Balancing act: allocating cash without missing out on market gains

When it comes to managing your investments, you may hear volumes about how you should always be “fully invested” to maximise your growth and income potential. It can certainly be good advice, but, as with all investing, there’s a nuance.

For an income investor, having enough liquidity may be as important as trying to maximise returns. The dilemma many face is working out how much cash is enough, while being careful to avoid holding too much, potentially dragging down portfolio performance. It’s about striking that balance between having enough cash on hand and still taking advantage of rising markets.

Let’s dive into the roles cash can play, the effects of “cash drag”, and some options for keeping the money working.

The different roles of cash

While cash itself is a straightforward investment, there are some considerations when it comes to your portfolio.

Investment costs

Keeping investment costs to a minimum is one of the only ‘free lunches’ in investing. But it’s an inescapable fact that there will always be some costs involved with maintaining a portfolio.

Taxes and financial advice fees are two common considerations. For self-managed superannuation fund (SMSF) investors, they will also need to ensure they can cover the costs of running the fund, as well as covering any insurance premiums being deducted from their accounts.

Strategic cash

Cash is generally the most capital-stable of investment classes, while offering some income. In recent years, the income available from cash has improved due to rising interest rates, making it an important consideration for investors to manage the risk and income levels in their portfolio.

Tactical cash

Markets have periodic corrections, which may offer the opportunity to buy assets at a perceived discount. Some investors choose to keep some cash on hand for such situations.

Cash allocation: How much is enough?

There is no one-size-fits-all answer to the question of how much cash to hold. The important thing is what your needs and circumstances are, which can be very different for any particular stage of your life and your financial goals.

Should you use a percentage or fixed dollar approach?

One question frequently arises: should you devote a fixed percentage of your portfolio to cash, or use an absolute dollar amount? Both approaches have their advantages.

A percentage might be appropriate in instances where one wants to maintain a certain level of liquidity relative to the portfolio’s size. This can sometimes be an effective strategy for investors whose portfolio value fluctuates, as it automatically adjusts the amount of cash held as the overall portfolio expands or contracts.

Other investors may be more comfortable thinking in terms of a dollar amount. That might work well for people who have identifiable, known needs for cash – whether it’s covering six months of living expenses, covering unexpected bills, or planning a big purchase. When you know the figure that you’re comfortable with, it’s an easier strategy to implement.

The negative aspect of holding too much cash

The trade-off with keeping cash on hand is that having too much cash can be a problem for your portfolio’s performance – a phenomenon known as cash drag.

How cash drag impacts returns

Cash drag is the term used to describe the opportunity cost of holding cash. The returns on cash are typically lower than other asset classes over the long term. Over the course of years or decades, this can make a big difference.

For the purposes of a projection¹, we’ll make the following assumptions:

• Investment timeframe: 40 years
• Investment return: 6% p.a.
• Monthly investment: $1,000
• Starting balance: $0

Let’s consider a situation where, instead of investing $1,000 each month, cash is saved over the course of a year, earning zero interest, to be invested in one lump sum at the end of the year.

For the sake of simplicity let’s assume there is $0 brokerage and 0.04% p.a. management cost² on the investment. We’ll also assume that we receive no interest on the cash.

We’re comparing this making monthly investments – all other assumptions are the same.

Source: Betashares. Hypothetical example provided for illustrative purposes only. Not a recommendation to invest or adopt any investment strategy. Actual results may differ materially.

The annual investor ends up with $1,838,577 at the end of year 40, while the monthly investor ends up with $1,970,010. Investing monthly resulted in a balance that was $131,433, or 7.1% higher.

Putting excess cash to work: Income-oriented alternatives

So, what do you do if you have more cash than perhaps you really need, but you still want to be conservative and liquid? There are a few options that may enable you to balance your needs for liquidity with the potential for higher returns.

Investors may consider income-focused ETFs, which may offer regular income and relative capital stability, depending on the underlying assets. ETFs holding bonds can offer attractive income with the potential for capital returns (gains or losses). ETFs offer daily access and are traded on ASX with T + 2 settlement.

OZBD Australian Composite Bond ETF provides exposure to a diversified portfolio of high-quality Australian corporate and government bonds selected on the basis of risk-adjusted income potential, while controlling for overall interest rate and credit risk.

Another avenue is to turn to floating rate bond ETFs or money market ETFs. While Australian banks are sound and their deposit facilities can offer a dependable income stream, the returns from senior floating rate notes and money market securities are expected to exceed income paid on cash and short dated term deposits. These securities also offer a high level of capital stability. . They could be particularly attractive for investors looking to preserve capital while still achieving an attractive return on their cash holdings.

QPON Australian Bank Senior Floating Rate Bond ETF invests in a portfolio of some of the largest and most liquid senior floating rate bonds issued by Australian banks.

MMKT Australian Cash Plus Fund (managed fund) invests in a portfolio of Australian dollar cash and short-term money market securities issued by investment grade entities.

Reevaluating your cash allocation over time

Cash is essential in any balanced portfolio, but holding too much of it drags down long-term overall returns. By taking a thoughtful approach to how much cash you hold onto and investigating higher-income alternatives, you can help ensure your money works hard for you, yet still provides the liquidity you want to feel comfortable and sleep well.

Whatever you decide, remember that your cash allocation needs regular health checks. Life is ever-changing, and so, too, should your investment strategy. You can reevaluate the amount of cash in your portfolio to keep it aligned with your goals and risk tolerance.

Footnotes

1. All projections in this article are in nominal and not real terms, i.e. they have not been increased to account for inflation. ↑

2. Based on the management cost for Betashares Australia 200 ETF (ASX: A200). ↑