Cash Thresholds: A Best Practice

For many clients and advisors alike, part of the goal of investing is beating inflation and cash does not typically return more than inflation. Holding too much cash in a portfolio keeps your client on a treadmill - you’re not generating enough to cover inflation costs, your purchasing power isn’t increasing, and you’re just working really hard to not go anywhere.

That being said, no matter how risk-tolerant a client is, every portfolio needs some level of cash for fees, distributions, the “rainy day” fund, college expenses, and other general life necessities. Investing every dollar leaves clients exposed to surprise expenses. As much as we don’t want to think about the loss of a job, the loss of a partner, or surprise medical bills, not planning for unforeseen expenses like these could cause negative effects such as the untimely sale of investments or falling into debt to cover costs. 

“Cash is a distinct asset class with its own properties, advantages, and risks. So it’s important to be as strategic about cash as you are about any other investment.”

• Matthew Diczok, Head of Fixed Income Strategy in the Chief Investment Office for Merrill and Bank of America Private Bank

Part of the solution to maintaining an appropriate amount of cash in a portfolio is using cash thresholds. A cash threshold refers to a target range that cash amounts should remain within, acting as a buffer for cash targets.

For example, in a $500,000 portfolio, cash could be targeted at 2% of the portfolio’s value with a minimum threshold of 1% and a maximum threshold of 3%. In this case, the aim would be to keep cash within a range of $5,000 and $15,000, with an ideal target of $10,000. As long as cash remains within the 1-3% range, no action would be needed. But as soon as cash exceeds or falls below the 1-3% range, appropriate trades would need to be executed to bring cash back into the range. 

There are several benefits to implementing cash thresholds.

• To prepare in advance for advisor fees. By implementing cash thresholds, advisors can have cash on hand to cover quarterly advisor fees, helping to avoid stressful and untimely cash raising. A best practice for many advisors is to maintain a minimum cash threshold of 1% to ensure that there is always enough cash to cover fees.

• To help advisors work more efficiently. Advisors save time from consistently checking and re-checking cash levels in accounts to ensure cash hasn’t strayed from the precise target amount.

• To reduce trading and transaction fees. Advisors can avoid placing unnecessary trades when cash amounts rise or fall slightly below the target amount. Because fewer trades are necessary, there are also fewer transaction fees.

• To minimize tax-inefficient sells. With traditional rebalancing, an overweight asset would need to be sold which could trigger capital gains in taxable accounts. Instead, by maintaining cash thresholds and utilizing new cash, excess cash can be dispersed among underweight holdings to help bring the portfolio back into tolerance. 

There is no one-size-fits-all approach to client cash targets. Here are some helpful questions and considerations to discuss with each client to aid in determining appropriate cash targets and thresholds.

• What are your anticipated expenses over the next 24 months?

• How much do you currently hold in cash?

• What cash vehicles do you currently hold? 

• Are you willing to invest any cash with the potential of earning higher returns?

Because financial situations are constantly changing, it’s important to re-visit these questions periodically and update cash thresholds and targets accordingly. 

Utilizing cash thresholds can be considered a best practice for many advisors. They help advisors prepare for advising fees, work more efficiently, reduce trading and transaction fees, and minimize tax-inefficient trades. Ultimately, cash thresholds can help advisors serve their clients better, ensuring that both the portfolio and the future are equally taken care of.