As an investor, you may find that the elements of your portfolio that seem to draw most of your attention are stocks and bonds. After all, these investment vehicles, and others derived from them, provide you with potential growth and income opportunities — which is why you invest in the first place. Yet, you also may find significant value in a more humble financial asset: cash. In fact, you might be surprised at the various ways in which the cash, and cash equivalents, in your portfolio can help you complete your financial picture.
One way to understand the uses of cash is to look at the “USES” of cash. In other words, consider the acronym USES:
Unexpected expenses and emergencies — You’ll need sufficient cash for situations such as a job loss, a home repair or an unplanned medical expense. During your working years, you should keep three to six months’ worth of living expenses in a cash account specifically designed to meet unexpected expenses. Once you’re retired, you may be able to get by on a smaller emergency fund — up to three months’ worth of living expenses, although you will need more for everyday spending.
Specific short-term savings goal — Are you anticipating a big expense —a wedding, a big vacation, a down payment on a new home, etc. — sometime within the next few years? If so, you’ll want to set aside sufficient cash, with the exact amount depending on your specific short-term goal.
Everyday spending — It goes without saying that you’ll need adequate cash for your everyday spending needs — groceries, utilities, entertainment, mortgage/debt payments, and so on. Of course, while you’re working, you will probably handle most of these costs with your paychecks, but you may still need to set aside one or two months’ worth of living expenses. Once you’re retired, though, it’s a somewhat different story. While your expenses may go down in some areas (such as costs associated with employment), they are likely to go up in others (such as health care). So your overall cost of living may not drop much, if at all. Consequently, it may be a good idea to set aside 12 months’ worth of living expenses, after incorporating other sources of income, such as Social Security and outside employment. In addition, you’ll have to decide on the most efficient way of drawing on your other sources of income, including Social Security and investment accounts such as an IRA, a 401(k), etc. It’s especially important to create a sustainable withdrawal strategy for your investment portfolio because you don’t want to run the risk of outliving your money.
Source of investment — You’ll want to have some cash available in your portfolio — perhaps 2% to 3% of the portfolio’s value — to take advantage of investment opportunities as they arise. Also, having even a small percentage of your portfolio devoted to cash can modestly improve your overall diversification — and a diversified portfolio is your best defense against market volatility. (Keep in mind, though, that diversification can’t guarantee a profit or protect against loss.)
So, there you have it: four key USES of cash. Taken together, they provide some good reasons to keep at least a modest “stream” of liquid assets in your portfolio.