How much cash should investors hold? Emergencies, buying opportunities, loss avoidance… the best strategies in current markets revealed
- Rookies are typically told to build an emergency fund of 3-6 months of salary
- Experienced investors might want to hold an ‘opportunities fund’ in reserve
- Interest rates are up and markets are volatile – so how much cash do YOU need
Experienced investors might want to hold an ‘opportunities fund’ in reserve for promising purchases
Rookie investors are typically cautioned to build an emergency fund of three to six months of salary before chasing better long term returns on their money on financial markets.
More experienced investors might want to employ cash in more sophisticated ways, such as keeping an ‘opportunities fund’ in reserve for promising purchases, or removing some risk from their portfolio at critical moments.
Right now, we have reached an interesting juncture regarding how much cash investors are best advised to hold.
Rising interest rates are improving returns from risk-free savings deposits, while financial markets are going through a particularly volatile period.
‘A regular question in any environment, and a key one as we enter 2023, is how much cash individuals and families need to set aside, rather than committing as investments,’ says Tim Bennett, head of education at Killik & Co.
‘There are many things capable of keeping people awake this year, most of which are a hangover from 2022.
‘As people’s fears surrounding the economy increase, they naturally begin to hold more cash.’
Bennett says investors need to bear in mind rising volatility across financial assets – from shares to bonds and property – decreasing earnings visibility across the stock market, and central bank ‘tightening’ which has seen debt costs rise as interest rates are lifted.
Meanwhile, he notes the current uncertainty around job security and wages as businesses try to cut costs.
Below, Bennett and other finance experts explain how investors can make best use of cash for both contingencies and opportunities in the present climate.
Holding cash within your investment portfolio
Investors will often hold back cash in an investment portfolio as a short-term tactical allocation to avoid losses in other asset classes, says Charles Stanley Direct’s chief analyst Rob Morgan.
But he cautions that market timing is always tricky, due to the risks and psychological challenges of attempting to sell high and buy low, and the transaction costs.
‘Being out of the market also interrupts the flow of potentially greater income returns from assets such as bonds, shares or property that offer interest, dividends or rental income.
‘Having said this, over the past year or so, cash as has become more relevant as a tool within an investment portfolio because it has started to produce a worthwhile return.
‘With Bank of England base rate hitting 3.5 per cent, and forecast to move a bit higher over coming months, cash is not quite the dead weight it was when interest rates were rock bottom.’
Morgan says this is particularly relevant for those requiring income and looking to draw flexibly from an Isa or pension account.
He explains that the strategy of keeping a modest cash buffer so you can carry on making withdrawals without selling assets – and therefore having to crystallise losses – could now come with less of a penalty. See the box on the right.
Morgan adds: ‘One option for those managing their own investment accounts is money market funds that invest in a diversified portfolio of short-term cash deposits, money market instruments and (in some cases) high-quality bonds.
‘These funds aim to produce returns over and above benchmarks such as the BoE base rate or the Sterling Overnight Index Average (SONIA), which represents an average of short-term lending between UK financial institutions.’
How to be an opportunist with your cash
‘When it comes to having cash on the sidelines, and then opportunistically putting it to work, you really need to be contrarian to take advantage of short term investor sentiment,’ says Juliet Schooling Latter, research director of FundCalibre.
‘You can take advantage if the market has a couple of big down days to add to your holdings or parts of the market that have suffered the most, but which you think can do better over the long term.
‘If the market keeps going down, keep adding a bit more. You can also take advantage of big up days to trim holdings or areas that have done well.’
But Schooling Latter warns: ‘Just be careful you’re not spending too much on the trading costs or it won’t be worth doing.
‘Sometimes it’s only really worth it if you’re moving fairly large sums around or if you’re buying and selling funds on a platform where trading is free. It’s also safer to do this strategy with funds or indices.’
‘Trying to play this game with individual shares can go badly wrong if you’re not very careful.’
Schooling Latter says being opportunistic with your cash can work really well in a range bound market. This is when a price fluctuates between a certain high and low level and fails to break out of it for some time.
She explains the key in this situation is to be disciplined and not get sucked into market narratives of why the market or a stock is up or down, and also to only do this with a small percentage of your portfolio.
‘You could have done well last year if you’d bought in when everyone got very negative in June and then sold out in August when everyone was positive. The downside is it won’t do well if the markets trend strongly in one direction.’
Schooling Latter says pursuing this kind of strategy is probably most dangerous when markets rise.
‘Usually, when markets fall you get a strong relief rally at some point but markets can grind up a little bit day after day for weeks or months. So if you sell into that rally, sometimes it can be hard to get back in.’
What else should investors bear in mind
Tim Bennett from Killik & Co offers the following tips on holding cash.
The benefits of cash: ‘The danger of holding too little cash is obvious – you may not have enough of a buffer when hard times strike,’ he says.
‘Emergencies can crop up, whether a sudden need to fix a car or the roof, or a child needing a short-term loan.’
Meanwhile, ‘opportunistic cash’ is useful in volatile markets, where investors spot bargains, or good entry points, or want to top up a favourite long-term holding, he says.
Bennett also points to the psychological comfort of holding cash: ‘We all feel more secure knowing we can’t get into too much financial trouble in the short-term.’
Pitfalls of holding too much cash: The perils include interest rates on deposits continuing to lag inflation, in many cases by some distance, says Bennett.
He also cites anxiety and FOMO – the fear of missing out: ‘When stock prices begin to rise, it can be stressful watching them do so, knowing that your cash is being eroded in “real” (post-inflation) terms.’
Bennett notes that only up to £85,000 in savings held with any one institution is protected by the Financial Services Compensation Scheme. Find out how the FSCS works here.
How to decide how much cash to keep back: ‘Individuals should keep around three to six months of their average monthly spending aside – erring towards the latter in the current uncertain climate.
‘Families need more – six to 12 months is my recommendation here. Of course, the exact amount has to be a matter of personal preference.’
Get the best return on cash you can: ‘Whatever amount is set to one side, it is important that it is both accessible but also not languishing somewhere that pays no interest,’ says Bennett.
‘With rates rising, even ready-access accounts should offer at least something by way of a return. Keep an eye on rates and do not be afraid to shop around for a better deal
‘Try not to lock in for longer than you need to, or for more of your reserve than you should. Consider using a comparison platform to speed up the moving process.’