Key takeaways:

• Cash held in your portfolio should be separate to emergency funds you hold as insurance against unforeseen events in life

• Experts typically suggest portfolios may benefit from a cash allocation of at least 5%, but this will vary from one individual to the next based on personal circumstances

While it is pretty standard practice to have some money set aside as part of an emergency fund' for everyday life, some investors are reluctant to do the same in the stock market because of low or no returns on offer - particularly with inflation eating into said savings.

However, there are a number of reasons why investors might wish to keep their powder dry by holding cash within their investment portfolios.

we're going to run through some of these reasons, but do keep in mind that there is no single answer regarding the decision to hold cash. Ultimately, it will depend on your risk appetite, investment objectives, and even your disposable income, among other matters. 

Nonetheless, the question over how much cash you should keep in your portfolio is one that you should regularly ask yourself, and here is what you should consider.

Emergency Funds

Most Australians would be familiar with the concept of an emergency fund. This is money you save to cover urgent or unexpected costs. For example, medical expenses, car repairs, unexpected travel costs, and so forth. 

The idea is that an emergency fund provides a financial safety net so you don't have to take out a loan, nor sell your prized possessions.

While experts generally agree that an emergency fund is essential, the recommended amount for an emergency fund differs. It not uncommon to hear experts suggest about three months worth of living expenses as an emergency fund, or six months in the case of having a mortgage and financial dependents. 

These are just estimates because every household situation will differ, and of course, everyone has to start from somewhere when building an emergency fund. Unlike what we will cover in a moment, the notion of risk appetite and time until retirement are less pivotal because risk follows us at every stage throughout our lives.

How Much Cash Should Be Held in a Portfolio? 

As far as keeping cash in your share portfolio, this is largely another matter altogether. It should not be mistaken as an emergency fund because ultimately it is funded by disposable income or savings that you assign to invest in the stock market. 

You neither want to fund potential emergencies with investment savings, or be restrained from investing in the stock market because you don't have cash set aside in your portfolio.

In contrast with an emergency fund, the amount of cash set aside in your portfolio is more likely to be guided by personal factors related to risk tolerance, investment objectives, and how far away you are from retirement. 

If you're cautious and risk averse, you may feel more comfortable holding a higher cash position than someone who accepts greater levels of uncertainty in the hope of potentially higher returns.

Your investment horizon will also help you determine the merits of holding cash in your portfolio. Those with a timeline spanning 10 or more years before needing to meet their financial objectives might be comfortable with a smaller cash allocation. If you foresee accessing your capital within the next three to five years, it may be wise to keep aside at least what you will need.

This explains why some investors, particularly younger investors, are happy to go all-in and fully invest their portfolio in equities, while investors closer to retirement might instead actively set aside a portion of their portfolio, often 20% to 30%, as cash. 

On the whole, however, there is general support among professionals that most investment portfolios may benefit from a cash allocation of at least 5%. It is not uncommon to see professional investors hold a cash weighting of between 10-20% of their portfolios for tactical purposes.

What Role Does Cash Serve in a Portfolio?

The versatility of cash is such that it can align with both defensive and aggressive investment strategies.

For example, a large cash allocation is seen as defensive, diversifying one exposure through the presence of a low-risk asset class. The goal is to safeguard one portfolio in the event market volatility leads to share prices coming under pressure. 

As paper losses grow, stability within a core part of the portfolio can provide investors with some confidence and peace of mind to keep their main holdings rather than being forced to sell. 

Cash can also serve as insurance' when market liquidity dries up. It means investors can tap into spare savings as opposed to selling shares at an inopportune time before their investment thesis has finished playing out.

On the other hand, when share prices tumble, cash can be used to fuel an aggressive investing strategy by allowing investors to capitalise on potential investment opportunities. Quite often, these opportunities may be very sudden in nature, which means investors need to be agile if they identify a cheap' stock.

One of the most famous advocates for sitting on a cash pile is none other than The Oracle from Omaha', Warren Buffett. The investing legend Berkshire Hathaway regularly holds more than US$100 billion in cash, waiting for the right moments to seize on opportunities that Buffett believes offer significant upside.

Of course, the other side of the coin is that cash may not do anything for extended periods of time. 

Furthermore, cash is not risk free. It may represent an opportunity cost if the market is rising. Similarly, if inflation is high, cash returns need to keep up with inflation otherwise the value of your money is falling over time. This tradeoff is something that investors need to decide for themselves and review from time to time.

For more on investing versus holding cash, read our article here.SelfWealth Ltd ABN 52 154 324 428 (Selfwealth) (AFSL 421789). The information contained on this website is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser and/or accountant. Taxation, legal and other matters referred to on this website are of a general nature only and should not be relied upon in place of appropriate professional advice.