• Basic Membership Access to Journal, Shadow Stock portfolio & monthly updates for stock screens
  • A+ Investor Full access to AAII.com, Journal, and a power data suite for investment ideas
  • AAII Platinum Full access to all of AAII's model portfolios and premium services at a significant discount
  • Dividend Investing Newsletter and model portfolio that focuses on dividend growth
  • AAII Growth Investing Find secular growth stocks poised for outperformance regardless of macroeconomic conditions.
  • Retirement Investing Discover trusted strategies for every stage of retirement. Get actionable insights and resources for smart retirement planning.
  • Sentiment Investing A research-driven newsletter with 10+ signals decoding sentiment across retail and institutional behavior.
  • Stock Superstars Report Get stock ideas inspired by the market's leading professionals
  • VMQ Stocks For the value investor looking to harness academic research in an actively managed portfolio
  • Bits and Bips Newsletter delivering insights on linking traditional finance, macro trends and cryptocurrency opportunities to help investors build stronger, more diversified portfolios.
All premium products come with free basic membership.
Explore All Membership Options
Join Now
Feature Asset Allocation Fixed-Income Strategies Portfolio Strategies Retired Investor

The Power of Holding Some Cash in a Portfolio

An allocation to cash can make sense in many portfolios both to reduce risk and, for retirees, to facilitate increased risk.

by Brian Haughey | March 2024

Featured Tickers:
  • A cash position will usually reduce overall portfolio returns but not always
  • Cash can play a role in seizing market opportunities and managing risk
  • Combining a cash position with equities in retirement may provide stable income along with growth

Companies often grapple with the question of how much cash, or cash equivalents, to hold on their balance sheets. In addition to providing a resource to allow a firm to weather unexpected financial emergencies, a sufficiently large cash reserve (“dry powder”) can enable firms to acquire competitors or other strategic targets at favorable prices when opportunities occur. However, too large a reserve position can result in complaints that the firm is using capital inefficiently, and that it should be returned to investors. This was the case in 2013 when Apple Inc. (AAPL) was criticized by activist investors who demanded that the cash position be used to finance a stock buyback program.

Investors, too, face a related dilemma. Sitting on a large cash position may appear to be a foolish strategy when equity markets are appreciating. The fear of missing out (FOMO) can lead investors to commit all of their available funds to the market. This occurs even when the markets become increasingly risky and noted investors advocate for being patient. The late Charlie Munger would say, “It takes character to sit with all that cash and to do nothing. I didn’t get to the top where I am by going after mediocre opportunities.”

On the other hand, famous fund manager Peter Lynch cautioned against attempting to time the market. He suggested that, in general, you should be fully invested unless you need cash in the next two or three years.

While holding cash has its advantages and disadvantages, it can make sense in many portfolios to both reduce risk and, conversely for retirees, to facilitate increased risk.

The Cash Drag

The performance of mutual funds and similar investment portfolios tends to suffer in bull markets, when compared to the returns of a market index, because of the drag associated with a cash position. For example, suppose cash returns 5% and the broad stock market returns 10% in a given year. A passive mutual fund may have 95% of its assets invested in a market-capitalization-weighted portfolio. The remaining 5% is allocated to cash to facilitate shareholder investments and redemptions. This mix will return 9.75% [(95% (AAPL) 0.10) + (5% (AAPL) 0.05)] and underperform the broad market’s 10% return.

A cash allocation will benefit a portfolio, however, in a flat or declining market. For example, if cash earned 5% but the market return was –10%, the fund’s return of –9.25% [(95% (AAPL) –0.10) + (5% (AAPL) 0.05)] might offer some slight solace.

In general, therefore, a cash position will usually reduce overall portfolio returns. But not always.

Using Cash to Capitalize on Stock Market Volatility

When you believe that the equity markets are likely to appreciate, it is natural to wish to be fully invested. However, maintaining an opportunistic cash reserve enables you to capitalize on the inevitable bargains that regularly appear in the market. As I noted in “Be a Wiser Investor Than the Crowd” (March 2022 AAII Journal), even high-quality stocks can be volatile, offering opportunities to the patient investor.

For example, an investor who purchased Visa Inc. (V) in late September 2022 at $177 per share—following a 24% decline from its $235 price that February—would have enjoyed a 56% run-up to a price of $277 by late January 2024 [(277 ÷ 177) – 1]. This contrasts with the 18% returned by Visa starting in February 2022 [(277 ÷ 235) – 1] and the 7% [(490 ÷ 457) – 1] returned by the SPDR S&P 500 ETF (SPY) over the same two-year period. See Figure 1.

FIGURE 1. Market Volatility Presents Opportunities for Those Holding Cash

While market timing is not for everyone, using a modest opportunistic cash position to implement a core-and-satellite strategy can enhance portfolio returns. For example, an 80% or 90% allocation to passive equity or bond funds and a 10% or 20% allocation to cash can enable an investor to take advantage of price declines in blue chip stocks that are expected to be temporary, offering the potential to boost returns with comparatively little additional risk.

Cash Can Reduce Portfolio Risk

While a cash position can be used to potentially boost portfolio returns, it can also be used to reduce portfolio risk. While equity investors should pay attention to market risk, bond investors also need to be concerned about volatility. As I discussed in “The Risks of Investing in Bonds” (May 2020 AAII Journal), and as bond investors were reminded in 2022, an increase in interest rates can lead to negative bond returns. These can often be significant as demonstrated by the 31.2% decline in the iShares 20+ Year Treasury Bond ETF (TLT) over the 12 months through December 2022.

It is true that the likelihood of a bond market decline, due to an increase in interest rates, is significantly less today than it was in early 2020. Indeed, the current inverted yield curve suggests that interest rates are likely to decrease over the next few years. Nevertheless, six-month Treasury bills offering returns in excess of 5.0% and one-year Treasury bill yields of around 4.7% compare favorably to average long-term bond index returns of 5.5%. Because of their low modified duration, money market funds and Treasury bills have little price exposure to changing interest rates, although a decrease in interest rates would result in reduced future returns on reinvested capital. An allocation to cash would, therefore, reduce the overall risk of a bond portfolio in the short term while offering attractive returns.

Similarly, investors concerned about equity market risk who choose to allocate a proportion of their portfolios to cash, and high-quality cash equivalents, can be confident that the cash position won’t lose value. It can also act as a quasi-hedge by allowing investors to purchase stocks in the future at lower prices in the event of a market downturn. A cash allocation, therefore, might be attractive to cautious equity investors.

The Role of Cash in a Retirement Portfolio

A key concern of many retirees is the risk of running out of money before retirement ends. While stocks are likely to outperform many other asset classes in the long run, there is always the chance that retirees seeking to generate current income may be forced to sell stocks in a market downturn, locking in what might otherwise be a temporary loss.

While holding cash can be conservative, a cash position in a retirement portfolio can also enable retirees to take on more risk.

The conventional wisdom from many retirement planners is to invest a large proportion of your portfolio in stocks when you are younger in order to take advantage of their greater expected long-term returns relative to those offered by bonds. As you get closer to retirement, the advice calls for increasing your allocation to bonds, because of their perceived safety. One such recommendation would be to have a percentage allocation of 100 minus your age to stocks, so that you might have a 75% equity allocation at age 25, while at age 65, you would have 35% in stocks. Indeed, so-called life cycle, or target date, funds adjust the percentage weights to stocks and bonds in such a fashion automatically over time. While such a strategy is likely to reduce overall portfolio volatility—which can be desirable as you approach and are in retirement—it is also likely to reduce future portfolio growth and the future income you can withdraw from your retirement portfolio.

As noted, one rationale for such a strategy is the fear that when faced with equity market declines, a retiree with a large equity position seeking income would have to liquidate equities at depressed prices. Meanwhile, those with a large bond portfolio could continue to recognize income from bond coupons and indeed may benefit from increases in bond values resulting from reductions in interest rates that might accompany an equity market decline.

By combining an appropriately sized cash position with the remainder of the investment portfolio allocated to equities, an investor can be reasonably confident of a stable income even in a market downturn while allowing for additional growth in the portfolio. This is particularly the case when compared to an investor with, say, a 65% allocation to bonds.

Scenario 1: No Cash Allocation

Consider Joan, a recent retiree, who has $1.5 million in her portfolio. We will assume that she lives on $93,000 per year and ignore the effect of taxes in our discussion. Social Security pays her $4,000 per month, or $48,000 per year, including a spousal benefit. She plans to withdraw 3% annually, or $45,000 ($1,500,000 (AAPL) 0.03) in the first year, from her portfolio. Her beginning annual income in retirement, therefore, is $93,000 ($48,000 + $45,000).

If we assume a long-term return on stocks of 10% and 5% on bonds, her expected portfolio return is 6.75% [(35% (AAPL) 0.10) + (65% (AAPL) 0.05)]. Her annual income will increase as her portfolio grows and her Social Security benefit is adjusted for inflation (assumed here to be 2% annually). If the portfolio withdrawal is made at the start of each year, then the portfolio—and the amount withdrawn—will grow at 3.5475% annually [(1 – 0.03) (AAPL)(1 + 0.0675) – 1].

After 20 years, the amount withdrawn is expected to have increased to $87,270 (growing for 19 years at 3.5475%). The ending portfolio value will be $3,012,199, as shown in Table 1.

TABLE 1 Retirement Portfolio With No Cash Allocation

Scenario 2: Including a Cash Allocation

Now assume that Joan’s twin brother Harry, also married and with the same Social Security benefits, adopts a more aggressive 100% allocation to dividend-paying stocks. He is comfortable following an aggressive approach, recognizing that his Social Security benefits can be viewed as an allocation to fixed income. However, aware that the market may decline in the future and that dividends might be reduced, Harry decides to deposit an amount equal to the first three years of withdrawals that Joan will make into a money-market account yielding 3%. This deposit is $139,845 ($45,000 + $46,596 + $48,249).

Harry is confident that even in a three-year bear market, he won’t have to sell any stocks if his dividends are reduced, as he can withdraw from the reserve to supplement his Social Security benefits. [Editor’s note: AAII’s Level3 withdrawal strategy calls for holding the equivalent of two to four years of withdrawals in safe assets such as cash.]

He will receive $4,195 annually from interest earned on this cash reserve. Harry’s initial portfolio balance, after establishing his reserve, will be $1,360,154 ($1,500,000 – $139,846). His portfolio will grow at 6.7% per year after he makes his 3% annual withdrawals [(1 – 0.03) (AAPL) (1 + 0.10) – 1]. By year 20, Harry’s withdrawal amount is expected to be $139,905, and his ending portfolio value is expected to be $4,975,956, as shown in Table 2. Compared to the corresponding amounts for Joan, these amounts are 60% and 65% higher, respectively.

TABLE 2. Retirement Portfolio With a Cash Allocation

It should be stressed that this is a simplified analysis that ignores the effects of taxes and assumes that the expected long-term returns are actually earned. It also assumes no additional top-ups to the reserve fund are made, which may be unrealistic. However, a more sophisticated analysis would require little additional complexity in the model. Also note that if interest rates decline, the income from the cash reserve would decrease, while Joan’s high-quality bond allocation is likely to increase in value in the same circumstances.

Whether a strategy such as Harry’s is appropriate for you depends on your risk tolerance, the likelihood and duration of any bear markets you anticipate and the returns that you expect to earn. Nevertheless, combining a cash reserve with an allocation to high-quality, dividend-paying stocks is certainly worth considering.

Cash Has Advantages Within a Portfolio

Maintaining a cash position can make sense for many investors, particularly when short-term interest rates are close to or above their long-term averages. By reducing the allocation to stocks and bonds, a cash position can reduce portfolio risk while offering investors the opportunity to take advantage of price declines in individual stocks or the overall market.

Meanwhile, an appropriately sized cash reserve position to meet anticipated liquidity needs for several years can enable investors to maintain a larger equity allocation in their retirement portfolio than they might otherwise be able to hold.

It should be noted that this discussion is for educational purposes only and is not intended as investment advice. Please consult with your tax adviser and retirement planner.

Discussion

GREGORY M from CA posted over 2 years ago:

For my 40 year career I was always 95% in stocks and never held a bond or any kind. However, now that I am near retirement and 3 month T-bills are paying north of 5% I have been buying them. For me this is a better value and safer insurance than buying "Put" options to protect my investments from the inevitable bubble burst.


D S from NE posted over 2 years ago:

My early investments were generally split between stocks and bonds. When I started investing long term treasuries were in double digits and hard to turn down. As interest rates declined, I invested mostly in stocks. My bonds basically all sold off when rates hit record lows. I have been buying some bonds in the last year or two. I have always kept a relatively large cash position. I think there were some studies years ago that indicated that the allocation between stocks, bonds, and cash were more important in determining return than specific purchases.


ROBERT A from NC posted over 2 years ago:

For the past 40+ years, I've maintained a 100% allocation to equities, and I see no reason to do anything different in retirement. When I began retirement a little over 10 years ago, I sold enough good stock to fund a year of expenses. I still regret that to this day. I now maintain no more than three months of expenses in cash (usually less). If a great investment opportunity comes along, I can sell a laggard to provide funds to take advantage of it. As James Cloonan stated, "the success of a strategy that is 100% in equities all the time is largely dependent on having done that from the beginning of your investment career." He advised that if you use a strategy heavy in bonds in early life, "you probably will not have built up the higher portfolio value to see you through any major downturn during the withdrawal stage." I think he was right. My allocation has put me in a position to be able to weather a huge downturn and has caused my assets to grow significantly since I entered retirement. The "danger" of selling assets in a down market is way overblown. In a down market (as in any other market), I can pick and choose what to sell in a way that maximizes the tax benefits while maintaining the portfolio's health. Of course, I should point out that my current burn rate is significantly less than the 3% used in the article's examples.


JOHN L from NJ posted over 2 years ago:

My father in law invested 100% in equities his entire life. He had nerves of steel and was never bothered by bear markets. Just prior to his death from cancer 6 years ago he asked that this investment strategy continue after his death. My brother in law was quite upset. He felt that 100% equity was not appropriate for an 89 year old widow. What would happen he asked if the stock market suddenly fell 50% like in 2008. Nothing I said as Mom has more than enough money even after a 50% decline to fund all her needs for the rest of her life. Since that time, mom's portfolio has doubled despite withdraws for ongoing expenses. Some day, mom will join dad. And my brother in law will be glad no one listened to his conventional financial "wisdom".


WILLIAM H from IN posted over 2 years ago:

I retired several years ago and have aligned my portfolio to generate an overall yield of 4% with an allocation of 72% equities, 25% fixed income (investment-grade & high-yield bonds, preferred stock, mortgage REITS, BDC's, and oil/gas pipeline pass-thru stocks) and 3% money market funds (MMF). My portfolio is 85% after-tax, 9% IRA, and 6% Roth IRA, and I am able to maintain a very low effective tax rate. I take 5% annually from the portfolio consisting of the 4% yield and 1% from capital gains (in equity down years like 2022 the 1% comes from the 3% MMF allocation). In the equity allocation, I have a bias towards value vs growth but maintain a healthy allocation to each including large-cap and small-cap. I expect the portfolio to increase 4%-5% annually, after deducting distributions and taxes which should grow annual distributions and portfolio value faster than inflation. This is a somewhat more conservative variation on the Level3 investing strategy promulgated by James Cloonan. But, I am comfortable with the overall allocation, investment risks and ability to not only grow annual distributions but also provide a growing portfolio for eventual distribution to our children and charities.


AL P from NY posted over 2 years ago:

Good Article, and good comments. At the end of 2024, my allocation was 79% stock and 21% cash/CDs. I no longer hold any bonds/bond funds. The catch is that the %'s are no longer meaningful. I withdraw from cash allotment in my 401K and Traditional IRA to supplement my pension. So in a good year the stock balance % goes up, and the cash % decreases from the withdrawals. I have to assume that this is similar for many others in the AAII community who have saved, and allocated appropriately during their working days?


BERNARD R from UT posted over 2 years ago:

I retired almost 16 years ago. Currently, my wife and I are receiving pension checks, social security checks, and available cash in our brokerage account. According to my monthly brokerage statements, it states that I am getting a 4% return on my investments, and this allows me to withdraw from my cash account approximately $2,500 per month. This allows me to pay my taxes, estimated taxes, and my long term care insurance without drawing from our pension and social security funds. Any cash leftover at end of year is used to consider more investments.


JAMES F from FL posted over 2 years ago:

We are retired. Our taxable account has target allocations of 70% diversified equity index funds, 20% tax-exempt bond funds and 10% cash. To rebalance and maintain targets, most years we would need to sell some equities resulting in large capital gains for long-held funds. Rather than letting the annual capital gain tax get too painful, we are edging toward a greater actual equity allocation, while bond and cash become a smaller actual percentage. Our Roth Ira is 100% equities and will go to our descendants.


AROON P from FL posted over 2 years ago:

Table 1 assumes 6.75% for portfolio growth and numbers match. $98213/1455000=6.75% Table 2 mentions 6.75% but calculates portfolio growth at 10%. 131935/1319350=10%. WHY? If Table 2 correctly calculates at 6.75%, then strategy of Table 1 will lead to better choice.


GEOFFRY O from TX posted over 2 years ago:

Correct, Aroon P


GENE M from MA posted over 2 years ago:

If the investments are in a tax-deferred account, RMD requirements will supersede 3 or 4% /year quickly. Perhaps in a future analysis, the withdrawals will be based on IRS RMD tables. If they are not in some flavor of IRA, rebalancing will trigger tax costs. And, while I would like the 10%/year rate of return (Table 2) called out by James and Aroon, I'm not going to plan on it.


DAVID L from UT posted over 2 years ago:

I received my paper copy of the AAII Journal in the mail today and read this article. It took me a minute to figure out something didn't add up in the examples given. As AROON P noted above (1 day ago from today), the second scenario and Table 2 use the full 10% equity return, while the first scenario and Table 1 use the blended rate of 6.75. So, I guess the conclusion is that you can forego the drag of bonds with a cash cushion, and put all investable funds into equities, which have higher returns over time. It seems like a back door approach to just say --- keep your equity allocations high.


BRIAN H from NY posted over 2 years ago:

David L, as you suspected, there's an error in the caption for Table 2. As noted in the text, the projections in this second scenario assume a 100% allocation to stocks after funding the reserve. Stocks are assumed to return 10%, with a 3% draw rate, so that the net portfolio return is 6.7%. You can confirm this by calculating (4,975,956/1,360,154)^(1/20)-1 = 6.7%. It's not so much a back door approach to recommending a full allocation to equity, but rather a demonstration that, given the assumptions described, it may prove to be an attractive strategy for some.


Peter N from TN posted over 2 years ago:

Where's a good editor when you need one? See previous comments about error on Table 2. Also both tables should have used the most recent 15-25 years of actual returns to demonstrate sequence risk.


Andrew S from UT posted over 2 years ago:

it all depends on what kind of cash. parked and unused cash sitting in a brokerage account cash allocation is a mistake, in the near term and the long. hunting for high yield cash equivalent, like VUSXX, on the other hand, makes total sense.


JEAN H from IL posted over 2 years ago:

Table 2 note has been updated on this webpage and in the attached PDF to read: The table assumes an expected return of 10%, an annual withdrawal of 3% and a net return of 6.7%.


DOUGLAS H from IL posted over 2 years ago:

I have always kept 5% to 10% of my portfolio in cash, more as a psychological anchor than for investment returns. In 401k accounts, the “cash like” option of insurance contracts and whatnot usually exceeded money market returns by a percent or two. But the comfort factor of knowing that some portion of my account was always appreciating was the main impetus. I never sold out of equities in 1987, the 2000 tech crash, the truly awful 2008 financial crisis or the 2020 bear market. Knowing I had a reasonable cash cushion made it much easier to weather those declines without panicking.


JAMES C from LA posted over 2 years ago:

Greed is insidious. I agree with the balanced viewpoint of the author. Another old saying is CASH IS KING. In an investment portfolio over the past 70 years that is something that can be ignored. Greed is insidious.


DAVID D from TX posted over 2 years ago:

Interesting. The older I get the more conservative I get as regards investments. Currently 22.2% cash in money market fund paying 4.96%. In a life of investing, this is my largest allocation to "cash." At the age of 86 I don't have time on my hands. The rest of my portfolio is in equities and a small fraction in bonds. I can assure you I will NOT out live my assets. Each case is different. I dare say not many articles will address the finances of an 86-year-old. Be your own informed advocate. I retired at the age of 56.


David L from AK posted over 2 years ago:

I enjoyed the article and ensuing mental exercise. Also enjoyed the reader's points of view and circumstances. Yes, Table 2 reflects an assumed annual equity return of 10%. The cash reserve apparently is $139,846 (= $1,500,000 minus year 1 Portfolio Balance) The 2% reserve column seems to reflect 3% annual return on $139,846 and not 2%. So, the Total Income column as shown is a little overstated. A correction would result in the Table 2 total Income column lagging Table 1 until year 4, but quickly gaining ground after that. Also, the $139,846 number does not equal the sum of any consecutive 3-years' withdrawals, but it is close to years 2-4. I suppose the reserve fund is to be used when the equities are in a bear market. Consider escalating the reserve fund to keep up with inflation, or the sum of one's last 3 year's withdrawals. As hypothetical Table 2 is currently shown, by year 9 the reserve covers only 2 years of withdrawals, and at year 20, only one year. This escalating of the reserve would be a drag on the Portfolio Growth and Ending Balance columns, but Ending Balance would still grow nicely. Escalating the reserve and tolerating the drag is more true to a philosophy of having a bear market reserve. Thx again for the article and thx fellow subscribers for your input..


You need to log in as a registered AAII user before commenting.
Create an account

Log In

Get your free copy of our special report analyzing the tech stocks most likely to outperform the market.
Download the FREE Report Here: