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How much cash is enough?

Discussion in 'Investing Strategies' started by Nigel Ward, 27th Oct, 2006.

  1. Nigel Ward

    Nigel Ward Team InvestEd

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    I've been thinking recently about how much of one's net worth should be held in cash. I think it's a question we've considered before here...

    Perhaps it's time for a poll?

    Cash is a risk modifier. As well as being the oil which greases the engine of capital growth :p

    Some people pull figures out like needing to have 3/6/12 months' expenses covered...others suggest a % i.e. 5/10/20%.

    Of course it depends on your actual and contingent liabilities... for example if you have a big margin loan with a relatively high gearing level then perhaps it's prudent to have sufficient cash on the sidelines to meet a big margin call...

    Conversely if you're just starting out then probably much bigger % of your net worth should be in cash. E.g. if you're worth $100k then holding 10-20% cash could be prudent to see you through those unanticipated expenses and life's emergencies.

    But if you're worth $10m would it be efficient to keep $1m-2m in cash???

    Just some random Friday musings...

    Cheers
    N.
     
  2. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Personally I don't believe in holding cash ... unless you have zero gearing (in which case you are obviously a very conservative investor and cash is quite appropriate).

    By "holding cash" I mean having money invested in cash for no other purpose than it being cash.

    You will generally get much better returns on your money by either depositing that cash into a loan account (which has a redraw facility), or if it makes more sense from a taxation point of view, to deposit it into an offset account.

    It makes no financial difference (ignoring the tax issue) whether you pay down debt or deposit into an offset account ... you have the same net effect. More the point, by then using that money for whatever contingencies it was there for (emergencies, margin calls, etc), you lose the benefits of using that money to offset the loan, regardless of whether you had it deposited into the loan or held in offset. Similarly, you lose any benefits you may have gained from holding it in a high-interest bearing account.

    The question is then ... should you instead "invest" that money with the goal of gaining a potentially higher return, taking into account that unless you have a liquid and capital guaranteed investment, you may well end up with less money than you started with, or indeed, not be able to readily access those funds when you need them most.

    There are generally three main uses that I can think of for "holding" cash:

    1. Personal emergencies
    2. Investment emergencies (margin call!)
    3. Investment return risk mitigation (conservative strategy, or minimising downside from a falling market)

    So from a planning point of view, you would work out a personal budget and then, depending on your risk profile, ensure that you had ready access to sufficient funds to cover for any contingencies that you think are necessary, for a particular length of time. This is the "3/6/9/12 months" worth of expenses type plan.

    You may also work out a plan to cover investment holding costs, based on the percentage of holdings (or percentage of borrowings).

    Planning for margin calls is a little more difficult, since you don't know how large the margin call might be. Not the end of the world anyway - at worst, the margin lender will simply sell down your holdings as required to cover it.

    Planning to hold cash for investment purposes is a completely different strategy. I think it is generally a very conservative strategy - regarldless of whether you are worth $10K or $10M ... it is a risk mitigation strategy as opposed to a wealth building strategy. How much you need will depend on the usual variables of your goals, needs, situation, and the nature of the other investments you hold.

    For most people who are aiming for something above a conservative approach, I personally don't think holding cash for the sake of it is a good strategy - unless it is a short term tactical move during a falling market, and/or while waiting for new investment opportunities to present themselves.

    If you have a range of relatively liquid investments in your portfolio - then you can always access cash when you need to.

    Think of it this way - is there really any difference between the lost opportunity of future gains after selling some of your holdings to meet short term cashflow needs, compared to not having invested in the first place to instead hold in cash just in case ? Please discuss.
     
  3. hiflo

    hiflo Well-Known Member

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    I think Sim has a valid point.

    There is no point in just "holding cash"- no interest benefit at all.

    I am currently having different thoughts as to how much I should be holding in Cash. As Sim says there are two main reasons for holding cash:

    1) emergencies
    2) for other investments.

    I used to think that I should have enough cash for emergencies. Having missed the opportunity to purchase BHP shares for $23.00- $24.00 because I did not have immediate cash available (all tied up in MF), I am rethinking as to how much "immediate cash" I should be holding. At that time I had less than $1K in bank- not worth buying the shares and be in mental agony.....when I had credit card payments, and bills due a few weeks later.
     
  4. Nigel Ward

    Nigel Ward Team InvestEd

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    I both Hiflo and Sim have raised some really interesting points.

    1) There are different ways to hold cash. Parking it in an offset account is great. ;)
    2) You need enough cash to smooth out timing mismatches between your outgoings and your income. For example, if you were running things so tightly that you needed say a quarterly MF distribution to pay essential and regular monthly bills then I think you need a higher cash float...
    3) Having some cash can let you take advantage of opportunities that arise e.g. shares being at a price you think is cheap...
    4) there is an opportunity cost to hold cash and not growth asset classes...

    N.
     
  5. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    I always thought of this as a bit of a furfy.

    Sure, from a tactical point of view, you may hold cash you've recently accumulated ready for a good opportunity (ie. timing the market)

    ... but from a strategic point of view, it doesn't make much sense to me - once the opportunity has come up, you no longer have any cash to invest - and how do you propose to get more to maintain your strategy of holding cash ready for the next opportunity ?

    ... and why cash and not other liquid investments ?
     
  6. Nigel Ward

    Nigel Ward Team InvestEd

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    Why cash? Because unlike other liquid investments it has no risk, i.e. there's no risk that the $100k you had yesterday isn't $50k today - which could happen in shares or managed funds.

    Of course there's a price for that stability and certainty, namely the lack of growth and the poor earnings (i.e. even at 6% after inflation and tax you're still basically going backwards slowly).

    The plan would be for the investment you've bought or others you have to throw off cash for the next "opportunity".

    Don't get me wrong, I'm not saying holding cash will make you wealthy, but having "enough", whatever that is for you, can give you options, help smooth things between income receipts and provide some protection from falls in equity markets.

    N.
     
  7. Simon Hampel

    Simon Hampel Co-founder Staff Member

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    Agree totally for the "insurance" aspect of holding cash.

    I was specifically referring to "why hold cash when waiting for that next investment opportunity" ?
     
  8. hiflo

    hiflo Well-Known Member

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    To answer this question, it will depend on your investment strategy. (I am still doing my reading on this so do not ever follow my advice!!!)

    When I mean cash for investing, it is holding it in share traiding account, waiting for the right moment for LONG TERM HOLD. Share prices fluctuate and after looking at the prices for a year or so, and see the right opportunity for a certain shares then you can jump right in (this is on top of looking at company accounts and your evaluation of whether the company will grow any further in the future)

    But for other investment strategy, I do not know whether holding cash for investing makes any sense, as you suggest.
     
  9. handyandy

    handyandy Well-Known Member

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    I keep about 1 years interest cover in cash in various accounts. This cash is also the source for my living expenses. I should point out that this isn't a planned amount it simply happens.

    This cash equates to more than the cost of a house in Sydney.

    Why do I hold so much cash? There are a number of reasons.

    1 Habit - when running a business the cash flow of the business accummulated regularly so we would always have a healthy bank balance, no overdrafts here :D

    2 Lack of oppurtunities to invest. Simply there are times to invest and times not to invest. Returns aren't everything there is the question of risk and accessibility.

    3 Debt retirement - Presently we have paid down all loans that aren't fixed. So can't use the cash to retire anymore debt without paying out loans. To this end we are just in the process of refinancing one loan (just came out of fixed period) so that we can retire more debt. This reorg has take over 6 months and is still not complete.

    4 Working capital - there is still a need to have working capital. Although we only invest now there are lumpy expenses like 1/4 ly interest costs, land tax and the dreaded BAS. Obviously if I needed to I could refine these needs and do a tighter cash flow budget.

    No doubt there are other reasons but can't think of any more at the moment:rolleyes:

    Cheers

    PS I should add that this cash is not held personally but is retained in me companies structure. I actually don't even have a personal bank account.
     
    Last edited by a moderator: 31st Oct, 2006
  10. APerry

    APerry Active Member

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    I'm privy to the finances of some particularly wealthy individuals, from my experience, unless they operate ongoing businesses with significant cashflow their income is generally very lumpy and consequently they tend to maintain significant cash reserves. This is particulalry the case for those that rely on property development for a significant part of their income. Their cash reserves allow them to enter longer term projects such as taking a project from rezoning right through to building, as well as allowing them to move quickly when good opportunities arise.

    Regards
    Alistair