How much cash is enough?

Co-founder of the Switzer Report
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I get to answer many subscribers’ questions, and apart from the usual suspects such as: Should I sell stock A or purchase stock B?, another very popular question is: ‘‘How much cash should I have?”.

This is usually accompanied by a description of the major assets in the super fund, meaning that the question is really about whether “I have too much invested in the share market” or “should I have more invested in the share market”.

As I say to subscribers who pose this question, there is no right or wrong answer. It depends on a number of factors that are particular to your fund and your members. With share markets sitting at high levels globally, it is probably timely to review the factors behind this decision.

Income -v- growth assets

When subscribers talk about “how much cash?”, they are usually looking at the distinction between ‘income’ assets and ‘growth’ assets. Cash is one of the income assets – and every fund should have enough of the folding stuff on hand to meet the next three to six months’ liabilities of the fund (such as paying a pension or paying tax). However, the income assets also include term deposits, fixed income securities, corporate bonds and hybrid securities. With these assets, the primary return for the investor is from income, such as interest – not price appreciation.

On the other hand, growth assets provide most of their return through price appreciation. Shares, international shares, property, commodities and collectables are the major asset classes.

Asset allocation is, at the top level, a division between ‘growth’ assets and ‘income’ assets, and at the next level, a division between the asset classes. Models are produced based on how different assets are expected to move together in value (in fact, they look for negative correlations), and target allocations are established.

The table below shows six standard asset allocations – with growth assets starting at 0% in the most ‘secure’ portfolio, and moving progressively to an almost pure growth allocation of 99%, which is labelled ‘high growth’.

Target asset allocations

Source: Switzer Financial Group

How do I know if my fund should have a ‘defensive’ or ‘growth’ orientation?

While there are obviously hundreds of permutations of asset class combinations, let’s return to the question about “cash”. What’s the right asset mix for my fund, and what are the factors I should consider?

Firstly, let’s start with your investment objectives. If the objective of your fund is, say, to ‘outperform inflation by 5% over the long term’, then you are going to need a fair mix of growth assets. On the other hand, if your objective is to ‘keep pace with inflation while avoiding a negative return in any one year’, then you could probably achieve this largely through income-based assets.

Accumulation or pension? If you are in the accumulation phase, then you probably want to grow your super, won’t need to liquidate any assets in the short term and are thinking a long way into the future. These are strong arguments for a bias towards growth assets. This doesn’t mean that if you are drawing a pension that you should go all conservative – one of the greatest mistakes we see in our financial planning business are people retiring and immediately going into capital preservation mode. As a retiree, you might have to plan on your super lasting for 30 plus years – which means some allocation to growth assets.

Timeframe. If you are in your thirties, you won’t be able to access your super until age 60 (more likely not until age 65 or 70) and you should also be thinking about making your super last for another 30 years after that. According to the ABS, a 65-year-old male can expect to live for 19.1 years, a 65-year-old woman 22.0 years. These are averages – increasing all the time, and if you are in reasonable health, you need to plan on quite a bit longer. There will be several economic and market cycles over the next 60 years – time is on your side, implying a strong bias towards growth-based assets.

What is your appetite for risk – or perhaps rephrased more correctly, your risk tolerance? If you invest in growth assets, the probability of having a year with a negative investment return increases. Every share market cycle produces years when the market goes backwards, like 2008 and 2009. There is no point in having a strong bias in growth assets if you are not comfortable with this expectation. The table below from Chant West is pretty conclusive – in the last 22 financial years, the median growth super fund has witnessed a negative return on three occasions – and two years of almost zero return – about a one in five occurrence.

Median Return % for a Growth Super Fund

Source: Chant West – Median Financial Year Performance for Growth Fund

Taking more risk should be accompanied by the prospect of a higher return – and the evidence for this is fairly compelling. Chant West has recently reviewed the performances of industry and corporate super funds over one, three, five, seven and 10 years – and as the data in the following table shows, as the proportion of growth assets in the investment option increases, the average return increases.

Interestingly, this is true of all measurement periods except seven years (which incorporates the GFC period of 2008 and 2009), however as the measurement period gets out to 10 years, then the pattern reverts to the expected case.

Super Fund Performance – % pa

Source: Chant West – Median Fund Performances to 30 June 2014

And finally, your investment outlook, as well as not investing in things you don’t understand or are not comfortable with, will guide both your allocation and investment timing.

Thinking about your investment objectives, fund status, timeframe, risk tolerance and investment outlook will help you decide on your allocation to growth or income-based assets – and ultimately formulate your individual answer to that question “how much cash is enough?”.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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