A common financial planning recommendation is that investors keep at least some cash available for emergencies. In this article, “cash” is defined as a readily available short-term financial instrument with high liquidity, minimal or negligible market risk, and a maturity period of less than three months.

Some investors may wish to include cash in their investment portfolios. “Our approach to assessing how much cash might be appropriate to hold is built on the relationship between an investor’s goals and three critical factors,” said Anatoly Shtekhman, CFA, head of Global Advised Portfolio Construction in Enterprise Advice Methodology. These factors are:

• Risk tolerance—how much market risk an investor is able to take on. Risk and return are a trade-off. Therefore, in many cases including cash not only moves a portfolio toward the more conservative end of the risk spectrum, it also moves it toward the lower end of the expected return spectrum.

• Time horizon—the length of time an investor can keep their money invested. The shorter that period is, the less likely they are to benefit from holding riskier assets like bonds and stocks. That’s because over the long term, the returns of those riskier assets tend to be higher than those for cash, while over the short term, they tend to be more volatile—and potentially even negative.

• Funding level—how close to fully funded an investment goal is. An investor who is close to fully funding their investment goal may be comfortable with some allocation to cash. On the other hand, an investor who is far from reaching their investment goal may be willing to allocate more to riskier assets for potentially higher returns to improve their chances of success, especially if they have a long time horizon.

Below we look at two investor profiles to highlight the roles cash might play under different scenarios for risk tolerance, time horizon, and funding levels.

Case 1: Johan is in his 50s and his main investment goal is to finance his retirement.

• High risk tolerance. Johan can handle a significant degree of volatility in returns. This means he is more likely to hold higher-risk, higher-return assets such as equities rather than cash.

• Long time horizon. While Johan has a target retirement date in mind, his spending goal has a long and uncertain horizon. By taking higher risk—what his risk tolerance and time horizon factors would support—he can reasonably expect higher returns, giving him either a larger portfolio to retire on or the flexibility to retire earlier than planned.

• Low funding level. He is currently far from the amount he is likely to need in retirement. Given that he also has a long time horizon and high risk tolerance, it’s unlikely an allocation to cash would give him the best chance of meeting his goal.

Recommendation: No cash in his retirement portfolio at this time.

Case 2: Dana is in the early stages of her career and has two primary financial goals: Maintaining emergency savings for unexpected expenses, and saving for a down payment on a home, which she hopes to purchase within the next 18 months.

• Low risk tolerance. Dana would likely not feel comfortable taking on investment risk that could jeopardize her emergency savings or delay her home purchase even if it might generate a higher investment return.

• Short time horizon. Her emergency savings might be needed at any time and the intended home purchase is less than 18 months away, if all goes well.

• Well-funded goals. She already has six months’ worth of expenses set aside and is very close to meeting her down payment target.

Recommendations: Hold her emergency savings in cash and hold a low-risk portfolio including cash for her down payment.

“Risk and return are always a trade-off,” says Aliaga-Díaz. “So while investors like Johan with higher tolerance for risk, longer time horizons, and underfunded goals may be better off excluding cash from their investment portfolios, our framework shows that including cash can make sense for investors like Dana who have lower risk tolerances, shorter time horizons, and well-funded goals.” 

• A framework for allocating to cash: risk, horizon, and funding level (18-page PDF, issued April 2024)
• The five factors that make up total ETF costs (article, issued March 2024)
• Active fixed income and our ownership structure (article, issued February 2024)