- All investors require some level of cash in their portfolios. Based on Vanguard’s easy-to-follow framework, the type of cash product and the amount to hold depend on three fundamental pillars: risk tolerance, investment horizon, and funding level. These factors are crucial in guiding portfolio construction decisions.
- While there is no generic investment approach, investors with a low- risk tolerance, short time horizon or a well-funded financial goal would benefit most from holding higher cash or cash-like allocations.
Cash can take many forms, including physical currency, money held in bank accounts, and short-term financial instruments. For our purposes, we will define “cash” as readily available short-term financial instruments with high liquidity, minimal or negligible market risk, and a maturity period of less than twelve months. Cash includes guaranteed investment certificates (GICs), money market funds, high interest savings accounts and ETFs (HISA), and high quality ultra short-term bonds. The yield on these investments can change frequently and is closely tied to the Bank of Canada policy rate or the policy rate of other central banks.
In this research note, we outline three aspects of cash that investors’ objectives tend to align to: returns, relation to inflation, and volatility levels. We also share our framework for assisting investors in considering cash for financial planning and strategic asset allocation.
Return-Where cash sits in the risk-premium spectrum
While equities and bonds both have higher expected median returns than cash, their returns are much more variable, with a much higher probability of negative outcomes. This is because of the risks associated with bonds and equities that cash does not face, such as bonds’ credit and interest rate risk or equities’ factor for market risks. Investors demand a premium, or extra return, to compensate them for taking these extra risks. To illustrate this, the box-and-whiskers graph in figure 1 highlights that the Vanguard Capital Market Model (VCMM) projects that there’s a 80% probability that cash will generate between 2% and 4.1% returns, global bonds between 0.4% and 9.6% while global equities are expected to be much more volatile, returning between -11.6% and 31.7% over a one-year horizon.
FIGURE 1: Risk and return for cash, bonds and equities
Notes: Returns shown are from Vanguard Capital Markets Model (VCMM); one-year-steady-state projections as of December 2023 are used. Equities are defined as 30% Canada/70% ex-Canada; bonds, as 60% Canada/ 40% ex-Canada. Three-month Canadian treasury bills are used to project cash returns. Box-and-whiskers icons plot the 10th, 25th, 75th, and 90th percentiles of returns for each asset class.
Sources: Vanguard calculations, using data from the VCMM.
The impact of inflation on cash’s return
Inflation is a crucial factor to consider when evaluating investment opportunities because it erodes the real value of money, or its purchasing power, over time—and because this erosion becomes more detrimental as the investment horizon expands. Historically, a key shortcoming of cash has been its limited ability to keep up with inflation. This results in it not protecting real wealth. This is particularly relevant for investors in the drawdown phase of their goal, whose expenses are increasing each year and whose accumulated assets may not keep up with inflation. The rapid rise in inflation to near double-digits as we emerged from the 2020 global pandemic serves as a reminder.
“Safe haven”—Cash’s low volatility
Many investors view cash as a safe haven because of its low volatility, especially in times of market stress. However, looking at low volatility ignores other important considerations. While cash may appear to be a secure investment, maintaining an excess of cash and/or attempting to time the market can have a detrimental and permanent impact on an investor’s financial outcomes. The most common misuse of cash as a safe haven is market timing. Taking risk off the table at the wrong time can lead to worse outcomes. Staying invested through volatile times is one of the key investment principles for success identified by Vanguard research1.
The three pillars of cash investing
Vanguard has developed a comprehensive framework to help investors effectively utilize cash in financial planning and strategic asset allocation decisions. Our framework considers the dynamic relationship between cash, investment goals, and the range of factors outlined earlier. For the sake of simplicity, we explore this framework in the context of self-contained investment goals in Figure 2. However, it also applies to investors with multiple goals, where the considerations become more nuanced given the interactions between different goals.
FIGURE 2: Three key pillars make up our framework for cash and cash-like investing
Risk Tolerance
Risk tolerance is a measure of how much market risk an investor is willing to take in their portfolio based on their financial goals, time horizon and psychological disposition. An investor’s risk tolerance should always be considered in combination with their investment goals. From a strategic asset allocation perspective, cash moves the portfolio towards the more conservative end of the risk-reward spectrum, All else being equal, including cash in a portfolio is more suitable for investors with a lower risk tolerance. The table below provides some guidance. The darker the shade of blue in the matrix, the more likely cash is recommended.
FIGURE 3: A matrix of investment goals and risk tolerance levels
Time Horizon
The longer the time horizon, the more likely it is that an investor will benefit from equities’ and bonds’ risk premiums. Using our VCMM forecast, we expand the 1-year investment horizon in Figure 1 to a 10-year horizon. We find that the distribution of returns for cash, bonds, and equities narrows with the longer horizon. Simply put, cash is less beneficial for investors with longer time horizons.
Using our VCMM forecast for a one-year period during the worst 10% of periods for each asset class, the median cash return is positive at 1.7% whereas for equities that number is –11.6%. As we increase the time horizon to 10 years, the worst-case dynamic reverses. Now, we see equities returning 3.4% over a 10-year horizon during the worst of times and cash is unchanged, still returning 1.7%. This highlights how as an investor’s time horizon increases, the benefits of holding cash diminish, even in the worst of times. As an investor approaches their goal and their time horizon gets shorter, they may want to shift some of their portfolio to cash.
FIGURE 4: Over time, the distribution of returns for cash, bonds, and equities narrows
Notes: Returns shown are from the Vanguard Capital Markets Model (VCMM); ten-year-steady-state projections as of December 2023 are used. Equities are defined as 30% Canada/70% ex-Canada; bonds, as 60% Canada/ 40% ex-Canada. 3-month Canadian treasury bills are used to project cash returns. Box-and-whiskers icons plot the 10th, 25th, 75th, and 90th percentiles of returns for each asset class.
Sources: Vanguard calculations, using data from the VCMM.
Funding level
The better funded a goal, the less return an investor needs and/or less risk they need to take to meet that goal. This is especially true for goals that are both well-funded and short-term. Over short time periods, there are benefits to holding capital in less risky assets such as cash. As an example, if investors have reached their goal, there may be little benefit in holding risky assets as this could increase the likelihood of shortfall risk. However, if a goal is not well-funded, an allocation to risky assets can be a valuable tool in helping investors achieve their goal. Increasing an allocation to risky assets is not always the optimal solution when the risk of shortfall is high. Other options should be considered such as increasing their savings rate, adjusting their goal amount, and allowing more time to achieve their goal.
Conclusion
All investors need some cash—the key questions are how much cash an investor should hold and where they should hold it. From a financial planning perspective, holding cash and cash-like instruments helps cover near-term expenses, and fund retirement payments, amongst many other goals. In this research note, we shared a framework that is built around the relationship between goals and three pillars: risk tolerance, investment horizon and funding level. Our analysis shows that cash allocations are ideal for investors with shorter time horizons, lower risk tolerances, and well-funded goals. The decision will be context- or goal-specific, and this framework is meant to systematically guide the investment decision, not constrain it.
It is important to underscore that using cash as a part of an investment strategy should be done systematically, in accordance with a well-defined framework and, possibly with the help of a trusted financial advisor.
Publication date: September 2024
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
Certain statements contained in this material may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.
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IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
Distribution of return outcomes from the VCMM are derived from December 31, 2023 simulations for each modelled asset class. Simulations as of December 31, 2023VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard's primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
All investment funds are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.