Original Content by AMC Wealth
Written by Jeff Deiss, CFP, AEP, Wealth Advisor
In investing, cash is generally viewed as something best avoided or minimized. Holding some may be necessary for basic liquidity/emergency needs, but mainstream investment advice is to keep as little on hand as possible and to put the rest to work toward long-term goals.
This academic view of minimizing cash for investment purposes is valid, but at odds with human behavior.
Clients routinely are introduced to us with “too much cash” (half or more of their retirement savings) and in the course of our initial planning, we’re asked for our expertise in determining “how much cash to keep on hand”. Once we’re invested, the market will inevitably wobble a bit and we’ll often be asked if now is the “time to go to cash”.
We could chalk up these concerns to the noise of the 24/7 news cycle and the fact that you can watch CNBC or Bloomberg and perhaps hear two “experts” on the same day with opposing views – one holding a high level of cash and another who is fully invested. So who can you trust?
But we observe these concerns so regularly in our day to day interactions that there has to be more to it.
And there is. Recent research suggests that holding cash – that is, the value of checking and savings accounts – was correlated with our financial well-being and life satisfaction. In fact, liquid wealth had a stronger relationship to those feelings than income, spending, investments or how much debt we have – even after controlling for all the other financial variables – age, employment status and relationship status.
“Wealthy people with very little in cash may still feel more financially distressed than poor people with relatively more cash.”
Investment time horizon, risk tolerance, and emergency needs all still make it impossible for there to be a single answer to the question, How much cash should an investor hold?
It’s certainly prudent to keep enough cash to cover a few months of expenses. Someone with a reasonable expectation of employment stability – say an unionized public school teacher or doctor- could get by having the cash to cover three months of living expenses, while someone in a less stable position, or where the demand for their labor swings with the economy, should hold more.
We now know that answer to the question is deeper than this, however. It doesn’t appear to matter if we actually need more emergency reserves or not. There is still an improvement in our financial well-being when we increase our liquid wealth. And if you actually feel happier when you hold more cash, then perhaps your portfolio should be adjusted accordingly.
This is not to suggest that cash is king. We know it’s not and, in most years, cash as an investment results in negative real returns (after taxes and inflation). But paradoxically, if keeping some amount of cash on hand first with the plan to meet your long-term goals (i.e. retirement savings and retirement income) and also helps you feel better, then you’re more likely to stay invested for the long run, which is key to investment success.
“Financial loss is 3x as painful as the pleasure from financial gain. We’re wired to go to great lengths to avoid that feeling.”
Of course, keeping cash at the expense of meeting your long-term financial goals is not a responsible strategy. Similarly, knowing that the key to long-term investment success is to stay invested, it’s not advisable to hold cash because you think that the market will go down. Correctly forecasting the stock market is nearly impossible. And even if you get it right on the “way out”, the much harder task is choosing the best time to “get back in” as historically, it occurs within days of when you got out and when the markets are the most treacherous.
“If you don’t know where you’re going, you might end up somewhere else.”
If our experience, the temptation (or even the habit) of attempting to get in and out of the market is more frequent in the absence of a “plan”. It’s fine to “play” the market by speculating or trading if you can afford to. For the rest of us, investment portfolios have a purpose and should hold stocks and bonds to serve that purpose. And the purpose should fit with our plan.
The new research suggests that fully investing our cash reserves may exact an emotional toll, and one that isn’t necessarily offset – mentally and emotionally – by the greater gains that may be achieved. The lack of cash conceivably makes us more likely to panic in volatile markets, whereas holding enough comfort cash might make us more willing to ride out times of uncertainty. Again, it’s not because we need the cash, but because it satisfies the need to fill our current assets mental bucket.
The bottom line is to recognize, in a world where human beings are not always perfectly rational, that the academic, mainstream advice may not improve our sense of financial well-being. Choosing to keep a substantial cash balance isn’t so much an inefficient investment decision as it is a decision to buy more happiness.
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