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How Much Cash Should a Retirement Savings Portfolio Include?

A reader writes in, asking:

“What do you think is an appropriate level of cash allocation in a portfolio for retirement savings?”

Let me begin with my standard disclaimer for any asset allocation question: there’s a broad range of what is reasonable. There is no one perfect allocation, and it’s a waste of time to try to find such.

For any particular investor, there’s an approximate overall level of risk that is appropriate, and there are countless different ways to get to that level of risk. So, for example, if you like to use cash instead of bonds because doing so allows you to feel comfortable with a slightly higher stock allocation, that’s perfectly reasonable.

But, in most cases, a retirement portfolio will not require a cash allocation at all.

As for our household (still in the accumulation stage), our retirement portfolio has no intentional cash allocation. It’s all stocks or bonds. (More specifically, it’s 100% Vanguard LifeStrategy Growth Fund and has been for ~10 years.)

That said, we do keep a few months of expenses in checking accounts. In part, that’s because my own income has a high degree of variation from one month to the next. That’s just the nature of self-employment. If we were both paid a predictable monthly salary, we would probably keep a smaller amount in checking accounts.

Similarly, if we were retired and our Social Security/pension/annuity income were sufficient to pay the bills, I’d be comfortable with a very small amount in checking. Assets from investment accounts can be tapped pretty quickly. Even for an unexpected large expense, you can use a credit card to pay the expense, then liquidate some assets from investment accounts to be able to pay off the credit card promptly (i.e., before paying any interest).

As far as cash as an asset class, it does what you would expect it to do: it reduces the overall volatility of the portfolio, but it earns almost no return, even before inflation.

Some people hope to use cash holdings to actually improve returns by deploying it at opportune times, but that’s harder than it might appear. For instance, by January of 2009, the market had spent the last several months moving dramatically downward. So it was clearly a better time to buy than it was several months ago. But was this the bottom? Or would it be better to continue to wait? (If you wait, it might turn out that this was the bottom, and you end up having to buy at a higher price.)

I certainly had no idea at the time. I never have any idea where the market is heading next, so I have no interest in holding cash just to hope to take advantage of such opportunities.

And for all of the years in which the stock market doesn’t provide any crash-fueled, obvious buying opportunity, the money that you have sitting in cash is just missing out on returns.

For instance, over the last 10 years, Vanguard Short-Term Treasury Index Fund (which we can use as a stand-in for cash) went up in value by about 12%. By contrast,

  • Vanguard Total Bond Market Index Fund has increased in value by about 39%, and
  • Vanguard Intermediate-Term Treasury Index Fund increased in value by about 30%.

Depending on which comparison fund we’re looking at, that’s a cumulative 18-27% return shortfall by having the money sit in cash. That’s not massive, but it’s not nothing. And it’s not as if a total bond fund or intermediate-term Treasury fund is any sort of terrifying roller coaster ride.

So, again, cash is a perfectly reasonable thing to include in almost any asset allocation, because it’s one tool that you can use to adjust the portfolio’s overall risk level to where you want it. But it’s uncommon for a portfolio to need any cash allocation at all.

There is one specific case in which I do think cash can play a critical role. If you’re retired and you’re temporarily spending from your portfolio at a high rate until Social Security (or a pension) kicks in, it’s important to use something very safe like cash or CDs for satisfying that extra-high level of spending, because, for that money, you can’t afford to take on much risk at all.

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