The role of cash in a portfolio

When considering the role of cash in a portfolio, advisers must first consider whether the term "portfolio" refers only to the funds held in a brokerage or retirement account, or to their client’s total investible assets.

Sometimes it can be easy to take a narrow view of the portfolio and look at cash as a drag on returns. But when financial professionals look deeper, cash is actually a necessity. While it’s true that over the long term, equities and fixed income have historically delivered higher returns than risk-free assets, cash plays an important role in the construction of holistic client portfolios and planning that is too often overlooked.

Modern portfolio theory explains the relationship between risk and return in terms of the greater returns available to those who take risks. A well-known formula is the expected rate of return, which equals the risk-free rate plus the historical market return adjusted for beta, or the historical correlation of the investment to overall market performance.

Modern portfolio theory was not meant to apply to an individual investor or a household since it considers only the portfolio and not the household, which will entail other considerations -- such as emotional and psychological factors -- that support holistic financial planning.

For example, at the household level, many financial advisers suggest clients hold an emergency fund equivalent to six to 12 months of expenses in cash. A 2018 study by the Federal Reserve found that while the trend line is improving, many Americans would struggle to pay an unexpected $400 expense using cash on hand. This is consistent with the findings of multiple surveys addressing the low levels of savings in the U.S., leading financial planners to agree that it’s important to have some form of an emergency fund.

[More: Interest in emergency savings accounts likely to grow post-COVID-19]

Quality wealth management begins with a solid financial plan. It's important to use the planning process to determine the client's goals and the most efficient way to achieve those goals. While cash is not generally the largest portion of a client’s asset allocation, maintaining access to a higher-yielding, FDIC-insured investment option for cash is critical. This is especially important in these times of heightened volatility and uncertainty that we have endured in 2020.

As an adviser, it's your responsibility to curate portfolios that will allow clients to remain invested to meet their long-term goals, even during a market downturn. As COVID-19 has roiled global markets and sent prevailing interest rates to zero, clients have been in a quandary with regards to finding yield on risk-free assets. Great success can be found in introducing clients to cash management solutions, which allow them to maintain full Federal Deposit Insurance Corp. coverage, yet continue to earn interest on their cash while the bulk of the industry is now paying little to nothing on cash deposits.

HOW MUCH CASH SHOULD PORTFOLIOS HAVE?

Generally, individuals keep cash in their investment portfolios based upon their risk profile and their overall goals. It is up to financial advisers to aid them in navigating the decision of how much cash that should be.

The 2019 Capgemini World Wealth report found those with investible assets of at least $1 million kept more than 27% of their total net worth in cash. This is comparable to the levels of cash held by family offices, which average a 30% cash allocation.

This may seem high, but the rationale is simple: Capital preservation is important to family offices, and having cash on hand to make new investments and purchases without having to sell other holdings can be highly beneficial. Having cash on hand is important to high-net-worth individuals, who are often able to be more opportunistic investors, as compared to the broader population, which relies on periodic savings plans such as 401(k)s.

CASH PROVIDES PEACE OF MIND

When markets turn volatile, cash provides clients with confidence that they can weather the storm. This is especially important as clients with too small a liquidity cushion may panic and be tempted to sell equities at precisely the wrong time. Holding cash can help clients stay the course and remain focused on their long-term financial plans.

With a new focus on safety, liquidity and yield, client interest in FDIC-insured bank accounts is growing. According to Google Analytics, market volatility precipitated by the COVID-19 crisis drove the volume of searches for the term “FDIC insurance” up by 500% as the pandemic hit in March.

We need look no further than the past four months to see the clear impact that cash has had on the overall comfort of clients. Having cash on hand alleviates the stress of meeting short-term spending needs and provides client with a sense of safety that they have access to the capital they need. This level of security allows them to remain invested with the risk portion of their asset allocation and avoids the risk that they will abandon their long-term investment structure in search of short-term solace.

CONCLUSIONS

If you haven’t spoken to your clients recently about the role of cash in their portfolios, now is a good time. While there is no one right answer for everyone, firms like Echo45 Advisors employ a planning process that aims to identify the goals of each client and the most efficient way to achieve those goals. You need to take into account your clients’ cash flows, assets, liabilities and dreams to come up with a portfolio that makes the most sense for them.

Since cash is the one asset class that everyone holds, being smart about cash is one way to earn the freedom to live life on your own terms.

[More: Low bond yields test 60/40 asset allocation]

Michael Halloran is head of business development and partnerships at MaxMyInterest and Jon Henderson is owner and founder of Echo45 Advisors.