Importance of cash in your financial portfolio

My cousin’s wife died a few days back. He is a senior citizen & gets a good pension besides getting rent. He has investments in fixed deposits and mutual funds. He wanted my advice on whether he should close a few of his FDs prematurely or redeem some of his MF investments since he did not have enough liquid cash to meet the expenses related to the funeral & other ceremonies. This highlights the plight of many of us. How much cash should we keep in our portfolio? Cash here does not mean hard cash kept at home. Cash in a savings account or liquid funds in emergencies like this is essential.

Let’s try to understand the importance of cash or its equivalent in portfolio construction & how you can deploy cash to earn that extra income.

Cash in a contingency fund

Financial planners advise that individuals must have a contingency or an emergency fund to take care of expenses for at least 6 months. The expenses could relate to household expenses, paying EMIs on a home loan or a vehicle loan, or insurance premiums. Emergencies can arise due to hospitalization, loss of job or failure in business etc. Since earning an income during an emergency could be difficult, the fund should take care of essential expenses. The funds earmarked for emergencies must be kept in a Savings account which not only offers liquidity & returns but also provides stability to the portfolio. Savings deposits are also insured by DICGC up to Rs 5 lakh.

For senior citizens or those individuals who have taken early retirement, their concerns are different. Their portfolio should address concerns of liquidity while also making sure that a good part of the portfolio gives decent growth. For them, the contingency fund should take care of expenses for a longer period- at least 12 months of expenses. The safety of the portfolio can be invested in a Senior citizen savings scheme up to a maximum of Rs 30 lakh.

Cash that you need after a day or so

Once you figure out the amount you need to meet emergencies, the excess can be invested in liquid funds which can give a higher return than the savings account. Liquid funds invest in money market instruments that have a residual maturity of fewer than 91 days & typically don’t charge any exit loads. These funds are highly liquid in the sense that redemption requests are processed within one working (T + 1) day. Some funds offer an Instant access facility through which the redemption proceeds are credited on the same day. Though mutual funds are not insured unlike bank deposits, the chances of an asset management company going bust is very remote thanks to stringent SEBI guidelines.

Cash that you may need for a year or so

Once cash is deployed in a savings account & liquid funds, the rest of the cash may be deployed in FD with a maturity of a year or thereabouts. For those with a higher risk appetite, the money can be invested in highly rated commercial paper or a certificate of deposits (CDs).To many of you who find investing in CDs or CPs intimidating or esoteric, the easiest way would be to invest in shorter-duration debt funds. These mutual funds invest in CPs, CDs & Treasury bills that have a maturity of less than one year. This part of cash can be used for financial goals that you need to meet in the next year or so like paying admission fees for the higher education of your children, saving for the down payment of a home loan, going on a vacation, or buying a car.

Cash that can be used as a war chest

Savvy investors always keep an extra 5 to 10 % of the cash component most of the time to exploit the anomalies that exist in asset classes. There will be buying opportunities always or what can be termed a “discount sale”. For example, some companies with solid fundamentals- companies that you wanted in your portfolio- may go through a couple of bad quarters & their share price may correct 15% to 20% or even more.

In the final analysis, it is for every individual to decide the proportion of cash in the overall portfolio. The thumb rule is, nearer the horizon of your financial goal- say 1 to 2 years, the higher should be the cash component of the portfolio.

(The writer is a CFA & a former banker & currently teaches at Manipal Academy of Higher Education, Bengaluru)