How much cash to hold right now

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With interest-rate, inflation, and potential recession considerations, high-net-worth investors need to carefully plot their strategy for holding on to, or divesting their portfolio of, cash in these uncertain times.

But there are also some potential bright spots. “It’s hard to go against holding cash when you’ve got yields close to 5 per cent,” says Richard Croft, chairman and chief investment officer of Croft Financial Group Inc. in Toronto.

Wayne Kozun, chief investment officer with Forthlane Partners Inc. in Toronto, says this is a difficult environment for investors to make decisions about holding cash, citing a higher level of uncertainty about inflation and interest rates, than seen for decades.

Though inflation eased somewhat in September, underlying price pressures remain broad. With that higher level of uncertainty investors have less confidence that central banks can safely keep inflation around the 2 per cent target. So they want a higher risk premium in case inflation gets out of control, he elaborates.

Investors are currently able to obtain a decent nominal return of about 5 1/2 per cent on liquid cash, higher than has been available in a long time, says Kozun.

Cash reserves can, therefore, provide a good option to park some money and earn a good return right now, particularly as investors wait for investment opportunities. And because cash is liquid, it can be deployed quickly to take advantage of various types of assets as market conditions dictate, he adds.

“I feel we’re at or near the peak of rates,” says Richard Leon, a partner and portfolio manager with Richter Family Office in Montreal.

“Our investment philosophy has evolved in anticipation of where we are today. Up until the second half of last year, we were okay with people building up cash buffers and using those buffers to remain defensively positioned. In the second half of last year, even though rates on cash were the highest that we’ve seen, we anticipated that spread was going to become less desirable from that point,” explains Leon.

How much cash to hold in a portfolio

The ideal percentage of cash to hold in an investment portfolio requires investors to take stock of their personal financial needs, as well as their investments’ capital requirements.

“We’ve preferred cash ahead of fixed income or bonds for our customers, because we’ve been concerned about the risks of interest rates going up. So that could be anywhere from 5 to 25 per cent in fixed income, which would primarily be cash,” says Kozun.

The longer term that a bond has, the more that bond price will fall if interest rates rise. Cash is like a very short-term bond so it falls very little if interest rates go up, he adds.

“We don’t really have model allocation percentages,” says Leon. “But if we look across the spectrum of our client base, I want cash needs covered for 12 months. The cash needs are coming from two places. They’re coming from the needs of the portfolio to support the family in meeting their personal goals, and from the needs of the portfolio to support its alternative investment commitment.”

The portfolio needs to be able to meet its capital activity requirements, such as capital calls from drawdown vehicles, and be able to handle paused or reduced distributions from existing investments. At times of market stress, the available sources of funds are reduced, meaning cash balances need to be higher than normal, he explains.

That will typically lead to around 5 per cent in cash today. A year or two ago that number would have been in about the 5- to 10-per-cent range, adds Leon.

“The principal objective for ultra-high-net-worth investors should be capital preservation. Growth is fine longer term. But a few percentage points of excess growth will not likely impact the lifestyle of the rich. I would consider holding at least 20 per cent of the portfolio in cash equivalent assets,” says Croft.

What factor inflation plays in where to put cash

Before investors decide where to invest excess cash, there needs to be more clarity around inflation. If, for example, there are signs of returning to the environment from the early 1990s through 2020 where inflation was between 1 and 3 per cent without a lot of volatility, “cash would likely be less attractive compared to other opportunities,” says Kozun.

“But if we’re in a new regime of uncertain inflation, then you may want to keep cash allocations high in the short term, because there could be more volatility in other types of asset classes, like equities or private assets. Having lots of cash gives you the option to deploy that cash into riskier assets, like equities or private assets, if they decline [in price],” he adds.

In the preceding historically low interest-rate environment, many financial instruments, including growth equities, real estate, some types of private equities, and infrastructure, benefitted. But the environment going forward may be different, and favour shorter duration assets, Kozun elaborates.

Croft believes inflation is coming down and will not be a longer-term issue. He also does not believe that Canada is headed into a serious recession, but rather experiencing a ‘rolling recession,’ which tends to flow from one sector to another without impinging on the entire economy.

“I think one of the reasons that’s occurring is that you’re getting more growth than one would expect given the significant rise in interest rates,” he says.

Looking for when interest-rate hikes stop

The key sign for investors to look for before deciding to disperse cash for other investment instruments is when the interest rate hikes stop, says Croft, who believes that will conclude in Canada and the United States by the end of 2023, reversing the rolling recession and turning it into a rolling expansion across various sectors.

When interest rates stabilize, ultra-high-net-worth investors could look at normalizing their portfolios by holding a cash allocation that is appropriate for their long-term objectives, as opposed to an overweight position for defensive purposes, he explains.

High-net-wealth families have the ability and the luxury of being exposed to risk assets at a greater level than perhaps other types of clients, and so they are able to accept more illiquidity, and more volatility, over a longer time horizon, says Leon.

So long as they can secure that stream of income to meet the needs of their portfolio and their lifestyle, they need to “allow the rest of the portfolio to breathe and suffer the volatility that basically comes with higher risk, higher return investments,” he elaborates.

Because the future is always uncertain, investors should always keep a well-diversified portfolio. “You have to keep all your bases covered if you want to build wealth for your family for multiple generations,” stresses Kozun.

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