept nearly 28 per cent of their portfolio in cash.
If (or when) the economy enters another recession, those cash reserves will allow these wealthy investors to buy cheap homes, stocks, and other assets. Cash facilitates all of an investor’s success, even if it looks like it’s not doing anything for long periods.
Cash as liquidity reserves
Another role cash plays in your portfolio is to serve as a liquidity reserve you can draw down when markets seize or stock exchanges are closed for months at a time. Under these circumstances, it’s nearly impossible to liquidate assets – you can’t turn your investments into real cash at these times.
Buffett is fond of saying 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.
In this capacity, the cash goes beyond giving you the ability to acquire attractive assets, it’s an insurance policy when you need to cover the bills and you can’t tap your other funds. Benjamin Graham once said that the true investor is rarely forced to sell their securities – if the portfolio management system is good enough, you’ll have the cash to make it through the darkest of times.
Retired investors are especially in need of cash to prevent losses when the economy begins a period of shrinkage.
Imagine you determine a safe retirement withdrawal rate is 3 per cent, all else being equal, for your portfolio.
You put Dh500,000 aside and invested it at a cash yield of 2.8 per cent. By keeping at least 10 per cent in cash, or Dh50,000, the economy could experience a 1929-style collapse, and you wouldn’t have to sell any of your holdings to fund your cash flow needs, no matter how bad it got.