Too Much Cash: Another Look-Retirees Listen Up

How much cash should be invested depends on portfolio size, age, and expected longevity. One or more of these factors is often ignored when suggestions are general and not specifically tailored for an individual.

A recent State Street study reported that the average American investor is holding 36% of her assets in cash, up from 26% two years ago. As a result, many advisors and financial writers are recommending that some of that cash be directed into the stock market. This is a winning strategy if the market continues to go up, but what if it goes down?

Quiz question: Is 36% of a total investment portfolio in cash too much? The answer: It depends.

Here are some considerations for the older investor with limited years ahead. In a nutshell, I believe how much cash should be invested depends on portfolio size, age, and expected longevity. One or more of these factors is often ignored when suggestions are general and not specifically tailored for an individual. Here’s why:

The less money someone has, the more that person depends on cash in a downturn. For example, a $100,000 portfolio could glean $4,000 a year in return to its owner and supplement the average Social Security monthly benefit for a retiree, which is $1,229 per month ($14,748 per year). The total, $18,748, of course, is barely enough to live on. If there were a significant market plunge, this pensioner could be in desperate straits until the market recovers. Though a bounce-back usually takes 2 years, it could be 7 (see Another Look at Downturn Duration below) or even 30, as it was in the late 1800s according to some authorities.

But, if her portfolio had 28% cash she would have enough for an extra $4,000 a year for seven years. This could make a big difference in her comfort. This is especially true if she were in what would traditionally be her more active elder years — the earlier years, compared to later, when generally more medical problems surface and less mobility is possible.

Naysayers would point out that even an investor with little money could do better longer term by choosing large-cap high-paying dividend stocks. And that would be true, if there were not a sustained market plunge during which her retirement years could be miserable without a cash cushion. This is because we’re not talking about expendable money for extras for this person. We’re speaking of money needed for basic survival. A sobering statistic from a 2012 New York Times article is this, “Seventy-five percent of Americans nearing retirement age in 2010 had less than $30,000 in their retirement accounts.”

A wealthier retiree is more fortunate. She might have a million dollars in her portfolio. Using the same potential return of 4%, the yield would be $40,000 per year. This, plus the average Social Security payment, could provide a reasonable living. This retiree might want to risk some of her cash in the stock market because her life wouldn’t be without resources if the market tanked for a sustained period.

Lastly, a wealthy retiree with $10 million in investable assets would receive $400,000 per year if the return were 4%. Clearly, this person can afford to invest cash. Even if there were a prolonged downturn, a comfortable lifestyle could be achieved.

As a caution, my figure of a 4% portfolio return is not easy to accomplish these days without higher risk. Perhaps a 3% return would be more realistic for most people. Still, the message is the same. If you have a limited number of years ahead of you, the less you have the less you can afford to lose. Consequently, a larger portion of cash as a percentage of total investable assets could be justified in specific circumstances.

All of this falls in line with a golden rule of stock market participation: “Never invest money you cannot afford to lose.”

Another Look at Downturn Duration

Downturns can be longer than expected. The below is from my column, “Worst Case Scenario” in Physician’s Money Digest, May 5, 2008

Usually downturns in the stock market last 2 years, so theoretically a 24-month cushion would be enough. But, as always, just like getting to know another person means she/he isn’t always what we think, the history of the stock market can reveal another face when we get to know it better.

A longer decline than 2 years that was relatively recent occurred between 1974 and the early 1980s. Then, anyone who was retired or retiring or lost a job could have suffered a considerable hit in their investment portfolio. This is not only because of the large drop in the market in 1974-1975. It is also because it recouped so slowly. Whereas the usual downturn takes 2 years to recover, this decline turned into a sloth. It didn’t come back until the early 1980s, about 7 years.”