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Understanding investment types

How much cash should I have in my portfolio?

10 minute read
  •  
September 04, 2024
Understanding investment types
Cash investments
Article
Page
Managing portfolios
risk-tolerance
Risk averse

Determining the ideal amount of cash to hold in an investment portfolio isn't a one-size-fits-all decision. It requires a personalized approach that considers several key factors, including your goals, time horizon, risk tolerance, and funding level.

What does it mean to keep money "in cash"?

First, what is cash? Cash can take many forms, including money held in your bank account or wallet. Additionally, there are cash investments (also known as cash equivalents), which are a type of short-term investment product that earns interest.

In that sense, we define "cash" as a readily available short-term financial instrument with high liquidity, minimal or negligible market risk, and a maturity period of less than 3 months.

How do time, funding level, and risk affect investing decisions?

Now that we've defined what cash is, it's important to understand how your time horizon, funding levels, and risk tolerance can influence your decision to hold cash investments.

Time horizon refers to the length of time you plan to hold your investments before you'll need to access the money. Funding level assesses how your existing assets are currently meeting your financial needs. Risk tolerance is the degree of variability in investment returns you're willing to withstand. Generally, taking more risk increases your potential for higher returns.

By evaluating these 3 critical elements, you can tailor your cash holdings to suit your unique financial situation and goals, helping you maintain the right balance between liquidity, risk, and return.

A matrix of investment goals and risk tolerance levels

Risk Tolerance
 

High

Low

Wealth growth Cash least likely to be recommended Cash less likely to be recommended
Wealth preservation Cash less likely to be recommended Cash more likely to be recommended

Note: The shades of red in the matrix's cells indicate the degree to which cash is likely to be recommended given the corresponding combination of investment goal and risk tolerance: least likely (light red), less likely (medium red), or more likely (dark red).

Source: Vanguard

As the chart shows, cash might play a significant role in a portfolio aimed at wealth preservation, while a growth-oriented portfolio might see a reduced reliance on cash. Learn more about the research behind our framework for allocating to cash (PDF).

Here are 2 examples of investor profiles that highlight the roles cash might play based on differences in an investor's risk tolerance, time horizon, and funding levels.

These examples are for illustrative purposes only and are not a recommendation to buy or sell a particular security. They do not take into consideration your personal circumstances or other factors that may be important in making investment decisions.

Case 1

Johan is in his 50s and his main investment goal is to finance his retirement.

  • High risk tolerance. Johan is comfortable with a significant degree of volatility in his returns. This means he's more likely to hold higher-risk assets such as stocks rather than cash, hoping they'll earn higher returns.
  • Long time horizon. Johan aims to retire by a specific date, but his spending needs after retirement are uncertain. By taking on more risk, which his risk tolerance and time frame allow, he can aim for higher returns. This could help his retirement fund grow and may even give him the option to retire earlier than he planned.
  • Low funding level. His portfolio balance is currently far below the amount he's likely to need in retirement. Since he has a long time horizon and high risk tolerance, it's unlikely an allocation to cash would give him the best chance of meeting his goal.

Consideration: Johan might not choose to have a cash allocation in his retirement portfolio at this time.

Case 2

Dana is in the early stages of her career and has 2 primary financial goals: maintaining emergency savings for unexpected expenses and saving for a down payment on a home, which she hopes to purchase within the next 18 months.

  • Low risk tolerance. Dana doesn't feel comfortable taking on investment risk that could jeopardize her emergency savings or delay her home purchase even if it might generate a higher investment return.
  • Short time horizon. Her emergency savings might be needed at any time, and the intended home purchase is less than 18 months away if all goes well.
  • Well-funded goals. She already has 6 months' worth of living expenses set aside and is close to meeting her down payment target.

Consideration: Dana might consider holding her emergency savings in cash, in addition to holding a low-risk portfolio including cash for her down payment.

The takeaway

There's always a trade-off when balancing risk and return. Therefore, investors like Johan, with higher tolerance for risk, longer time horizons, and underfunded goals, might opt to exclude cash from their portfolios. However, for investors like Dana, who prefer lower risk and are investing for well-funded, short-term goals, including cash in their portfolios can be a sensible strategy.

Learn more about your cash investment options

What are the benefits and risks of investing in cash?

When deciding whether cash investments are right for you, it's important to consider the advantages and disadvantages.


Pros of holding cash:

  • Stability: Cash investments are less prone to market fluctuations, providing a stable portfolio component.
  • Risk and return: During periods when interest rates are high, saving strategies can yield relatively high returns for their low-risk nature.
  • Accessibility: Cash is highly liquid, meaning it can be immediately accessed or converted into other forms of currency and doesn't require selling an investment.

 

Cons of holding cash:

  • Lower long-term returns: Historically, cash investments yield much lower returns over the long term compared with stocks or bonds.
  • Shortfall risk: The low returns associated with cash may limit growth potential, making it harder to achieve your goals.
  • Inflation uncertainty: Cash is vulnerable to inflation risk, which means the purchasing power of money may decrease if inflation outpaces the interest earned on cash holdings, as it often has in the past.  

How much return can I expect to earn on cash investments?

Interest rates on cash and cash-equivalent investments typically vary depending on the type of investment and the current economic environment. We can also compare nominal returns, or the stated returns, against real returns adjusted to reflect the true purchasing power after inflation. Over the last 60 years, cash's real return has decreased over time. In fact, cash has only provided a positive real return in 4 of the last 20 years. Here, you can see the impact of inflation on cash returns.

Historically, cash's real return has tended to be negative

Notes: For the years 1960-1977, cash is represented by the Ibbotson 1-Month T-Bill Index. For the years 1978-2022, cash is represented by the FTSE 3-Month T-Bill Index. Inflation is represented by the Consumer Price Index (Seasonally Adjusted) from St. Louis Federal Reserve Economic Data (FRED).

Source: Vanguard calculations, based on data from FTSE and FRED. 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Historically, cash's real return has tended to be negative

Cash return, before and after inflation, 1960–2022

Notes: For the years 1960–1977, cash is represented by the Ibbotson 1-Month T-Bill Index. For the years 1978–2022, cash is represented by the FTSE 3-Month T-Bill Index. Inflation is represented by the Consumer Price Index (Seasonally Adjusted) from St. Louis Federal Reserve Economic Data (FRED).

Sources: Vanguard calculations, based on data from FTSE and FRED. 

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

How much money should you keep in cash?

Although we generally discourage holding cash for long-term investment goals and caution its real returns, Vanguard recognizes that there are important uses for cash. Keep enough to cover your regular spending needs, which includes both your cost-of-living expenses and your discretionary shopping budget.

Don't forget to set aside cash for your emergency fund. You should hold enough cash to cover potential spending shocks, which are unplanned expenses, like a broken windshield or a root canal, that require immediate funds. Income shocks are another scenario to consider for emergency savings. However, given their rarity, you may weigh the potential missed investment opportunities before deciding to maintain this reserve entirely in cash.

Beyond these basic considerations, some investors, especially those with a low risk tolerance, might choose to keep extra cash for added security. However, it's important to be aware of the opportunity cost associated with holding more cash than necessary. If you decide to go this route, make sure to seek out options that offer the highest possible return on your cash holdings to maximize your financial benefits.

When it comes to cash in your portfolio, it's personal. You should consider your financial circumstances and objectives, time horizon, risk preferences, and liquidity needs. By following our framework, you can determine a suitable amount of cash to hold to meet your personal needs while keeping the rest of your investment portfolio best positioned for your long-term success.

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All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Vanguard funds not held in a brokerage account are held by The Vanguard Group, Inc., and are not protected by SIPC. Brokerage assets are held by Vanguard Brokerage Services, a division of Vanguard Marketing Corporation, member FINRA and SIPC.

IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.

The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.

The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.