How much cash should I hold?

By Chris Dillow , 16 February 2012

Our reader, who refers to himself as an "economic Cassandra" is 66 years old and has been investing for 50 of those years.

His investment objective is to be wealthier every year in real terms. "We have sufficient pension income to cover routine living expenditures but not things like new cars. I am not concerned whether the increase in portfolio value comes as capital gain or dividend income. Most holdings are in Isas anyway," he says.

While he describes his risk attitude as "moderate" he admits that given his "excessive level of cash" he might be better described as a "very cautious" investor. "More likely the problem is natural gloominess and aversion to making a loss."

Having lived through the 1970s crash, he describes himself as "cynical about the stock market" and "very cynical about professional money managers."

Chris Dillow, Investors Chronicle's economist, says:

You say you have an "excessive" level of cash, reflecting your natural gloominess. With two-thirds of your portfolio in cash or gilts, I suspect many people might agree. But I'm not one of them.

For one thing, your cash weighting is consistent with the old rule of thumb that the proportion of your wealth held in equities should be 100 minus your age. If we count preference shares as equity, you are almost bang on this rule.

Granted, this rule infuriates the intellectual purists. But there's another asset allocation guideline that your portfolio also conforms to - the Merton equation. This says that the proportion of equities in your portfolio should equal the equity risk premium, divided by the product of equities' variance and a measure of risk aversion.

Let's call the equity risk premium 4 per cent or 0.04 - say, a 2 per cent expected return on cash and a 6 per cent return on equities. The annual volatility of equities has been 20 per cent, giving us a variance of the square of this, or 0.04. It then follows that a coefficient of risk aversion of three (where one is risk neutrality) gives us an equity allocation of one-third: 0.04/(0.04 x 3) = 0.33.

Such a coefficient is common. It's hard to measure people's risk aversion, as it varies so much from context to context; it seems low in gameshows and labour markets, but higher in asset allocation. Studies of the latter in the US and Italy, though, suggest that a coefficient of three is not unusually high.

Your cash holdings, then, are not obviously "excessive". To check this, consider the riskiness of this portfolio. Assuming the above numbers, there's a roughly 30 per cent chance of you losing something in a year (in nominal terms - there's a higher chance allowing for inflation) and a roughly one-in-40 chance of losing 10 per cent or more.

Does this sound too risky? Or not sufficiently so to reap higher returns? Only if the latter is the case are your cash holdings excessive.

Why, then, the presumption that they might be excessive? There are at least two biases here.

One is path dependency. For most of the period from the 1950s to the 1990s, a big equity allocation paid off. This created the cult of the equity and a presumption against large cash holdings. But equity returns then were unusually high, and there's no compelling reason to suppose they will recur. The asset allocation that was correct for years, therefore, might not be right for now.

Also, people are shying away from cash because of low interest rates. This is dangerous. Interest rates are low because central banks think the economic outlook is poor - which means shares are a dangerous investment. Low rates, then, are no reason in themselves to avoid cash. The failure to see this might lead to too much risk taking.

Yes, I have a quibble with this portfolio – I think its equity portion is over-diversified as 46 stocks is too many. But its cash-equity split isn't obviously wrong.

What I suggest is simply that you look out for attractive equity opportunities. If you see them use that cash. If you don't, then keep hold of it, because the very fact that you can't see such opportunities tells you a lot about the investment world. What you should not do is buy shares simply because you think your cash holdings are excessive.

KeithBowman, equity analyst at Hargreaves Lansdown stockbrokers, says:

We are assuming that you've no significant debts such as a mortgage, and considered broader financial planning issues such as the making of a will and wider inheritance tax planning.

Your use of tax wrappers such as individual savings accounts (Isas) is most commendable and has led to you accumulating an equity portfolio of over a quarter of a million pounds beyond the reach of the taxman. This doesn't include the other investments, which may also be held within a tax-efficient wrapper.

As you state, the most obvious feature of this portfolio is its comparatively high weighting in cash or cash-like instruments. Add these together and we calculate that around 70 per cent of your portfolio is held in low-risk investments, while the equity portion contains many defensive shares such as Vodafone and GlaxoSmithKline.

We would urge you to consider the cost of holding this much in cash, particularly in light of prevailing inflation rates. With central banks in many parts of the world eager to encourage spending or in effect discourage saving, holding cash potentially incurs a price. In the UK especially, cash is losing value in real terms.

The challenge is a familiar one: how to get better returns without taking on too much risk. Normally, we would recommend managed UK equity income funds such as the JO Hambro UK Equity Income, or perhaps something a bit more exotic, such as the Newton Asian Income fund. However, I note that you are not a fan of managed products generally and prefer to do things yourself.

Also, you already own many of the shares likely to form part of an equity income fund, such as Royal Dutch Shell, Land Securities and Vodafone. Although there are other ways to acquire investments offering relatively attractive income yields exist, they all carry risk. In the current uncertain environment, a reader in his sixties who clearly remains concerned about the outlook might best stay heavily weighted towards cash and low-risk investments.

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