Question:
For many years I have heard standard advice to keep three to six months of living expenses in cash. Now with the markets taking a dive, I am hearing advisors recommending one year of cash as a minimum. Then I read somebody’s advice to keep 18 months, and another advisor said he keeps two years worth of cash for all his clients. (I wonder just when he started doing that and how long it will last if the market starts booming again.) Is this really the right thing to do? Or do these advisors just find it impossible to find good investments for all that money and are taking the easy way out? I have heard some of these same advisors complain about mutual fund managers keeping money in cash and not staying fully invested. What do you think?
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PARESH KAMDAR:
This is a very good question, and the right answer depends on the upcoming needs of the portfolio.  One size doe not fit everybody. Managing the allocation to bonds and to cash is a very important decision that should be made after carefully looking at the pros and cons.  Let me give you a couple of answers that are quite different. Yet I think each one is correct.

I have a client who is regularly withdrawing what amounts to about 3% of her portfolio’s value. She and her husband are fairly comfortable with their portfolio's recent drop in value; they tell me they are looking forward to a resumption of worldwide economic growth. I have learned that they want to leave a lot of this portfolio to their grandkids and to a few causes they believe in.  They have no debt and could easily tap into the equity of their mortgage-free residence in case of an emergency.  Based on their financial position and their comfort with market volatility, we have decided that their 40 percent fixed-income allocation is enough and they don’t need to hold cash. They liquidate a small part of their overall portfolio every month to meet living expenses.

On the other hand, I work with another retired couple who react differently to bad news in the economy. They too are drawing an income from their portfolio. They do not need growth and are much more comfortable if they have two full years of cash set aside, a position they have maintained for many years. This obviously works for them, and they don’t break a sweat over what the market is doing at any given point. In their case we have allowed this cash position to shrink to 18 months so that we don’t have to tap into their long-term investments in the current slump. We plan to replenish their stash of cash when the portfolio value begins to recover. This might look like market timing, but I don’t think it is. I think this is a cushion that makes it possible to ride out a storm.  

You can see that each of these cases was decided based on the individual needs and desires of the clients. Their income needs, their overall financial condition and their feelings about risk are not likely to change radically over time, and that makes it possible to adopt a policy (instead of merely reacting emotionally to the markets). However, as their needs and desires naturally evolve, we can adjust these policies from time to time to make sure we are doing what’s right for them.

Mutual funds are another matter entirely. This is NOT the kind of decision that most of us want fund managers to make. The job of a fund manager is to invest in the manner spelled out in the fund’s prospectus. The manager has to achieve results for thousands of shareholders whose needs will vary all over the map.

Paresh Kamdar is a financial advisor for Merriman