The key themes in recent weeks were ISIS, Russia, Ebola, the Fed and Bill Gross. Bill Gross announced in late September that he is departing as the head of Pacific Investment Management (PIMCO), the firm he co-founded in 1971, for a rival firm, Janus Capital. PIMCO is one of the largest fixed income investors, with $1.9 trillion in assets. The significance of his departure is that many investors are expected to withdraw from PIMCO’s funds, an estimated $300 billion according to Citibank. These redemptions will probably increase volatility in the bond market, although long term it should all smooth out. Anticipation of rate increase signals by the Fed led to a rise in the benchmark 10-year U.S. Treasury from 2.34% at the end of August to 2.60% at the time of a mid-September Fed meeting, but with no real reason for treasury rates to go up they quickly came back down (remember, the equivalent German 10-year bond rate is under 1%, making U.S. treasuries a bargain). On October 1st, the 10-year yield declined a massive 0.10% to 2.40%, right back near its 2014 lows. We still see no reason for interest rate pressure any time soon. Also notable in Q3 was a 7% surge in the value of the U.S. Dollar versus six major currencies, the biggest quarterly rise since 2008. The dollar move was one of the factors that led to a 14% drop in oil prices (the lowest in about 18 months) and an 8% drop in gold prices.
Now on to our next topic, How Much Cash Do You Need to Hold? Too much cash and you are taking a loss since cash interest rates are near zero while inflation runs at about 1.6% annually. Too little cash and you may leave yourself with insufficient liquidity if an unexpected job loss or sudden cash need emerges. Many sources cite a rule of thumb to maintain cash equal to six months of living expenses and some recent recommendations are for nine to twelve months given “today’s economic environment.” DIA does not subscribe to this rule of thumb and for most people that we work with, one to four months of cash is sufficient. This excludes cash that may be needed for one-time events like a house down payment.
It seems that the six months rule stems from the fact that many people don’t have six months of savings in any form (1 in 4 has more credit card debt than savings). In this case, yes, it is imperative to save at least six months of expenses, and if this is your only financial cushion, keeping it all in cash makes sense. However, those who have more savings should ignore the rule, assess their specific situation, and consider a much smaller cash holding.
One way to summarize our view is that the stronger your financial situation the less cash you should hold. If you own investments that total several multiples of your six month expenses and are easily covering expenses with your salary, holding little to no excess cash is reasonable. What happens if you lose your job for an extended period of time? Then you would sell some of your investments. Yes, if this happens during a market decline, it could result in selling some assets at a loss, but if you had these investments for many years the opposite is probably true. You will also likely have some lower volatility fixed income investments that can be sold without incurring a loss—all better than a guaranteed annual loss from holding too much cash year-after-year.
Similarly, if you have a reasonable level of savings, there are two salaries in your household, and the loss of one will still leave you able to manage, then a smaller cash reserve is needed, perhaps two to three months. If your investments generate dividends and interest, you can consider this income as part of your potential cash cushion, offsetting the need to hold cash. On the other hand, if your savings/investment base is small and there is only one income, a larger cash cushion is needed, on the spectrum of three to six months.
For a retired individual with sufficient savings cash should also be kept to a bare minimum. If the financial plan is set up properly a retiree should be generating cash for living expenses from dividends and interest, withdrawals from investment accounts (e.g. required distributions from an IRA), and social security and pension income. If cash sources are sufficient there is no need to hold more than a month or two of cash. The entire portfolio should be working to generate growth and income, not sitting in cash. If an emergency arises then sell some investments.
Another recommendation for investors with significant investment holdings is to maintain a margin account. A margin account allows you to borrow cash from your brokerage firm, typically up to 50% of your total holdings. Margin borrowings will allow you to quickly access cash without immediately selling investments. Interactive Brokers, who DIA uses as one of its third party custodians, offers the lowest margin rates in the industry, currently at 1.6% for borrowings under $100,000. While we do not recommend the permanent use of margin for living expenses, a margin account can provide an outlet for short term liquidity needs as an alternative to permanently holding emergency cash.
What if an investor is wary of the market and wants to hold cash not for liquidity purposes but simply to lower investment risk? Again, this choice guarantees an annual loss for this part of the portfolio. A better approach is to create an appropriate low risk allocation plan with a smaller proportion to stocks (or none at all perhaps) and a higher proportion to safer investments like high quality corporate bonds—anything but cash.
Many professional investors, including hedge fund managers and investment advisors, often talk about holding cash as “dry powder” to scoop up investments cheaply at some point in the future. Or similarly, that current investment opportunities are too expensive and that cash is the best option. These arguments imply that these investors believe they can accurately time the market, which research has shown to be impossible. As we have explained in previous blog articles, the vast majority of mutual funds and hedge funds perpetually underperform the market indexes; attempted market timing and holding zero-earning cash are a key culprit. DIA’s recommendation is to determine your proper cash holdings and promptly invest all remaining cash according to your allocation plan.
Last comment: DIA has recently evaluated several advisor managed portfolios that hold as much as 20% of assets in cash (or cash equivalents, like money market funds). We pointed out that the advisor is being paid a fee simply to hold cash. The cash level may be correct but should not sit permanently in an account that incurs a fee. Instead, keep cash in your bank account and be sure that advised accounts are fully invested.
Note that this article was written to provide information and education, and is not intended to be considered investment advice, which can only be provided by DIA following a consultation and execution of an Investment Advisory Contract.