Holding cash has a cost measured against what else the money could earn, and a value in optionality and sleep. Sizing it deliberately is part of portfolio construction rather than what is left over.
10 min read · Level 2
I think cash is the most misunderstood position in most portfolios because it is judged only on its return. Its return is poor and its job is different: it decides whether you are ever forced to sell something else at the worst possible time. Priced that way, a deliberate cash holding is often the cheapest protection available, and an accidental one is just drag.
Cash in a portfolio does three jobs:
Job What it provides Spending money funds known costs without selling anything Shock absorber avoids forced selling when markets fall Optionality lets you act when opportunities appear
It also has a cost. Compare a portfolio held fully in growth assets with one holding 10% cash, using illustrative returns of 7% for the growth assets and 2% for cash:
Blended return with 10% cash: (90% x 7%) + (10% x 2%) = 6.5%
100,000 over 20 years at 7.0% about 386,968 100,000 over 20 years at 6.5% about 352,365 Difference about 34,600
That difference is the price of the flexibility. Whether it is worth paying depends on what the cash is for.
A useful way to decide the amount is by purpose rather than by percentage:
Purpose Amount Known spending in the next year or two the actual amount needed Cushion against income interruption a figure you choose deliberately Opportunity reserve only if you will actually deploy it
The third deserves scepticism. Holding cash to buy market falls only works if you buy during them, which many people find difficult when the moment arrives.
Because cash usually ends up as a residual - whatever happened to be left - rather than a decision. Sized that way it is often too small to help in a crisis and too large to be free.
It also connects to behaviour. An investor who can hold their other positions through a fall because their spending is covered has bought something real with the lost return.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Two investors during a 30% market fall, each with 200,000 invested and 40,000 of annual spending.
Investor A: no cash. Must sell 40,000 of investments during the fall to cover a year of spending. Investor B: 40,000 in cash. Spends from it and leaves investments untouched.
Investor A sold at depressed prices and permanently removed those units from the recovery. Investor B gave up some return on 40,000 in the years before the fall - at the illustrative 5 percentage point gap, about 2,000 a year - and avoided selling into weakness.
Treating cash as the leftover after investing, rather than sizing it against specific purposes and accepting the cost.
Separate near-term spending, income cushion and any opportunity reserve.
Use actual figures rather than a round percentage.
Multiply the cash balance by the gap between cash and portfolio returns to see the annual cost.
Only hold cash for opportunities if you have deployed it in past falls.
When setting or reviewing an asset allocation, or after a large change in income or spending.
Do not hold large cash balances as a way of avoiding a decision about markets. Deliberate cash is useful; indefinite hesitation is expensive.
Investors commonly describe building cash balances intending to buy during market falls, and then not investing when falls occurred, because the same conditions that lowered prices made buying feel unwise. Studies of investor behaviour have repeatedly found inflows to funds rising after strong markets and falling after declines.
If you hold cash for opportunities, write down in advance what would trigger you to deploy it.
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