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How Much Cash Should You Have In Your Portfolio?

A reader writes in, asking:

“I’m not sure if you would consider a blog post or similar regarding cash (CD’s, Short Term Treasuries, Money Market, etc) but after reading and following your portfolio recommendations I’m curious if you have opinions on cash and how much to keep at any given time. I recognize all situations are different but you’ve always done a good job of laying out the options. My specific situation is: recently retired but my wife is working for another 2 years at which point we will both be retired.”

Firstly, I’m going to assume for the sake of this article that you already have a sufficient emergency fund in place or do not need an emergency fund. That is, we’re assuming that you already have a way to cover an unexpected major expense without incurring financial disaster. The question is simply: what part of the non-emergency-fund portfolio should be invested in cash?

And I’m also going to set aside the case of a “tactical” cash allocation (i.e., holding cash with the goal of investing it at just the right time after a downturn), because I’m not optimistic about the ability to do that in any useful way. Instead, I’m focusing on a static cash allocation (i.e., holding cash, with the intent of it being an ongoing part of the allocation).

The following chart from PortfolioVisualizer shows a $1,000,000 initial portfolio balance, neither adding to nor spending from the portfolio over time. This is from January 1987 – January 2024. (January 1987 is the earliest date for which PortfolioVisualizer has “total US bond market” data.)

The blue line represents a portfolio of 40% total US stock market, 20% total international stock market, and 40% total US bond market. The red line represents of portfolio of 41% total US stock market, 20% total international stock market, 29% total US bond market, and 10% cash.* (The 1% increase in stock allocation is to keep the overall risk level similar.)

Here’s the PortfolioVisualizer link, in case you want to examine the numerical metrics or adjust any variables on your own.

To me, those look functionally the same.

Now let’s look at a portfolio from which we’re spending. The following chart from PortfolioVisualizer shows a $1,000,000 initial portfolio balance, using a “4%” rule type of spending strategy (i.e., spending $40,000 in the first year and then adjusting that spending upward with inflation). Again, this is from January 1987 – January 2024. And the asset allocations are the same as above. So this is a pretty significant cash allocation: 2.5 years worth of spending (10% of the portfolio, when spending 4% in the first year).

Here’s the PortfolioVisualizer link, in case you want to examine the numerical metrics or adjust any variables on your own.

Again, they’re very similar. And I think we can at least agree that, if the cash did make a meaningful difference, it was not in a useful direction.

And I get a similar set of conclusions whenever I run Monte Carlo simulations, whether via PortfolioVisualizer or RightCapital. Swapping out a chunk of the bonds for cash (and then adjusting the stock allocation upward a smidge, to make an apples-to-apples comparison) is…fine.

There’s nothing magical about cash. Whatever we can achieve by shifting a chunk of the portfolio from bonds into cash, we can probably achieve by just slightly bumping up the overall fixed-income allocation instead. This is just another case of “Asset Allocation Isn’t Magic.” There are lots of different asset allocations that will get you to a given level of risk and expected return, and any such allocation tends to be about as good as another.

Personally, I tend to opt for the simplest route (i.e., whichever allocation involves the fewest number of total funds or the least rebalancing).

But one relevant caveat is that, if cash specifically, relative to other types of fixed-income, helps you feel better about your portfolio (i.e., it makes bad days/months/years in the market feel less stressful because you know “I’ve got ___ years of cash, ready to tap into, if needed”) then that’s a compelling point in favor of a cash holding. But from a purely financial perspective, there doesn’t appear to be any specific need for a big cash allocation.

*PortfolioVisualizer uses 3-month Treasury Bills as the return for “cash.”

Asset Allocation Isn’t Magic

Asset allocation is a dial that you can use to adjust the risk and expected return of the portfolio up or down. And, for the most part, that’s it. Anybody who expects more than that — anybody who expects any magic (additional return without additional risk, or a reduction in risk without a corresponding reduction in expected return) from clever asset allocation — is likely to be disappointed.

Let’s use PortfolioVisualizer’s “backtest asset allocation” tool to show you what I mean. (Note that their “backtest portfolio” tool is also of interest, but it requires you to use specific funds, which often leads to a shorter period of data available.)

Let’s start with a basic Bogleheads-style “3-fund portfolio” of 40% total US stock market, 20% total international stock market, and 40% total US bond market.

Here’s what happens when we substitute 20% of the total US stock market allocation with 20% REITs. (So now it’s 20% total US stock market, 20% international stocks, 20% REITs, 40% total US bond market.)

(Portfolio Visualizer link here.)

This is for the period Jan 1994 – Sept 2023 (because January 1994 is the earliest date for which Portfolio Visualizer has REIT data).

When I look at those two lines, the thing I overwhelmingly notice is how similar they are. Are they exactly the same? No. But boy they’re close. (And frankly this isn’t super surprising. We replaced stocks with stocks.)

No magic.

What if we use small-cap value stocks?

Here’s what happens when we substitute half of the total US stock market holding with 20% US small-cap value stocks, and then also move 1% from each of those two US stock categories into the bond fund, in order to adjust for the fact that small-cap value stocks are slightly riskier. (So now the portfolio is 19% total US stock market, 20% international stocks, 19% US small-cap value stocks, 42% total US bond market.)

(Portfolio Visualizer link here.)

This is for the period Jan 1987 – Sept 2023 (because January 1987 is the first period for which Portfolio Visualizer has data for total US bond market). Again, they’re very similar. If either portfolio is suitable for somebody, then the other portfolio would clearly be suitable also.

No magic.

What happens if we change the bonds? The chart below uses intermediate-term Treasuries instead of the total US bond market. And because Treasuries are slightly safer than a total bond fund, we’re adjusting the overall stock allocation up by 2% to keep roughly the same overall risk level. (So now the portfolio is 42% US stock market, 20% international stocks, and 38% intermediate-term Treasuries.)

(Portfolio Visualizer link here.)

This is again for Jan 1987 – Sept 2023, because January 1987 is the first period for which Portfolio Visualizer has data for total US bond market.

Again, nothing magical happening here. They’re so, so similar.

What about short-term Treasuries? Below is the chart if we use 43% total US stock market, 20% international stocks, and 37% short-term Treasuries. (Again bumping up the overall stock allocation ever so slightly, relative to the portfolio with intermediate-term Treasuries, to account for the fact that short-term Treasuries are a bit safer than intermediate-term Treasuries.)

(Portfolio Visualizer link here.)

This is again for Jan 1987 – Sept 2023, because January 1987 is the first period for which Portfolio Visualizer has data for total US bond market.

Overall, same conclusion.

Let’s do one last comparison. This time we’re using short-term Treasuries and a tilt toward small-cap/value. (The “comparison” portfolio is 21% total US stock market, 20% small-cap value, 20% international, 39% short-term Treasuries.)

(Portfolio Visualizer link here.)

I truly cannot imagine getting excited about the difference between the two lines on any one of these charts.

Admittedly, these were just comparison portfolios I came up with in a few minutes. You can test different portfolios for yourself. You could look at different periods. Some portfolios will look better than others.

But between two reasonable portfolios with similar overall risk levels, the return will generally be similar as well. Yes, one portfolio will always come out a bit ahead, but you can see periods where the other portfolio was ahead instead.

This is not to say that asset allocation doesn’t matter. But, at least in my opinion, it’s probably not worth spending a tremendous amount of time on — other than trying to figure out what overall risk level is right for you. Once you know that, there are plenty of different ways to get there. (I usually vote for whatever is simplest.)

And I would enthusiastically encourage you not to rely on any magic from having a clever asset allocation. (Asset allocation is a fruit salad, not a cake.)

Why I Think International Diversification Is a Good Idea

A question that comes up, over and over in my email as well as on the Bogleheads forum is whether you really need international diversification, or whether sticking with only U.S. stocks is fine.

I’m a firm believer that it’s worthwhile to include an international stock fund in the portfolio.

The reason, however, has nothing to do with a rebalancing bonus, mean-variance optimization, or any particularly complicated math. As I’ve written elsewhere, I’m not optimistic about the possibility of creating a portfolio of assets with low correlation to each other, in such a way that they can reliably smooth out each other’s periods of poor performance. (And if you bother to look, international stocks and U.S. stocks actually have reliably high correlation with each other.)

For me, including international stocks in my portfolio is about diversification in a very fundamental, basic way: if I include international stocks, I have more stocks in my portfolio. This is diversification in the sense that your great, great grandparents would still have intuitively understood.

If any one stock has terrible performance, it has less of an impact on me. That’s a good thing. Because companies blow up sometimes.

And diversification is helpful from the other perspective as well: not just in terms of minimizing harm (from a company failing) but in terms of minimizing the likelihood of missed returns from failing to include a shooting star.

In the 20-30 years I’ve been learning about investing, the finding that stunned me the most was that most stocks actually have lower lifetime returns than 1-month Treasury bills. It’s a relatively small handful of very high-performing stocks that account for the entirety of stocks’ collective outperformance over safer assets. (When looking at the US stock market, if you eliminate the best-performing 4% of stocks, the remainder of the stock market has only matched Treasury bill performance.)

I don’t have any method for reliably picking those superstar stocks. (If I did, I would not be using mutual funds at all.) I want to own all the stocks, to be sure that I own those 4%. And that means owning international stocks also.

The Cake/Fruit Salad Theory of Asset Allocation

When you make a cake, you start out with a bunch of dry powdery white stuff (flour, sugar, baking powder, salt), some eggs, and some butter. And when you’re finished, the final product doesn’t look anything like those ingredients with which you began. It’s magic. The whole is greater than the sum of its parts.

And if you mess it up even a little bit (e.g., you leave out a teaspoon of baking powder) it can be a disaster.

Many people in the investment industry will tell you that asset allocation is like baking a cake. If you get it just right, in precisely this way (and definitely not that way), you’ll have something magical.

Some people become well known by promoting their own recipe (which does of course look amazing in the backtests).

But 5, 10, or 15 years later, what you’ll typically see is that the recipe turned out not to be magic. If the person is still in the industry, they’re now promoting a different recipe. The magic ingredient that five years ago was apparently the key is now, for some reason, not included in the portfolio. The magic ingredient/asset class is now just quietly left out (in favor of something else) because it’s no longer helpful in the backtests.

The thing to understand is that asset allocation is not like baking a cake.

Asset allocation is like making a fruit salad.

If you put in more blueberries, nothing magical happens, nor is there any disaster. Your fruit salad just has more blueberries. We can’t even say whether that’s necessarily a good thing or a bad thing; it depends entirely on how you feel about blueberries.

If you add more risky stuff, okay, now your portfolio is a little riskier. If you add more safe stuff, okay, now your portfolio is a little safer. That’s it. There’s no magic (except in backtests).

And if you choose to have just 3-4 ingredients in your fruit salad instead of 7, that’s fine. It will still get the job done.

There’s no one single recipe that beats the others. There are plenty of functional recipes. And you don’t have to be super precise about it — a little more or less of something than you had intended is not a disaster.

Calculator for Backtesting a Portfolio or Asset Allocation (Also Monte Carlo Simulations)

A reader writes in, asking:

“Is there a website or calculator that you recommend for showing the historical results of a portfolio? Something where I can enter an asset allocation and the calculator will tell me what the return would have been and how risky.”

Yes, absolutely. PortfolioVisualizer.com is an excellent tool for this sort of thing. From the homepage, select the link for “backtest asset allocation” if you want to choose from inputs such as “US large cap,” or click the link for “backtest portfolio” if you would prefer to provide the ticker symbols of specific mutual funds.

The calculator lets you adjust your modeling for various rebalancing options. For example, you can assume the portfolio is rebalanced monthly, rebalanced annually, never rebalanced, or rebalanced using “rebalancing bands” (e.g., rebalanced whenever the allocation is off-target by 10%).

And it lets you make assumptions about ongoing contributions to, or spending from, the portfolio. You can make adjustments such as whether the spending is a fixed percentage or a fixed dollar amount. (And if it’s a fixed dollar amount, should it be inflation-adjusted over time?)

After you provide all of your inputs, the calculator tells you the historical return, standard deviation, best/worst years, maximum drawdown, and other various results.

PortfolioVisualizer also has the option to run Monte Carlo simulations. (Select the link for such from the homepage.) On the Monte Carlo simulation page, you can have it use historical data, or you can select other options for the return assumptions (e.g., “parameterized returns,” which lets you input expected return and standard deviation for yourself).

The PortfolioVisualizer website also has a ton of other calculators that I’ve never even used. In short, it’s an incredible resource. And it’s free. (Though there’s also a paid version that gives you some additional capabilities, such as saving results, exporting to spreadsheets, etc.)

Of course, when backtesting, be sure to remember the limitations of relying on historical data. Just because a portfolio provided a particular return in the past doesn’t mean it will do so in the future. And the same goes for all of the other outputs (e.g., how risky an allocation would be, or whether it would have satisfied a particular spending rate in the past).

And ditto for the Monte Carlo simulations. They can be useful, but remember that we don’t actually know what the future distribution of returns will look like for any asset class. If a set of Monte Carlo simulations shows, for example, that a particular portfolio has a 92% chance of satisfying a given spending rate over a given length of time, we don’t actually know that the portfolio has a 92% chance of satisfying that spending rate over that length of time. Rather, what we know is that, given the assumptions that you used, the portfolio had a 92% chance of success.

International Allocation: Maximum and Minimum

What percentage of the stock portion of your portfolio should be invested internationally? Vanguard’s website (in a section only accessible if you’re logged in) contains this statement:

“Investing up to 20% of your stock portfolio in international stocks can help you diversify. Between 20% and 40%, your diversification improves, but at a lower rate. And because of the risks of international investing, an upper limit of 40% is wise.”

20-40%. That’s more or less in keeping with conventional wisdom.

But conventional wisdom seems to gloss over something here: Having 80% of your portfolio (more than 80% if we assume that the entire bond portion is invested in U.S. bonds) invested in one country is not diversified–especially for anybody whose income is largely dependent upon the U.S. economy.

Past and Future

I assume Vanguard’s statement is based on an analysis of historical returns. I can only guess which exact period(s) they’re looking at, but surely it’s limited to the 20th century plus the first decade of this century–a period during which the United States went from being a young upstart nation to being the world’s largest economic superpower.

It’s hardly a surprise that based on an analysis of that period, a U.S.-heavy portfolio looks pretty darned good. What I’m not so sure we can expect is for the next 10, 20, 30, or 60 years to look the same.

Starting Point: Market-Weighted Portfolio

To me, it seems that the starting point for discussion should be a market-weighted portfolio. At the moment, such a portfolio would be invested approximately 60% in the U.S. and 40% internationally.

From there, you can make adjustments to cater to your specific needs. For example, if you’re in (or close to) retirement, it could makes sense to decrease your international allocation for two reasons:

  • First, you’re going to be spending down your investments soon, which means that it would be good to minimize currency risk (the risk caused by fluctuations in exchange rates that comes with owning non-U.S. investments).
  • Second, you have fewer years remaining in the workforce, meaning that you’re less dependent upon the U.S. economy that somebody who is, say, 25 or 30.

Avoiding the “Growth Trap”

What I’d caution against, however, is falling into the growth trap–overweighting emerging markets (China or India, for instance) simply because you know they’re going to grow at a faster rate than the U.S. over the next couple decades.

When it’s obvious that a country’s economy will be growing quickly, that growth should already be reflected in the price of their stocks. To earn above-market returns, you need to invest not in countries (or companies) that grow quickly, but in countries (or companies) that grow more quickly than expected.

If you’re going to invest more of your portfolio in non-U.S. investments than conventional wisdom would suggest, do it with the goal of diversification, not with the goal of earning superstar returns.

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