Pete and podcast guest Matthew Yeates discuss how much you should hold in cash.
PM: Many of my listeners have read ‘Beyond the 4% Rule’ by Abraham Okusanya, and he is one of the foremost people in this country who talks about holding cash and investing. How much cash, generally, would you suggest that people keep? Is there a set amount that’s the same for everybody, or does it depend on circumstances?
MY: We go for two years’ worth of income in cash. That’s a really interesting question, particularly in relation to the 4% rule. You see lots of numbers being bandied around as if they were a rule of thumb, and just as I don’t believe there’s a single, sustainable income or draw rate, there’s no right percentage.
It depends on the all of the other assumptions. There’s no such thing as a perfect amount of cash to hold in reserve in the short-term box, and anyone who says they’ve found it is being disingenuous.
What we needed to come up with was an amount that we think provides a reasonable amount of buffer. Unless you hold 100% in cash, you’re never going to be 100% certain that you’re never going to eat into your investments. However, it also makes it possible to do the other part of the equation, which is important for us.
When people talk about putting money in buckets, and cash in reserve – imagine if you had your invested portfolio and all you did was put a bit of cash into it to serve as a buffer against short-term volatility.
All other things being equal, that will reduce the amount you have invested and so reduce your investment return. It creates what we call a ‘cash drag’ in portfolios. Importantly, what we want to do and we do when we construct our buckets is that we hold an amount in cash (two years) but we also hold an amount in the higher-risk pot which exactly offsets that amount of cash.
The impact of that is that we keep the overall risk of the profile the same. When we asked, ‘Why two years?’ it’s because two years for us has a high 90% probability – and this is me using my maths brain – of covering you for drawdowns that might happen.
It also makes that balancing act possible, because anything longer made it difficult. It also provides a reasonable, slightly-longer-than-short-term cover for a portfolio to allow it to recover if necessary and for investors to keep taking income.
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