The Question of Cash

Economic decisions revolve around cash: companies concern themselves with consistently producing cash in excess of their operating costs; non-profits need regular infusions of cash to provide the service or content they organized to provide; households have to keep an eye on cash reserves to manage the flow of bill payments and to maintain a comfortable level of "cushion" against unexpected demands on the checking account.

The investing world is similarly concerned with cash in a few specific ways:

• For investors in the "sustaining" or "distribution" phases of their lives, cash flows out of their portfolios may be a crucial part of their investment objectives.  In the "old school" conception of fixed income investors (typically represented as retired, older folks on a pension), the cash coming out of their bond portfolios represents a significant portion of their monthly spending money.
• In formal terms, all investments are predicated on a simple cash in --> cash out formula: the rational investor chooses among investments based on the relative likelihood of improving their eventual cash position.
• In terms of asset allocation, cash represents an asset class with a mix of serious pros and cons.  On the positive side: cash is a great parking place for funds to escape volatility; historically cash earned some nominal interest rate (in savings accounts, money market accounts, etc); cash on hand provides flexibility to take advantage of non-cash investment "deals" that come along.  However, the con list of holding cash is long too.  Among the disadvantages, the prime concern is related to return: based on historical numbers, the expected "real" return on cash is 0% ("real" return is adjusted for inflation), and in the current interest rate market the expected real return is actually negative.  Choosing to allocate significant funds to cash in the present market is equivalent to accepting an expected negative return (albeit a small one) on that portion of the investor's overall assets.

As an investment adviser, I am constantly confronted with the decision to hold or invest cash on behalf of my clients.  Today, as of this writing, approximately 3% of the funds under my management are held in interest bearing money markets, but as mentioned above the current interest rates are very low vs historical averages.

Is 3% too much or too little to hold in cash?  Is there an "ideal" level for all investors?

The decision making process from my perspective is complicated by the fact that individual investors exhibit considerable variability in their particular situations.  For some clients, the assets invested with my firm represent a small portion of their overall wealth, and those clients may very well be holding considerable cash in their personal bank accounts (or even in cash management accounts with another adviser or broker).  In other cases, a client household may work with me very carefully to dial in to a targeted amount of money to hold on hand in the bank (typically a cash "operating" balance plus an emergency fund) and direct me to keep the rest invested in (potentially) productive assets for them.  Still other clients fall along the spectrum, and may be using brokerage assets as a piece of their emergency fund, or have a stated objective of maintaining a target liquidity.

My approach is to consider each client (or client household) individually and try to balance their desire for return (in line with their risk and objective profile) with practical requirements related to liquidity, expense management, opportunity costs, and on and on.