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How much cash should you keep on hand? It depends on the alternatives.

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

 

How much cash should you have on hand relative to your total assets? How can we evaluate the benefits of cash versus the opportunity costs?

 

Cash is stable in the short-term, but decays in the long-term
Cash is liquid. It can be reliably and rapidly exchanged for goods and services. Cash has a relatively stable value in the short-term, barring hyperinflation. If you buy exactly the same groceries, cell phone plan, and clothing every year, the amount of cash required for your lifestyle isn’t going to jump around all that much. The price of any single item may double or fall by half, but the total will rarely change by more than a few percent from one year to the next. Unfortunately, the direction of that change is almost always up.

 

US Inflation Rate, 1914 – 2018

 

Value of a Dollar, 1914 – 2018

 

Even interest-bearing accounts can lose value

The last chart shows you the value of a dollar under the mattress, but what about interest? Below we show the real value 1-year Treasury bills and savings accounts, both before and after 30% tax (interest is taxed at regular income rates). I subtracted 0.5% from T-bill rates to estimate the average savings account (this may be generous to banks, but let’s assume we shop around).

It’s clear that even with 1-year T-bills (which you can own through low-cost ETFs), the best you can hope for is that your money loses value slowly. During periods of financial repression like the 1940s, 1970s, and 2000s, inflation can outstrip interest. In fact, interest-bearing US dollar accounts lost 50% of their value in the 1940s, and about 15-20% in both the 1970s and 2000s. Cash may feel secure, but from a long-term perspective, it isn’t a reliable store of value.

Fortunately, savers have more options available today. For starters, anyone can buy ETFs that hold Treasury, municipal, or corporate debt of various durations. The better Treasury note ETFs offer higher yields than almost all savings accounts, usually better than CDs, with the benefit of full liquidity. Stepping out to 5 or 10 year T-notes will tend to increase returns, if also volatility. This helps but doesn’t fully solve the inflation problem, as all debt instruments are promises to pay fixed amounts of dollars, so if the value of the dollar declines, so will that of debentures.

What is the cost of short-term stability?

To recap what we have seen above, T-bills and savings accounts offer stability over short holding periods, although their net returns are often negative. When you hold cash for only a few months you don’t notice the loss from inflation – on the contrary, it is comforting to see your nominal account balance reliably increase, even if slowly. The question is, what is that stability worth in terms of foregone returns?

Diversification = value preservation and growth

Gold, real estate, and equities can be hedges against inflation, because their values are independent of the dollar. Business profits increase with inflation, so stocks keep up if they are fairly valued to begin with (otherwise multiple compression brings them down at first). The same goes for REITs because rents and land prices increase. Gold of course behaves as a currency in its own right, having always been considered the hardest money. Its price is volatile, but it doesn’t decay like government-issued currencies.

Let’s take a look at an alternative to cash accounts, which we’ll call a rainy day portfolio or RDP. It’s simply 25% each in T-bills, 10-year Treasuries, gold, and the S&P 500 (we’re starting the clock here in 1920, so we can’t include REITs, which only became widely available in the 70s).

Returns after inflation, 1920-2018

 

In real terms, T-bills and savings accounts have averaged under 0.5% per year, with negative returns for long stretches. The RDP has averaged 3.2% real, which translates into about double the purchasing power every 20 years. The after-tax comparison should look even better, since interest on bills and savings accounts is taxed continuously at regular income rates, whereas most ETFs are taxed when sold, and at dividend and capital gains rates.

On time frames shorter than a couple of years, the RDP is far more volatile than the cash options, but over longer spans its return has been steadier, and its worst declines have been shallower than those of T-bills or savings accounts. The most it has lost is about 20%, in the late 1940s,1980, and in 2008. Remember, cash accounts lost half their value in the 1940s and have lost 15-20% at other times. The stability of the RDP shouldn’t be surprising, as the 50% allocation to government-guaranteed Treasuries has low volatility, while the gold and a largecap equities help it keep up with inflation.

 

If you don’t feel safe without a big cash reserve, your investment account is too risky.

If you will need $100k for a down payment next year and that’s all you have in liquid assets, you had better keep it in the bank. However, if you’ll need $100k cash and have $300k between your checking account and non-IRA brokerage account, there’s no need to keep $100k in the bank until you’ll need it, unless of course your portfolio is all stocks. The NASDAQ has fallen 70% in 12 months, and even the diversified S&P 500 has fallen by 50% in a year.

In contrast, an all-weather portfolio like the RDP allows your brokerage account to serve as your savings account, which can make a big difference in net worth over time. The trick is to make sure that your portfolio can withstand hard times, because this is when you might need to lean on your savings or use them to scoop up cheap assets. A traditional portfolio clearly isn’t the solution, since these decline in recessions. An inverse portfolio might go up as risk assets come down, but the costs of holding hedges make them poor savings vehicles. The best solution is simply a basket of uncorrelated assets that together never lose very much value.

Price-based risk controls can reduce short-term volatility.

The RDP is an elegant solution, but the portfolios we run for clients offer more diversification and also apply price-based risk-controls. They tend to be smoother and have higher returns for a given level of volatility. Again to illustrate the basics, below we apply a rudimentary 12-month moving average stop-loss to the most volatile components of the RDP, namely, gold and the S&P 500. Returns are generally improved and declines become shallower. A portfolio like this is easy to live with, so that you may feel comfortable considering it a reservoir of liquidity.

Returns after inflation, 1920-2018

 

Don’t be a wimp. Accept a little volatility for a lot more stability.

Money today is primarily a unit of account and a means of exchange. It makes a reliable store of value only in the short-term when precision is required, but when we are saving for the future we need to own hard and productive assets. The prices of those assets will necessarily fluctuate with Mr. Market’s mood, but their actual values are far less ephemeral than that of modern currency.

Purchasing power is what matters – how many bags of groceries will a thousand dollars saved today be able to buy in 10 years, 40 years? Unless you yourself are investing in that future through hard and productive assets, rather than depositing your savings for crumbs of interest, someone else is reaping the benefit. As much as we focus on reducing needless volatility in our portfolios, so much of financial success boils down to seeing beyond volatility to longer-term returns. Looking forward a generation or two, the perceived security of steady interest has large hidden costs in terms of actual financial security.

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