How Much Cash Should You Hold?

There’s no right answer, but given the extraordinary times we’re living in, I think the more interesting thing to consider is “what to do with it?”

But first things first. Let’s talk about how much cash may be appropriate, then address what to do with it.

Traditional Wall Street thinking holds that cash is a drag that actually holds you back. The argument, particularly in a low interest rate environment, is that cash actually produces a negative real return because it really isn’t “earning” anything while it burns a hole in your pocket and gradually loses ground to inflation.

I have a problem with this argument in that it’s based primarily on the assumption that there’s nothing better down the road.

I believe cash is key when it comes to providing the flexibility needed to safeguard wealth or capitalize on new opportunities – even now.

Not to make light of the current situation in Europe or our woes here in the United States, but the way I see things you can either ignore the problems and hope they go away in which case your cash is a dead asset, or you can learn how to deal with the uncertainty and profit from it in which case your cash is an asset.

If you’re retired, holding something on the order of two to five years of living expenses is prudent. That way you can plan for regular expenses like insurance, medical bills, a mortgage if you’ve got one, and investing. Especially investing.

Now, if you’re still working and have a regular paycheck, you can take some risks and hold less cash on the assumption that future income will offset the risks associated with a lower cash “buffer” on hand. A generally accepted rule is six months, but I think given today’s economy 12-months worth of expenses is more appropriate.

Either way, the goal is the same – to have enough cash on hand that you don’t have to spend money you don’t want to at an inopportune time nor sell something when you don’t want to.

For somebody in my situation, I think having about 20% of my investable assets in cash is about right.

If that strikes you as low in today’s markets with all the risks they harbor, bear in mind I also use trailing stops religiously and I’m prepared to go to cash if things roll over. If you aren’t disciplined or aren’t prepared to be as nimble as the markets require, perhaps a more conservative 40% to 60% is appropriate. Maybe more.

Once you’ve decided what level of cash is appropriate for your particular situation, you can get to the bigger question of what to actually do with it.

This is where things get really interesting because even cash can be tweaked for better performance.

Now, I can already sense the snarky e-mails heading this way telling me I have lost my mind or don’t understand the risks associated with rising rates.

I haven’t. Rising rates will make bonds tumble, and bond funds – with very few exceptions – will lose money.

But consider this: The chronic state of economic misery that we live in now may be with us a while. That’s going to help keep interest rates low because the government believes – wrongly I might add – in stimulative economics that don’t work and have never worked in recorded history.

More to the point, the U.S. Federal Reserve, for example, has announced that it’s going to keep rates near zero through 2013. To me this is a near picture perfect repeat of the “Lost Decade” in Japan, which now is actually entering its third lost decade. We’re on the same path.

The uncertainty could drive investors to bonds and actually make rates fall still lower from here, as hard as that is to imagine.

Or, if you’re bothered by the concept of holding bonds right now, try the American Century Capital Preservation Fund (MUTF: CPFXX). Started in 1972, CPFXX is one of the most senior and established Treasury-only money market funds in the investment industry. As such, it’s an ideal place to stash your cash while waiting for new investment opportunities. It’s also worth noting that CPFXX is exempt from state income tax, too.

There are two keys to watch here. First, if the benchmark yield on 10-year Treasuries begins to rise above 2.20% or ratings agencies downgrade U.S. debt, you could reduce your exposure and transfer cash back to a traditional bank account.

Something like the EverBank foreign currency CDs or WorldCurrency Access Deposit Accounts may be a great way to start if you don’t travel internationally or are not “Swiss” worthy*.

The former offers a mix of currencies in a single CD that helps diversify the risks associated with cash itself. The latter allows you to transfer money between currencies in a single, global deposit account. Both are insured by the Federal Deposit Insurance Corp. (FDIC).

These are being marketed aggressively right now and come with their own set of wrinkles, so take the time to understand what you are getting into.

In a nutshell, structured products are essentially annual income generators designed as substitutes for low yielding traditional bank accounts. The yield is usually pegged to underlying stocks or in some cases bonds.

If the underlying portfolio rises, the investor receives a coupon payout equal to that amount. And if the underlying portfolio stays flat or falls, the investor is out a fee of 1% to 3% depending on the individual product.

If held to maturity, many structured products guarantee principal which is a good thing if stocks are headed higher. But if they’re not, investors may have to recover their losses before any principal coupons are paid.

Be careful though, all investments involve risk…even cash.

*Special Note of Disclosure: Money Map Press has a promotional relationship with Everbank .