How much cash should I hold?
A lot has been talked about how much to invest, but how much should remain in cash? This question is just as important.
Understanding cash in investment portfolios
It's a common misconception to consider cash as part of an investment strategy. Unlike stocks or bonds, cash doesn't yield dividends, interest, or capital gains. Thus, it's not a wealth-maximising asset in the long run.
However, if you peek into your Selma portfolio, you might spot some cash. This isn't an oversight. Think of cash as the fuel for your investment engine. It facilitates seamless transactions, accommodating the varying share prices of different funds.
Three things you need cash for
You need cash to cover your everyday living expenses, paying taxes or bigger purchases you have planned. It is also a good idea to keep a bit of cash for "unwanted" situations like job loss, illness or accidents.
To understand how much cash you should keep, let's have a look at these major categories of cash needs.
Calculating average living expenses
How much cash one needs to cover these expenses is not so easy to figure out. You'll most likely noticed that your spending varies from month to month. There are, for example, one-off items like seasonal gifts or bigger one-off items like holiday trips.
How do you solve this? Check how much you spend over the last 12 months (this can also be from May 2022 to April 2023). Then divide this sum by 12 to get the monthly average. This will iron out the seasonal bumps in your spending. Your monthly earnings should be larger than your monthly expenses. Then you can also consider investing part of your monthly savings, but we get to that point later.
Planned spending over the coming months
The second thing you may need cash for are bigger purchases. This can be the new TV for your home theatre or a planned trip to the Caribbean. Whatever it is, if it is coming up within the next 2 years, it is smarter to keep that money in cash, than trying to invest it.
Why is it smarter? Because successful investing requires patience and a long-term perspective. Markets swing up and down. If you exit your investments at a bad time, you might make losses only to have enough money to upgrade your home theatre. 📉
Leveraging future savings
Hopefully, you are able to save some money over most months. These future savings can partially cover your upcoming spending plans. This can help to not have to set aside the full amount for your TV or holiday trip right away. Selma takes this into account by reducing the cash needed for planned expenses by the amount of one year's monthly savings. 💰
The importance of a cash buffer
Life is unpredictable. A cash buffer acts as a financial safety net during:
- Employment disruptions
- Unexpected medical bills
- Major unplanned expenses (relocation, need of a new kitchen)
A good rule of thumb is for the cash buffer to equal around three times your average total monthly expenses. For example, if you spend 5’000 CHF per month, then consider keeping a cash buffer of 15’000 CHF in your bank account. This is a very crude rule-of-thumb. You may come up with larger or smaller numbers that make more sense to you. 🙌
Putting it all together
Now to the question: how much can you invest? Take what you earn and subtract your average monthly spendings. Take what is left and subtract your planned major spendings. The money that is left is what you could invest monthly.
Similarly, you can now add up your major spending plans (ideally reduced by future savings potential) and your desired cash buffer to get the amount of cash you should leave in your bank account.
Daniel is an economist (MSc) and financial analyst with over 10 years experience in the Swiss banking industry. He leads the investment management at Selma and he’s passionate about finding better ways to invest for everybody. Follow him on LinkedIn to get regular updates on what he thinks about financial markets.LinkedIn