How to Effectively Use Cash as Part of Your Finances
So when we think about different types of assets and their role in an overall financial plan, we can see where cash fits in by using the simple but effective Three Pot Theory™
The Three Pot Theory™ helps you to manage your funds more effectively
Pot 1 is your ‘daily’ pot where all of your short-term incomings and outgoings sit. In retirement there will also be a portion here for unexpected requirements such as medical bills.
Pot 3 is your ‘long term’ pot which holds less-liquid investments. These often provide us with more than just monetary value – for example, our homes, holiday homes or art. In the long run these investments may turn out to generate great returns but they can’t be used to meet short-term cashflow needs. And as their value is likely to fluctuate substantially from month to month and year to year, these assets are not so suited to provide the stable core of your holdings.
Therefore, we may often hold more in Pot 1 (cash) so we can be certain that we can cover our cashflow needs. Yet being prepared in this way can cause us to err too much towards caution, which can have a significant impact on our wealth over time as this article explains here.
This is where Pot 2 comes in – holding investments that can generate returns in the long run but which remain readily accessible if we need to draw upon them. Pot 2 is a liquid, low-cost portfolio or combination of portfolios. It is made up of equities and bonds and designed to generate returns over the medium to long term.
While Pot 2 doesn’t provide the value certainty and easy access of cash, you can allocate different portions of the pot to different levels of risk. This gives you some degree of control over expected investment fluctuations and you can therefore match these up with your needs.
The chart below shows the historic characteristics of our seven Risk Levels. While you can see that with our lower risk portfolios there is less upside in the good years, there has also been less downside during the worst periods.
How the upsides outweigh the downsides for Netwealth portfolios
Source: Netwealth; Strategic Asset Allocations and Historic Returns for the period 1993 -2018.
Please note that past performance is not indicative of future performance.
The right amount of cash will evolve with you over time
The chart below is an example of how the mix of the three pots might evolve over your life. When you are young and saving for a property, cash will likely be a large proportion of your total assets in the short term. As you get older your outgoings can grow considerably with costs such as childcare and education, meaning you have less to save. If you have a regular income, you may need to hold less in cash and instead focus on long-term and tax-efficient savings such as pensions and ISAs.
Then, in retirement, when you no longer receive employment income you may want to hold more cash. Perhaps one year’s worth of outgoings is sensible to make sure you can meet unforeseen costs and have a safety net in case investment markets are volatile.
How your cash allocation may change over your lifetime
Where to hold your cash
Whatever level of cash you plan to hold, it’s important to think about where this sits within the mix of wrappers and account types you may have. Let’s consider an example of someone who is 45 with £100,000 worth of ISAs, £400,000 of pensions and a £50,000 pot outside of any wrapper (which is subject to taxation). They also want to hold cash of £25,000.
If this amount is held in their pension, then while their overall asset allocation might look appropriate, it can’t meet one of the primary roles of cash we discuss above – instant access. This is because in nearly all cases you can’t access your pension savings until you reach 55. In this example that isn’t the case for another 10 years.
The other downside of this setup is that you are not taking advantage of one of the main benefits of pension savings – tax-free investment returns. So, you can see it is not only important to get the overall mix correct for your plan, but also to make sure it is implemented correctly.
The same would be true for substituting true cash with an alternative. In most – if not all – cases you will be compromising on liquidity or value certainty.
Cash is a valuable and versatile component of any investor’s toolkit. While it won’t give you the long-term returns you need, its stability value and easy access are incomparable – and ideal to deploy in the short term.
However, the key is to get the balance right: you need enough on hand to prepare for everyday outgoings (and some surprises), but also you shouldn’t allocate too much cash to places where it is damages your overall wealth.
If you would like to talk to us about your specific situation and find out how we can help you, please get in touch.
Please remember that when investing your capital is at risk.