How much cash should I actually hold?
tl;dr I define the purpose of holding cash (and other stores of wealth), then lay out a framework for cash allocation
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In the 1951 Disney classic comic, Scrooge McDuck (Donald Duck’s rich uncle) builds his iconic Money Bin, an enormous storage unit hoarding his three cubic acres of cash. And perhaps in its most famous scene vaulted into pop culture status, Scrooge’s money dive epitomizes the image of wealth:
While business tycoons like John D. Rockefeller served as an inspiration for Scrooge’s character, the reality of wealth (and cash) management is far astray from this cartoon portrayal.
Before we tackle how much cash to hold, we need to first establish why hold cash at all.
The purpose of cash (and other stores of wealth)
There is a common saying that “in this world, nothing can be certain except death and taxes.” There is likely also a third missing component - inflation. And while one day I might write on why modest inflation is healthy for a functional economy versus the alternative risk of crippling deflation, let’s just accept here that inflation is an ever present invisible force that should continue to permeate any long-term goal of personal financial planning. This is why my family’s wealth management objective has always been to protect and enhance our long-term purchasing power.1
By establishing the importance of inflation’s slow, slicing death to fixed income instruments, we begin to see Scrooge’s fallacy. Cash and its various derivatives (e.g., checking/savings accounts, money market funds, CD’s, Treasury bills, etc.) lose value to inflation over time. Therefore, it runs contrary to the first component of our objective to protect and enhance purchasing power.
But wait, you may notice that Scrooge’s money dive was into gold coins. Won’t gold, TIPS, or crypto2 protect the owner from inflation?
Perhaps yes, but all these still fail the second “enhance” component of our long-term objective. The trade-off between gold coins versus investments can be best described as the opportunity cost between a store of wealth versus a creator of wealth. In other words, while the gold coins sit idly by in the Money Bin, Scrooge could have enhanced his purchasing power by investing it into ventures that provide real goods and services. In 30 years, the value of that gold today could have been used to revitalize an urban center, decrease the cost of genetic sequencing, or facilitate scalable software companies through cloud computing. Instead all that gold stays locked on a hill, occasionally used as a hedonistic and painful swimming pool.
It is important to pause and recognize that all stores of wealth have real practicality in personal financial planning. In each of these options, the owner trades the acceptance of guaranteed long-term deficiency in protecting and/or enhancing purchasing power for more immediate optionality (i.e., liquidity). Holding cash means you can pay your bills. Holding treasuries means during the March 2009 or 2020 liquidity crises, you can buy investments on the cheap. And holding gold (or a reserve currency) in a politically unstable or hyperinflationary country means you retain some near-term fungibility of your wealth.
But just know that the long-term outcome of holding large amounts of excess cash like Scrooge McDuck is you trade productivity for preservation. Unsurprisingly, Scrooge is seen as miserly not only because he denies others the productive use of his capital, but also he denies himself the ability to protect and enhance his own purchasing power.3
Now that we have established the purpose of cash, we can tackle how much cash to hold.
A framework for cash allocation
Imagine you are drinking from a water fountain.
The water that comes out of the spout represents your income source. Your immediate water consumption represents your current spending. Any leftover water goes down the drain as savings.
In Scrooge’s world, all that drainage just funnels into his Money Bin, locked away forever in cash. How can we be better than Scrooge?
Rather than have just one bin, imagine we have three cascading bins. We’ll continue to call the first one, the Money Bin.
As mentioned earlier, the purpose of cash is to preserve optionality while recognizing it fails to protect and enhance long-term purchasing power. Therefore, it makes sense to only build a Money Bin large enough to meet near-term needs, but no bigger.
How large should your Money Bin be? As with everything personal finances related, it depends on your unique circumstances. The bin size is contingent on the consistency and size of your normal income and spending flow. It is also affected by your total net worth. There’s no magic formula, but we tend to keep 2-3x monthly spend in a checking account (our Money Bin).
What happens when our checking account grows to say 4x monthly spend? Staying on the water fountain analogy, any excess water automatically overflows from the Money Bin to the next bin, the Transition Bin.
The Transition Bin represents assets set aside for lumpy and uncertain future expenses such as unpaid time to start a new business, a period of substantial life uncertainty, or capital calls on impending fund commitments.
Finally, all remaining flow automatically goes into the Investment Bin which has infinite capacity. I could write an endless number of posts on the philosophy of managing this Investment Bin, so I won’t start here. For context, my Investment Bin is filled with real estate, private equity interests, individual stocks, and ETFs. The purpose of this bin is to facilitate your long-term goals, may that be financial independence, estate planning, or philanthropic aspirations.
What does this water fountain framework force me to do? It keeps me disciplined on staying fully invested. It also keeps my personal and investment attributes separated. When the markets go down and fear creeps in, I don’t rush into preservation mode and expand my Money Bin. And when greed is rampant and everyone’s making money hand over fist on silly things, I don’t open the floodgates of my Money Bin and jump on the bandwagon. My bin sizes stay similar because they match my financial goals/liabilities, which do not change as quickly as do market movements:
How to manage the Transition Bin (extra credit reading)
I would guess most readers here conceptually understand what types of assets belong in the Money Bin (checking, savings, etc.) and in the Investment Bin. The Transition Bin is in a bit of a gray zone. On one hand, there’s nothing in the Transition Bin that requires immediate liquidity like monthly bills. But the Transition Bin also represents reserves set aside for major events like a potential home renovation that could get impacted if the market takes a major dip.
Traditionally, longer dated fixed income has played a vital role in the Transition Bin which includes corporate bonds, munis, MBS, treasuries, and to a certain extent some high-yield debt. But in this world of anemic interest rates, even fixed income participants have learned to get creative.
The more creative types have found mock substitutes like unleveraged real estate, music royalties, or litigation financing. What I call “reformed traditionalists” stick it out with low returning bonds while supplementing the portfolio with multi-currencies, precious metals, other commodities, or even crypto. Then we have the real daredevils who reach for yield through duration extension and sovereign exposure, like picking up 100 year Argentinian debt.
No matter how you slice it, it’s not a pretty picture. The proverbial more (potential) return, more risk (of permanent loss) rings very true here.
So what could one do with this Transition Bin? Here are some options:
BASIC PLAN
The Basic Plan accepts low rates but ensures liquidity. It uses traditional fixed income tools, and potentially also includes TIPS or shortened duration securities to mitigate inflation and interest rate risk, respectively.
The Basic Plan can be constructed relatively cheaply with ETFs.
It won’t get you very far, which means you’ll likely need a sizable Transition Bin that locks more capital from flowing into the Investment Bin, thereby hurting your long-term goals.
BASIC PLUS PLAN:
The Basic Plus Plan utilizes more creative variants of income producing assets.
They’re less liquid (e.g., takes more than a few clicks to sell farmland), but it allows you to pick up more potential yield.
Some of these variants such as unleveraged real estate could also have some natural inflation protectors built in (i.e., rents keeping up with inflation).
The Basic Plus Plan works best for reserves set aside for optional and farther away future expenses.
ADVANCED PLAN:
This is a bit of a mind flip, but the Advanced Plan means having no Transition Bin at all. As the Investment Bin grows large enough, besides dividends and capital gains, it also provides a source of financing for more lumpy needs. It gives you the power to create a “ghost” Transition Bin on demand.
Examples include securities lending for both public and private shares, dividend recapitalization of closely-held family businesses, or equity refinance of commercial real estate. There are tax advantages here (as you’re not selling) and allows you to retain what are hopefully attractive businesses.
Of course, the biggest risk here is leverage. So absolutely proceed with caution and the investment portfolio needs to be able to support the financing.
Okay, seriously need to emphasize the leverage risk here. If you’re considering this option, make sure to thoroughly understand the portfolio and seriously stress-test assumptions.
You’re welcome to mix and match plans. To reiterate, with personal finance, the sizing and management of each bin is contingent on your unique circumstances. So no two individuals’ financial plans will look the same.
Note that our objective is to protect and enhance our long-term purchasing power. It is not to front load returns by taking on more risk while we’re young, or to outperform any particular benchmark every year, or to not lose money. I have heard many derivations of these aforementioned strategies, and none substitute our objective.
Cryptocurrency can become a store of wealth, although one could also conjecture the potential adoption of a more robust store of wealth such as crypto as a service in itself. I surmise that Bitcoin’s run-up is driven by partly this narrative, partly a store of wealth, and partly speculation on continued price momentum.
Allow me to indulge just a little more on crypto. Still don’t believe me that crypto is just another potential store of wealth? In Scrooge McDuck’s Money Bin, he employs armed guards and designs booby traps to guard his inanimate coins. All that effort wasted to dig shiny stuff from underground, build a box, and then protect that shiny stuff above ground. Where else do we waste vast amounts of finite resources to mine useless things that are now shiny only in our imagination?