What asset allocation should you consider?
As I have written already, one’s asset allocation should be unique to his or her comprehensive investor profile. You will need to come up with your own allocation formula.
But perhaps I can offer some advice in general.
Today we will look at cash equivalents.
Life Cycle Phase
A big part of one’s investor profile is dictated by one’s phase in the life cycle.
For a refresher, please read Life Cycle View of Wealth Accumulation.
Cash and Cash Equivalents Recap
In general, cash equivalents, including money market instruments, are low risk and low return investments. They are typically highly liquid and stable assets.
But as we have seen, within this asset class there are also high risk investments that may lack liquidity. So be careful.
Cash equivalents are useful for maintaining emergency funds.
Cash is also a good investment for any short-term personal objectives. These may include vehicles, housing, weddings, children, and such.
Cash is also needed to cover short-term obligations in full or as part of periodic payments (e.g., loan repayments with interest).
As short-term objectives and obligations approach, you can shift assets from less liquid and more volatile investments into liquid and stable cash assets.
Finally, maintaining a portion of capital in liquid assets is useful to take advantage of sudden investment opportunities.
Cash for the Accumulator
Accumulators are typically young people starting out in life. Or individuals who have experienced a disruption in the normal cycle. Those who have been unemployed, out of the work force for personal reasons (injury, illness, raising a family, etc.), or new entrepreneurs.
In this phase of life, cash requirements may be high as individuals often accumulate 3-6 months emergency funds, begin to start families, and repay relatively high debt loads. All during a phase where income levels are relatively low.
There likely will not be much excess disposable income with which to invest for retirement. After liquidity allocations, what little one has to begin long-term investing probably should not be placed in cash equivalents.
This is because young investors have a long time horizon until retirement. They can prudently accept higher risk in their investments in order to pursue higher returns. Also, Accumulators will have a relatively high percentage of current wealth allocated to cash anyway. Money that is in emergency funds and available for short-term requirements.
As such, it is hard to estimate what young investors should maintain in cash. Many models suggest 5-25% of total assets in cash for investors with greater than 20 years until retirement. The lower end for aggressive investors, the higher end for conservative.
But perhaps you only have $30,000 in assets. Monthly expenses for rent, food, et al., are $2500 and you want to maintain 3 months of expenses in emergency funds. That equates to 25% in cash and does not even factor in any short-term objectives or payments due. So even if you want to be an aggressive investor, you may need a higher cash allocation until you attain a critical mass in your wealth.
For those who are extremely risk averse, 25% in cash might still be too aggressive for their personalities. They might want to have up to 100% of their assets in cash equivalents. Not what I would recommend for most investors developing a long-term investment strategy, but it might be appropriate for those with absolutely no risk tolerance.
As a quick aside, note that some investors maintain their emergency funds in investments other than cash equivalents. They accept some risk – potentially reduced liquidity and loss of capital – in order to generate higher potential returns.
Cash for the Consolidator
Typically, consolidators are individuals in the middle of their careers, probably in their mid 30s to late 40s or early 50s.
Income is relatively high and expenses are low. Personal wealth has increased and debt significantly reduced. There is excess cash available for serious investing.
Individuals should still maintain cash in an emergency fund. But given the level of savings already generated, it may not need to be 6 months worth. And, as a percentage of one’s investment, it will probably be small.
In the example above, the person only had wealth of $30,000. So $7500 in emergency funds equalled 25% of total assets. But if the individual now has $300,000 in assets, a mere 5% allocated to cash for emergencies would be $15,000. Double what was put aside in the accumulation phase. If one maintains the same $7500 in reserves, the percentage allocated to cash falls to 2.5%.
As you can see, the percentage of assets allocated to cash must take into account both your potential hard dollar needs as well as your total wealth.
Consolidators may require additional cash for short term objectives. Buying a vacation property, taking a major vacation, paying for the education of children. Or even just generally upgrading one’s lifestyle with a larger home, better vehicle, and new wardrobe.
As this phase of life will see the bulk of one’s investing, it is also a good phase to maintain some free cash reserves to take advantage of opportunities that suddenly arise. Without available cash, an investor will either need to miss out on the investment or have to liquidate other assets to invest. In selling other assets, an investor will pay transaction fees. The investor may incur taxes on capital gains or face losses if forced to sell something prematurely.
Cash for the Spender
Spenders are those at or near retirement age.
Income will be low, but so too should be one’s fixed expenses. By now, people in the spending phase should have accumulated a relatively large amount of capital.
Because accumulated wealth is high, the percentage allocated to cash equivalents may be low. For example, with $2 million in assets, a reserve of 1% would still be $20,000.
But while mandatory expenses may be low, retirees usually want to enjoy life. With increased leisure activities (e.g., vacations, dining, etc.), discretionary expenses may result in a desire for greater liquidity and ready cash.
This is an areas that individuals often forget about when planning for their retirement needs while in their 30s and 40s. They factor in fixed costs, but do not include the increased discretionary spending that comes when retirees want to enjoy their leisure years. Without doing so, retirees may have enough money to live comfortably, but not enough to travel the world or engage in other more expensive leisure activities.
Also, with little to no income, many individuals in the spending phase will have substantially less risk tolerance. They will want to allocate a higher amount of hard dollars to cash as protection in case of emergency (health problems, stock market crashes, etc.).
The Magic Number
I do not think that it is prudent to allocate a percentage of capital to cash. Using a percentage calculation makes little sense.
Regardless of life cycle phase, allocate fixed amounts based on your needs and desires.
1. Determine what you want to maintain in emergency funds.
Funds that will cover 3-6 months fixed expenses.
2. Add in any money needed for planned short-term expenditures.
For Accumulators, this might be vehicles, wedding, children, debt repayment, etc. For Consolidators, a larger home, cabin at the lake, extra car, etc. For Spenders, vacations, known medical work, etc.
3. You might want to include a reserve for unplanned expenditures as well.
This may be especially prudent for Spenders. With no income other than savings and pensions, having cash available for unexpected costs (e.g., medical) may be wise.
But it may be a consideration for others as well. If personal circumstances dictate (e.g., health issues, young children, lack of medical or dental coverage at work, live in a location with violent weather, etc.) you may want to maintain a reserve for unplanned expenses.
4. Include a cash reserve for any investing opportunities that arise.
I suggest that this be an amount equal to what you may typically invest in any one asset. If you only invest $1000 at a time, that should be adequate. But if you normally invest in lumps of $20,000, your reserve will be higher.
How much you allocate to cash in each area will depend on your specific requirements.
If you work in a volatile industry with frequent layoffs, you may want to keep 6 months expenses in an emergency fund. If you work in a stable job, 3 months may suffice.
If you live in a hurricane belt, you might want to maintain some reserves for potential home damage and disruption of life.
How much you allocate will also be based on your personal risk tolerance.
The risk averse might want to save 6 months expenses regardless of how stable their employment is.
Aggressive individuals may want to keep little, if any, reserves for emergencies. Or the more aggressive may want to maintain their cash reserves in more risky cash assets such as foreign currency or short-term corporate paper.
The potential permutations are endless.
Once you total the above hard costs and factor in your risk tolerance, you will come up with the necessary cash component. Based on your total wealth, that will be the percentage that you need to allocate to cash equivalents.
As your wealth and circumstances change, while your needed hard costs may be the same, the percentage allocated to cash will shift.
Next, a look at fixed asset allocations.