Reader Asks: How Much Cash Should I Hold in My Portfolio in 2024?
An interesting, relevant question from a paid subscriber.
Dear Mrs Pennies,
I’m worried that the market has gone up so much in the last 2 months of 2023. I still think a recession in 2024 is possible. How much cash should I keep in my portfolio, to be safe?
D.L.
Dear Reader,
Cash, as you know, is a valuable and important asset in your portfolio.
It allows you to make use of opportunities in the market.
For example, in a recession, as you mention, the S&P 500 may drop by 25-30% in the worst case scenarios. That is a big opportunity for investors with cash.
However, in bull markets, it is hard to deny that a large amount of cash becomes a drag on performance and may give you feelings of FOMO.
From A Portfolio Perspective: How I Determine Cash Levels
How I approach cash levels in my own portfolio depends on probabilities planning in my mind.
Outcome 1: 70% chance of no recession — or a mild one that is ‘rescued’ by the Federal Reserve cutting rates.
Outcome 2: 30% chance of a recession or sticky inflation — and the three rate cuts the Fed has stated are not enough to stem the recession.
For my own portfolio, I would hold a maximum of 40% cash at anytime, even a catastrophe.
However, I currently hold cash levels of 10%. Since I have a moderate risk appetite and balanced perspective, this amount of cash may be too much or too little for most investors on the risk spectrum.
Am I worried about having too little cash in the portfolio?
Not really.
Reason #1
My portfolio construction has a nifty and inexpensive way of overcoming the problem of too little cash in the portfolio.
As it’s easy enough to be done by everyone, I have explained it in the post on 2024 portfolio construction.
Reason #2
While I have 10% cash currently in my portfolio, I’m not too worried.
Passive income continues to come in over the new year 2024, to allow me to continue investing in the market.
Collectively, over the next 12 months, I will accumulate about 30% of the portfolio from passive income to continue investing into the stock market.
Reason #3
You may have heard about Ben Carlson CFA from A Wealth of Common Sense fame.
He’s a smart professional who takes a purely quantitative approach to the markets and to his portfolio.
So, he doesn’t care about recessions, inflation or interest rates.
He’s stayed invested all the time, and advocates just investing your cash regardless if markets are up or down.
As the above chart shows, it has taken the market about 1 year to recover to its previous high in Jan 2022, including dividends.
This is despite all kinds of adverse occurrences in 2023 — regional bank failures, Swiss bank collapse, the fastest hiking cycle in history and two wars.
This doesn’t mean that it is easy to just stay invested without selling in a panic. What Ben advocates is actually very, very hard to do from a behavioural perspective.
Which brings me to my next point: behavioural bias.
From A Personal Finance Perspective: How to Determine Cash Levels
How much cash to hold largely depends on your own behavioural bias and your age.
By Age
If you are a young person below 40, by all means hold little cash (other than the 6 months of emergency cash reserves or any other short term financial needs such as buying a house).
If you are a middle-aged person, let a little conservatism in. Your cash levels should be in between that of a young person and an older person.
If you are an older person near or in retirement, you should make sure you have enough cash (in fixed deposits, T-Bills or money market funds) to last a few years of spending needs.
By Risk Tolerance
One’s risk tolerance can be determined by the sleep test.
If you are like Ben Carlson and can withstand huge market drawdowns of 50% or more, without losing sleep, then you may have a higher-than-normal risk tolerance.
In such a situation, you may hold lower cash levels.
However, if minor market corrections of 20% give you sleepless nights, it is safe to say you have a lower risk tolerance.
In that case, you should hold higher cash levels and a well-diversified portfolio.
My cash levels may not be suitable for you, individually.
As everyone is different with different life situations and risk profiles, it is important to determine your own risk tolerance and examine your short term financial needs before committing to a cash level suitable for yourself.
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