How much cash or liquid assets should I hold in my investment portfolio?
Most personal finance advice usually tells us that from a risk-return perspective, we should hold a balanced investment portfolio, say 60:40, split between stocks and bonds. But this comes from a time when bond returns were much higher, closer to stock returns, rather than the miserable 1.5% or less that we have for bond yields today. Hence, it has been more fashionable to hold a higher proportion of our investment assets in stocks, both in order to have enough for retirement, and for our income in retirement to be able to keep pace with inflation. But this does not mean that cash or liquid assets are no longer needed. In fact, we need to keep some of our assets in cash as an emergency fund, for a rainy day. So, how much cash or liquid assets should I hold in my investment portfolio?
Emergency funds – Why do we need it?
The idea of having an emergency fund is well established in personal finance. It is where you put away money that is intended to be used during times of financial hardship. This includes the loss of your job, a debilitating illness, or a major repair to your home or car. Or even a crisis like the COVID-19 pandemic in 2020/21. It is definitely not where you would be stashing away money in preparation for a vacation, house purchase, wedding or any other kind of planned expenditure. Emergency means emergency!
But what kind of emergency? Form the non-exhaustive list above, unemployment would probably be the most likely one. Let’s put some numbers to this. Looking at the various numbers from SingStats and Statista, we can see that the unemployment rate for residents in Singapore has varied quite a lot over time. However, it always peaks during recessions, like 1999, 2003, 2009 and 2020.
Resident Unemployment Rate in Singapore (1999 – 2020)
But that’s not all! Singapore only considers people out of a job for less than 6 months to be unemployed. Non-residents (e.g. your work permit holders, S-passes, and Employment passes) have to leave if they cannot find work within 6 months, so they conveniently drop out of the total unemployment figures. If you are unemployed for more than 6 months, you will be considered to be Long Term Unemployed. And if you finally give up looking for a job even though you are capable of taking up one, you will be classified as one of the Discouraged workers! The most recent figures for 2020 show that the Long Term Unemployed account for 0.9% of the labour force, while the Discouraged workers account for another 0.75%.
Finally, you will still be employed according to the official statistics even if you work part time (less than 35 hours a week). The proportion of part time workers in Singapore as of 2020 is roughly 11%. Part time work counts towards employment, but obviously pays less, so you might also consider it something of an emergency situation whereby you need to break the piggy bank. So, putting it together, you might face up to a 17% chance of falling into hard times during a recession in Singapore. Given that we have seen 4 recessions (1999, 2003, 2009, 2020) within a 25 year period, and a person typical has a career lifespan of 40 years, we figure that a person could very well face a financial emergency at least once in his/her working lifetime.
With a 17% chance of unemployment or underemployment every recession, and a possibility of facing 6 recessions in the course of your working life, you will probably need to draw upon your emergency funds at least once in your lifetime
Emergency funds – How much do I need?
Now that we seen the need for an emergency fund (if you have not retired early with a hoard yet!), let’s consider how much is needed. In other words, how much cash should I hold? To answer this, let’s look at how long a spell of unemployment usually lasts. Form the SingStats data, we can see that the median respondent to the labour force survey usually describes their unemployment as having lasted between 6 to 12 weeks so far.
Median duration of unemployment (1999 to 2020)
As expected, the median duration of unemployment goes up during a recession (see 1999, 2003 and 2009). The exception of course is 2020, but that was the impact of the Jobs Support Scheme (JSS) in saving jobs! But the median duration shown above is what the unemployed residents responded during the survey, and not the actual duration of their unemployment from start to finish. We can make the assumption that the median unemployed resident is somewhere about halfway through their spell of unemployment, so the actual duration of unemployment will be between 12 to 24 weeks, or 3 to 6 months. Interestingly, degree holders tend to have longer stints of unemployment, perhaps due to the more specialised nature of their work, and so requiring more time to find a new job.
Duration of employment in 2019 and 2020 (‘000)
But let’s not forget about the long term unemployed, i.e. those who have spells of unemployment for more than 24 weeks. There is a significant number of them, and their spells of unemployment can be for 52 weeks or more.
So where does this bring us? For the amount needed for the emergency fund, we should budget for at least 24 weeks or to round up, 6 months worth of expenses. Hence, the standard personal finance advise to put aside 6 months of expenses in reserve seems to be quite well founded. But if we dig deeper, allowing for the fact that degree holders and PMETs tend to have spells of unemployment which are 50% longer than the median, and allowing for the possibility of long term unemployment, it seems prudent to allow for 9 to 12 months of expenses in the emergency fund instead.
While the average spell of unemployment can last for up to 6 months, and hence the emergency fund should cover at least 6 months’ worth of expenses, taking into account longer unemployment stints for PMETs and degree holders, and the possibility of long term unemployment, it would be more prudent to budget for 9 to 12 months of expenses instead
Does the emergency fund have to be kept in cash under the pillow?
Now that we have discussed the need for an emergency fund, and the size of it, the final question which remains is, what form should the emergency fund take? While most financial advisors advocate keeping all of it in bank deposits which can be withdrawn easily, this is not necessarily the case throughout your life, as your investments will grow and change over time. We can look at it by life stages:
Early in your career, when you have few investments, it is best to accumulate and keep the emergency funds in bank deposits. This can be in savings deposits, current deposits, or even fixed deposits. Regardless, the key consideration is that the emergency fund must be able to maintain its value (even in a recession when it is needed) and also its liquidity (i.e. it can be withdrawn easily and quickly.
As your career progresses, it is likely that you will invest savings in excess of the emergency funds into stocks and bonds (that is stock and bond funds, by the way). But at this point, there will be some overlap between your emergency funds, and your bond investments. After all, if you have invested in diversified and low risk bond funds, they are similarly low risk, and can preserve their value well even in a recession. Many high grade bond funds fell by only 5% during the Covid-19 crisis in 2020, and virtually all have rebounded back to previous levels quickly.
Hence, it is possible to keep part of your emergency funds (which may be quite large now as your monthly income and expenses rise over time) as part of your bond fund allocation in the context of your overall portfolio. Apart from the possibility of a slight slippage in value in times of need, bond funds are also somewhat less liquid than bank deposits, requiring perhaps a few days to a week to be sold and redeemed in cash. To overcome this, it is better to keep one to two month’s worth of expenses in the form of bank deposits, to provide a ready source of funds when needed in the short term, before the sale of the bond funds for longer term funds can take place.
Is one to two months of cash enough? Or is it too much to leave in low yielding bank deposits? Well, from most studies of depositors’ behaviour, it is often found that a significant number of transaction accounts are drawn down almost fully after the salaries have been paid for the month. This means that for most households, monthly expenses are roughly equal to monthly income. Hence, keeping a month or two of expenses in a bank deposit gives a good margin of safety for the times when the income runs out suddenly.
In the early stages of your career, it is better to keep the emergency funds in banks deposits to preserve their value and ease of withdrawal. As your investments grow, you can consider parking part of it in liquid and low risk bond funds, while keeping a month or two of expenses in bank deposits
What about retirees? Does this advice hold for them?
Retirees are in a somewhat different situation. For a start, they will not have a regular income every month outside of their investment (or annuities or pensions). Also, their investments are likely to be liquid stock and bond funds, as they need to be sold along the way in retirement for income. How much cash to hold basically depends on the strategy for drawing down their investment during the course of retirement.
Early Retirement: Dividend and income producing assets
At the start of retirement, the biggest risk to retirees is Sequence of Returns Risk. This is the risk that a few years of poor returns on their investment will drain their portfolios so much that they cannot sustain the entire course of retirement. To counter this risk, we advocate setting up a dividend and income producing asset portfolio, at least for the first few years of retirement. Such a portfolio will provide enough income during this initial period (at least before inflation necessitate a higher and higher level of withdrawal from the portfolio) such that there is no need to sell any of the investments for income. Avoiding the need to sell from the portfolio during recession years early in retirement is the key to avoiding Sequence of Returns Risk.
Suppose you have a Yield Shield portfolio for retirement, from which you will draw 4% annually for your living expenses. The Yield Shield is projected to have a dividend yield of 4% to 5%. How much cash on hand do you need? Well, from our experiments here, it appears that holding half of the withdrawal rate (i.e. 2%) in cash is a pretty safe answer to this question. Even when dividends are cut, as in 2020, the retiree never runs out of cash at any point. And even though the cash balance on hand may fall from time to time, it is quickly replenished by the incoming dividends.
Cash balance for a $1000,000 Yield Shield over time
Later retirement: Selling asset for cash
Once the retiree is past the first 5 to 10 years of retirement (this could be longer for early retirees as we need to get into the last 20 years of retirement), he or she would be past the period where Sequence of Returns Risk dominates. As retirement expenses rise with inflation and increasing healthcare costs, it may become necessary to switch to selling assets over time to fund retirement. Alternatively, the retiree may wish to switch away from a Yield Shield portfolio to one with a good proportion of growth stocks as well, in order to keep ahead of inflation. This would also necessitate the sale of investments periodically to fund expenses, as these growth assets produce lower dividends, by definition.
How much cash should I hold in this phase of retirement? As a rough guide, there should be at least enough cash to cover the period between the sale of assets. If the retirees decides to sell investments every six months, then at least 6 months of expenses should be available after every sale of investments. If the interval between selling of investments is 12 months, then similarly, at least 12 months of expenses need to be held by cash on hand after every sale. This may seem unintuitive to the younger readers, who may trade more actively and believe in selling to take advantage of market highs, rather than on a fixed schedule. But believe me, nothing is more tedious or boring to a retiree than constantly monitoring how the markets behave on a daily basis!
Retirees who hold mainly liquid stocks and bonds can tailor the amount of cash they hold according to how often their dividends replenish their cash holdings, or how often they intend to sell investments for living expenses.
Setting up an emergency fund is a fundamental tenet of personal finance. However, most of the time, the advice we get is based on untested assumptions e.g. putting aside 6 months worth of expenses. How much cash should I hold? Taking a hard look at the employment and unemployment data here we find:
- In every recession, there are up to 17% of the workforces in employment or in underemployment through part time work, which necessitates drawing upon their emergency funds
- Having seen 4 recessions from 1999 to 2020, it is very likely that we shall see 5 or 6 recessions over the course of a 40 year working life, hence an emergency fund is absolutely vital
- Based on the data on the duration of each spell of unemployment, we can expect unemployment to last for up to between 6 to 12 months. Hence, the emergency fund should ideally cover 9 to 12 months of expenses
- It is not necessary to keep all of the emergency funds in bank deposits. As your investment portfolio grows, it is possible to keep part of the emergency funds in low risk and liquid bond funds. However, based on bank deposit account drawdown studies, it is advisable to keep one or two months worth of expenses in cash or bank deposits at all times as investments still need time to be sold.
- Things are a bit different for retirees: For a retiree using a Yield Shield portfolio, staring off with half the annual withdrawal rate in cash is pretty safe.
- For a retiree selling assets to fund retirement expenses, the amount of cash on hand should be enough to cover expenses over the interval between selling investments.
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