How much cash should investors hold back for emergencies?

Newbie investors are usually cautioned to build an emergency fund of three to six months’ salary before chasing better long-term returns on their money in the financial markets.

More experienced investors may want to deploy cash in more sophisticated ways, such as maintaining an opportunity fund for promising buys, or removing some risk from their portfolio at critical times.

At this point, we’ve come to an interesting point regarding the amount of cash investors should hold.

Rising interest rates are improving returns on risk-free savings, while financial markets are going through a very volatile period.

“A regular question in any environment, and an important question as we enter 2023, is how much money individuals and families should set aside, rather than invest as investments,” said Tim Bennett, head of education at Killik & Co.

“There are many things that can keep people awake this year, most of which are a 2022 hangover.

“As people’s fears of the economy increase, they naturally start to hold more cash.”

Bennett says investors should consider increasing volatility of financial assets – from stocks to bonds and real estate – with diminishing visibility of stock market gains and central bank ‘tightening’, which has seen debt burdens rise as interest rates rise are being raised.

Meanwhile, he points to the current uncertainty around job security and wages as companies try to cut costs.

Below, Bennett and other financial experts explain how investors can best use cash for both contingencies and opportunities in the current climate.

Holding money in your investment portfolio

Investors will often withhold cash in an investment portfolio as a short-term tactical allocation to avoid losses in other asset classes, says chief analyst Rob Morgan of Charles Stanley Direct.

But he cautions that market timing is always tricky because of the risks and psychological challenges of trying to sell high and buy low, and the transaction costs.

Being out of the market also interrupts the flow of potentially larger income from assets such as bonds, stocks or properties that provide interest, dividends or rental income.

Having said that, cash ash has become more relevant over the past year as a tool within an investment portfolio as it begins to provide valuable returns.

“With the Bank of England’s base rate reaching 3.5 per cent and expected to rise slightly higher in the coming months, cash is no longer the dead weight it was when interest rates bottomed out.”

Morgan says this is particularly relevant for people who need an income and want to draw flexibly from an ISA or retirement account.

He explains that the strategy of keeping a modest cash buffer so you can continue to withdraw money without having to sell assets — and thus crystallize losses — could now come with less of a penalty. See the box on the right.

Morgan adds: “An option for those who manage their own investment accounts are money market funds that invest in a diversified portfolio of short-term cash deposits, money market instruments and (in some cases) high quality bonds.

“These funds aim to generate returns that exceed benchmarks such as the BoE base rate or the Sterling Overnight Index Average (SONIA), which represents an average of short-term lending among UK financial institutions.”

How to be an opportunist with your money

“When it comes to having cash on the sidelines and then putting it to work opportunistically, you have to be really contrarian to take advantage of short-term investor sentiment,” said Juliet Schooling Latter, research director at FundCalibre.

“You can take advantage if the market is having a rough few days to add to your positions or parts of the market that have suffered the most but you think can do better in the long run.

“If the market keeps going down, keep adding some more. You can also take advantage of big catch-up days to trim companies or areas that have done well.”

But Schooling Latter warns, “Be careful not to overspend on the trading fees or it’s not worth the effort.”

“Sometimes it’s only really worth it if you’re moving fairly large amounts of money or if you’re buying and selling money on a platform where trading is free. It is also safer to do this strategy with funds or indices.’

“If you try to play this game with individual stocks, it can go horribly wrong if you’re not very careful.”

Schooling Latter says being opportunistic with your money can work really well in a narrow-reach market. This is when a price fluctuates between a certain high and low level and doesn’t come out for some time.

She explains that the key in this situation is to be disciplined and not get sucked into market narratives about why the market or a stock is going up or down, as well as only doing so with a small percentage of your portfolio.

“You could have done well last year if you bought in when everyone was very negative in June and sold out in August when everyone was positive. The downside is that things don’t go well if the markets move strongly in one direction.’

Schooling Latter says following this type of strategy is probably most dangerous when markets are rising.

“Usually when the markets fall you get a strong relief rally at some point, but the markets can deteriorate a little every day for weeks or months. So if you sell in that rally, sometimes it can be difficult to get back in.”

What else should investors keep in mind

Tim Bennett of Killik & Co offers the following tips on holding cash.

The benefits of cash: “The danger of running too little cash is obvious — you may not have enough buffer when the going gets tough,” he says.

“Emergencies can arise, whether it’s a sudden car or roof repair, or a child who needs a short-term loan.”

Meanwhile, “opportunistic money” is useful in volatile markets, where investors spot bargains or good entry points, or want to upgrade a favorite long-term asset, he says.

Bennett also points to the psychological comfort of holding cash: “We all feel safer knowing that we can’t run into too many financial problems in the short term.”

Pthe pitfalls of holding too much cash: The dangers include interest rates on deposits that continue to lag inflation, in many cases by some distance, Bennett says.

He also cites anxiety and FOMO — the fear of missing out: “When stock prices start to rise, it can be stressful to watch them do so, knowing that your money is being eroded in “real” (post-inflation) terms. ‘

Bennett notes that only up to £85,000 in savings at an institution is protected by the Financial Services Compensation Scheme. Find out how the FSCS works here.

How to decide how much cash to withhold: “Individuals should set aside about three to six months of their average monthly expenses — in the current uncertain climate, they are drifting toward the latter.

“Families need more – six to 12 months is my recommendation here. The exact amount should of course be a matter of personal preference.’

Get the best return on cash you can: “Whatever amount is put aside, it’s important that it’s accessible, but also doesn’t sit where no interest is paid,” says Bennett.

“With rates rising, even ready-made accounts should offer at least some return. Keep an eye on the rates and don’t be afraid to shop around for a better deal

“Don’t try to hold on longer than you need to, or for more of your reserve than you should. Consider using a comparison platform to speed up the moving process.’