I often get asked by clients, friends, and family, how much cash the right amount is to hold on deposit. Too little and you run the risk of not being able to meet short term or emergency needs and be forced to borrow, use unsecured debt, or sell investments. Too much and, over time, there is a risk of its real value being ravaged by inflation or missing opportunities such as improved tax efficiency or achieving a real return.
So how much should households be retaining in cash? Well, several years ago; following the 2008 financial crash in fact, a colleague and I sat down and worked out what a sensible rule of thumb should be. We recognise that all clients are different and that where some of our clients have difficulty sleeping if they have less than £100,000+ in the bank, others fear holding cash in case they spend it all at once! But we must start somewhere and today that start point is best described by the following formula:
EF + KC + PW = Ideal cash balance
EF – Emergency Fund
We always want to ensure all our clients have access to cash on deposit for emergencies and other unforeseen needs –boiler repairs or replacement windows, storm damage, or sudden need to come to the aid of a son or daughter. The list of potential dramas is endless and so how can you budget for the unknown? Well, as a rule we would always encourage people to budget between 3 – 6 months expenditure. So, if your household spends £6,000 per month on average, having an amount in cash equal to £18,000 – £36,000 is probably not a bad start.
KC – Known Costs
Most of us have plans or projects we expect to complete in the short term where the costs are known if not in the ballpark. I’m currently building a garden room for example, and some small-scale landscaping is required which probably won’t be completed until Easter. Your needs might also be home renovation related but could equally be a large family holiday which hasn’t been fully paid for yet or perhaps a gift to one of your children to help them onto the property ladder.
The key in budgeting here is that the costs and the timeframe are known – typically 12-24 months. Say, you plan to give £5,000 to your daughter as wedding gift in May 2023, you want to repave your driveway in July at a cost of £15,000 and have £8,000 outstanding on a Cruise down the Nile due the following August, you would need to ringfence £28,000 in cash.
The reason this is important is because we don’t want to be relying either on higher cost borrowing (loans or credit card) or relying on an investment withdrawal which could be needed at the worth possible time in investment markets resulting in a permanent loss of capital.
PW – Portfolio Withdrawals
The final part of the formula applies to those who are drawing down on their pension and investment portfolio to meet some or all their lifestyle needs. We call this decumulation.
Again, everyone is different, but we would typically we recommending people hold 6-12 months’ worth of portfolio withdrawals in cash. So, if £6,000 per month is being withdrawn, we would hope to see an additional cash buffer of £36,000 – £72,000 depending on their attitude to risk and wider circumstances (e.g., if essential lifestyle costs are met through a final salary pension).
The reason this is important is that during periods of extreme market volatility such as we saw in 2008 and 2020 (COVID), a cash buffer provides a cushion enabling us to protect the portfolio by reducing or switching off withdrawals altogether which avoids turning paper losses into actual losses.
Not every part of the formula will apply to all clients all of the time however it is a framework which has protected our clients through six market corrections from 2008 to date.
Individual situations do change which is why we always review the cash needs of our clients against their short- and medium-term objectives.
In Part II, we will look at cash accounts generally and where clients should be holding their money.
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