February 28, 2023 – The onset of the new year brings new trends and, with them, questions. More and more clients have asked, ‘how much should I hold in cash?’. Given 2022’s market turbulence and that forecasts of 2023 will share similar characteristics, it’s a reasonable question. With many fearing the possibility of an extended bear market, it’s understandable that investors would want to ensure they have a cash cushion they can comfortably lean on.
Before we discuss assembling a cash cushion, let’s step back and clarify what it is. When people say “cash,” they’re usually referring to liquidity. We define liquidity as dedicated cash and equivalents held separately from an investment portfolio. These funds are typically used to cover short-term goals for less than one year. Separate cash assets cover expenses if earned or passive income is no longer available. For some, it’s there to help avoid selling assets within their portfolio at an inopportune time.
Accumulating adequate liquidity — or a ‘stash of cash,’ whichever term you prefer — is crucial to achieve wealth planning goals and to strengthen financial health. The amount of liquidity a person should consider varies in accordance with their personal needs, the overall market environment they’re operating in, and their risk tolerance. Risk in this context is the need to sell investment assets to raise cash: selling when markets are down leads to less-than-optimal portfolio returns. Risk may also include the need to draw on a costly line of credit.
Each year presents a fresh set of economic considerations. With much of 2023 still left to go, now is the time to take control of your situation and actively incorporate liquidity planning into your wealth strategy.
Considerations for Liquidity Planning in 2023
There are three fundamental goals of liquidity planning today:
- Avoid drawing from your portfolio now if you can. With the looming possibility of markets lowering even further, it’s worth preserving as much of your assets as possible. Withdrawing during market lows tends to lead to less-than-optimal outcomes for portfolio returns in the long term.
- Avoid borrowing from pledge assets lines, as interest rates are between 5.5 to 8.0% right now. Instead, look to lines of credit as an easily accessible emergency source.
- ‘Dry powder’. Good investment opportunities arise even in adverse market conditions such as the ones we’re currently facing. To take advantage of these timely investments, be sure to have enough liquid assets.
There are several factors posed by the current environment that need to be taken into consideration. While inflation decreased from the highs seen last year, it remains unclear how long, if or how fast this downward trend will continue. The worst of 2022’s inflationary highs may be behind us, but today’s rate is still substantially higher than the long-term average of about 2.5%. It doesn’t pay to keep money under the mattress or in relatively low interest-bearing accounts, as your purchasing power is reduced. The rising costs of everyday items, to say nothing of big purchases, only compound this problem. With that in mind, park your money in cash equivalent securities or money market funds bearing an appropriate interest rate. Relatively safe cash equivalents are currently earning between 3 and 4.5%. This rate is still not enough to retain all purchasing power but will help act as a buffer against inflation.
Current loan interest rates should also serve as a warning sign against borrowing from a line of credit. Rates are presently the highest they’ve been since 2008. Over the last few years, many drew down from lines of credit to fund lifestyle, property purchases, or alternative investment commitments. Understandably so, we were in a ‘risk on’ environment, and it was likely wise to take advantage of low interest rates in the bull market by keeping the portfolio intact. Those who utilized their credit are now paying high-interest rates. Borrowing more and investing is not an advisable move now. Instead, consider paying down your line of credit. Think of it as every dollar paid back on a pledged asset line effectively earns you an interest rate of 5-8%. This is a higher return than investing in a cash equivalent earning 3-4.5%.
Approaching Liquidity Planning Thoughtfully
There are a few rules of thumb when it comes to liquidity planning. Here, at Robertson Stephens, we typically do not rely on rules of thumb, as they were most useful at a time when it was hard to gather relevant financial information, and the tools for analyzing such data were cumbersome. Today, personal financial data is relatively easy to access and collect in a secure fashion. The applications used to analyze this information are quick, accurate, and flexible, meaning clients and advisors alike can leverage this technology to provide a customized approach to wealth management. The same is true of liquidity planning.
Working in tandem with a wealth manager, there are several steps you can take now to maintain control over your liquidity. For one, get organized: with tax season in full swing, now is as good a time as any. This means updating your balance sheet, estimating your income and expenses, and assessing your liquidity needs. You may consider asking yourself several questions in the process, including, “How much do you need to meet your lifestyle needs and other expenses this year?” Your answer should account for taxes, non-discretionary and discretionary spending. It’s also worth considering how much money you’re comfortable setting aside for potential opportunities. Set the total estimated amount aside from your portfolio in liquid cash equivalents that are earning 3-4.5% or higher.
Additionally, you should evaluate whether or not you can reduce your line of credit and, if so, by how much. The answer to this question should arise from a combination of technical analysis and one’s personal view of a safe debt amount. When interest rates were low, debt was much less of a concern. Now that the situation has changed, it’s worth consulting with your wealth manager to see where you stand and establish your optimal liquidity level.
If you feel comfortable assessing your liquidity independently and don’t intend to go through the process with your wealth manager, here is some conventional wisdom to remember. Financial planners often emphasize the need for an “emergency fund” and traditionally recommend setting aside three to six months’ worth of living expenses along with an additional amount for short-term goals. However, three to six months may not be enough in the current market environment. Since 1928, the average length of a bear market has been ten months. Normally, we believe a good starting point for liquidity is 12 months from the start of a bear market. The last bear market started in January 2022, and we may or may not still be in one, depending on who you ask. Wealth planners err on the conservative side, and we recommend planning, but not hoping for, another 12 months of liquidity.
Another factor to keep in mind is what stage of life you are in. Clients who are still building their wealth and establishing their portfolio should consider their earned income. Dual-income families have less risk than single-income households, and less cash is required to achieve a sufficient liquidity buffer, where six months of expenses could be enough. These calculations should account for dependents as well as discretionary and non-discretionary expenses, all of which will likely add a few months’ worths of funds to your ideal amount. Likewise, leave out taxes on earned income and savings — if you’re not earning income, taxes are not owed, and savings should be a low priority. Retirees who rely on their portfolios to help fund their lifestyle may consider keeping 18 to 24 months of liquidity aside. If necessary, this amount of runway will decrease the probability of needing to withdraw from your portfolio when markets are down. For high and ultra-high-net-worth clients, liquidity calculations may also include estimated taxes, capital calls, dry powder for new investment opportunities, margin for tangible property maintenance, and travel. No matter where you are in life, liquidity should be reassessed every six months.
Distilling Liquidity Planning
When planning for the year ahead, accounting for liquidity gives you the opportunity to both improve your portfolio’s long-term resilience and enhance your overall financial security. In view of 2022’s market conditions and the outlook for 2023, the accompanying peace of mind could be invaluable. We recommend taking a tailored approach to liquidity planning by working with your wealth manager or at the very least, using conventional wisdom to settle on a number that suits your needs.
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