Your target asset allocation should be unique. Driven by your comprehensive investor profile.
As such, you will need to come up with your own personal asset allocation formula. But perhaps I can offer some advice.
Today we will look at cash equivalents.
A big part of an investor profile is dictated by your current 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. For a little more detail, please review Cash & Cash Equivalents.
But as we have seen, within this asset class there are also high risk investments that may lack liquidity. Be careful.
Cash equivalents are useful for maintaining emergency funds.
Cash is a good investment for any short-term personal objectives (e.g., vehicles, housing, weddings).
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. Do not wait too long to shift to cash. Otherwise, you may receive less than optimal value on disposition due to the asset’s liquidity and risk.
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 (e.g., injury, illness, raising a family), or new entrepreneurs.
In this phase of life, cash requirements may be high as individuals often accumulate 3-6 months emergency funds, begin 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. 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 an aside, 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. We are not talking venture capital. More like short term bond funds or even some lower risk equity funds.
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 overall allocation, 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, entertainment), discretionary expenses may result in a desire for greater liquidity and ready cash.
While in their 30s, planning retirement needs, many forget about leisure. They factor in fixed costs, but do not include the increased discretionary spending that comes when retirees want to enjoy their free time. Without doing so, retirees may have enough money to live comfortably, but not enough to travel the world or engage in other more expensive pursuits.
Also, with little to no income, many individuals in the spending phase will have substantially less risk tolerance. They will want to allocate higher amounts to cash as protection in case of emergency (e.g., health issues, stock market crashes).
As you can see, your unique personal situation and risk tolerance will dictate what percentage of funds should be allocated to cash equivalents. And, as circumstances change, so too will your asset allocation percent and/or amounts.
In Part 2, we will summarize and look at the key points to focus on for your cash allocation calculation.
