The answer is just enough as per your portfolio goals: here’s how to calculate it

While “cash is king” in many cases, it is not the most suitable thing to have in large amounts in a portfolio since cash does not beat inflation. There are 4 uses of cash in a portfolio, beyond the usual monthly expenses:

• emergency fund (and sinking fund)
• opportunity fund
• funding of short term goals
• cash portion of assets in a retirement portfolio

Keeping cash beyond the 4 heads above will reduce gains due to low-interest rates on cash.

📚 Table of Contents

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• Emergency fund
• Opportunity fund
• Funding of short term goals
• Cash portion of assets in a retirement portfolio

Emergency fund

An emergency fund is money kept aside for usage in a sudden or unplanned expenditure or contingency. This money is needed to be available for immediate use in emergencies. Without this safety net in place, people will have to run around for money, depend on a loan or use a credit card at high interest rates.

The standard advice is to store 6-12 times monthly mandatory expenses and EMIs in cash and equivalents as described in detail in this post. An additional cash balance is used to keep the sinking fund for known periodic expenses like insurance premiums and festival travel/gifting.

Opportunity fund

This fund is for taking advantage of opportunities that might arise in the markets or a deal that you are looking for. A few examples are:

• A temporary fall in stock markets allows you to take advantage and invest extra money
• A house is available suddenly in a complex that you have been scouting for purchase for some time
• A contact brings up an opportunity to invest in a lucrative business that will be available for a short period
• To start a business or try new passive income streams

The amount to be kept as “dry powder” will depend on the number of possible opportunities that may come up and their sizes. If the purpose is to take advantage of a stock market fall then a possible target will be to hold around 15-20% of the equity portfolio in cash form. This will however introduce significant cash drag on the returns of the portfolio and it is only suitable for those whose goals are funded.

Funding of short term goals

Short term goals, as per the principles of asset allocation, need to be kept in safe and liquid assets like bank savings account, FD, RD or suitable debt mutual funds. These goals are of two types

• goals that are short term by nature: buying a car 3 years from now, school admission fees for a newborn (4 years from now), a foreign vacation in 5 years are examples of such goals
• originally long term goals that are now due within the short term window: typical goals can be house down payment, children’s education or the first few years of retirement once retirement is about to start. These were longer goals at the start but now due to the passage of time, have become shorter goals.

Let us say that the return in the cash bucket is 2.5%/year post-tax and there are 3 goals:

• New car purchase for ₹8 lakhs due in 3 years
• UG College admission for ₹11 lakhs due in 4 years
• Foreign vacation for ₹5 lakhs due in 5 years

We will use the Plan Excel workbook for this example. The Excel model shows that for these 3 goals, we need to have ₹13 lakhs in the cash bucket and invest ₹31,375/month.

Cash portion of assets in a retirement portfolio

Here we will use the bucket theory of goal-based investing to calculate how much money we need for this cash balance for retirement. Bucket theory divides the portfolio into 3 buckets - broadly cash, debt assets and equity assets. The cash bucket is for funding goals due within the next 5 years. We choose 5 years as a reasonable balance of risk and return. This cash bucket gives the peace of mind that a 2008 style crash in the equity markets will not require a fire sale of the stock portfolio to fund regular expenses.

Here in the example, ₹1.5 crores are invested for 23 years with ₹7.2 lakhs of yearly expenses. The cash bucket has ₹29 lakhs and contains 5 years of living expenses and the emergency fund and is inflation adjusted to last 5 years.