Strenuous market environments often shine a light on one of the more challenging aspects of personal finance, cash management.  How much cash is too much? How much is not enough?  If you have excess cash, where should it go?  If the answer is financial markets, when is the right time to do that?  These questions are universal whether you are at the start of your career and just beginning your accumulation plan or a seasoned saver near the end of your career, and everyone in between.  Let’s review these in sequence.

How much cash is too much cash?

While holding cash gives the perception of safety and security, it has also generally given one of the lowest long-term returns.  It is important to remember that while volatility risk, or the risk that your principal may be lost, is near zero with cash it is not the only risk that applies.  Inflation routinely eats away between 2-3% of the value of your dollars each year, on average.  In other words, the value of a dollar is measured by the goods and services that you can trade it for.  As the price of those goods and services rise, your dollar buys less.  Another way to say that is that your dollar has lost value, even though it is still in your hand (your principal is intact).  With interest rates now at historically low levels, the gap between the interest your cash earns and the expected rate of inflation is wide, meaning the inflation penalty on your cash balances the largest since the Great Recession. Therefore, it is possible to hold too much cash from a defensive perspective, as well from an opportunistic perspective.

Savings can be thought of as three basic categories: emergency funds, short term goals, and long term goals.  Given the short-term nature of an emergency fund and short term goals, defined as planned major expenses coming within the next 1-2 years, these should be funded with cash.  The short time frame limits the damage done from inflation and is too short to take on the volatility risk associated with financial markets.  A proper emergency fund should contain somewhere between 3 and 6 months worth of your non-discretionary expenses.  If your emergency fund is adequately funded and you have cash set aside for known major expenses coming in the near future, then any cash beyond that level could be considered excess and should be considered for your longer term goals, like retirement.  If these categories aren’t fully funded, then your focus should be on building those cash balances before shifting your focus to your longer-term goals.

Excess cash

Assuming that you are already on track with your target savings rates for your longer-term goals, as determined through your accumulation plan, and that your necessary cash levels are satisfied, the next decision is how best to make use of your excess cash.  In its simplest form, this decision boils down to paying down debt or adding to investment portfolios.  While it’s rarely a bad idea to pay down debt, the dramatic move lower in interest rates has provided an opportunity for the refinancing of debt at very low levels, thereby achieving the goal of reducing your overall interest expense without dedicating significant capital.  The lower the interest rate level, the less attractive it is to pay that debt down more aggressively.  At the same time, heavily discounted markets provide the opportunity for attractive intermediate and long term returns in excess of the savings to be had by paying down low rate debt.  In the end, the decision to pay down debt or increase your savings rates will need to be made on a case by case basis with the help of your trusted advisor.

Is now the time to get in the market?

There’s no question that the speed and scope of this bear market has been unnerving for investors.  While most people intuitively understand that you want to buy when prices are low, the reality is that it’s much harder to follow through when faced with a market like this.  Market bottoms are rarely a comfortable time.  Rather, markets usually bottom when we feel the worst, making it all the harder to accurately time them. With this in mind, the question for investors is whether it’s better to be early, and potentially feel some initial downside, or be late and miss some of the initial bounce.

As the chart above shows, it has historically been more profitable to be slightly early when putting cash to work. Yet, investors with cash to invest often want to wait for markets to settle down, meaning they wait until they feel better about things.  Given the speed with which markets move in these types of environments, this strategy often leads to investors getting in after the market has bottomed.

The right decision

As with much of personal finance, it’s impossible to accurately and repeatedly time markets in any environment, let alone during periods of immense volatility as we’ve seen during the COVID-19 bear market.  That being said, all bear markets end at some point and transition into a recovery.  While it may be an uncomfortable prospect to put more of your assets at risk, history has shown us that times like these eventually reveal themselves as buying opportunities once we have the power of hindsight.  Now is the time to work with your trusted advisor to determine a cash management strategy that is appropriate for you and your goals.