Managing your cash

Compared with other aspects of your financial life, managing cash may not always be top of mind. Yet how you allocate cash could affect the overall performance and efficiency of your portfolio. “Because it serves multiple long- and short-term roles, cash should be treated as a distinct asset class just as worthy of strategic planning as your stocks, bonds or alternative investments,” says Brian Colalucci, Senior Fixed Income Strategist for Bank of America Private Bank.

Consider the essential properties of cash: Access to your funds when you need it, safety, and some return. “Even within those parameters you can find a wide range of cash and cash-like investments for specific needs,” Colalucci says. “In some cases, sacrificing a bit of liquidity and assuming slightly more risk could help you boost returns without compromising your overall strategy.” Optimizing your cash starts with determining the right amount to have on hand and then selecting an investment option designed to meet your unique needs.

How much cash is enough?

“Cash is vital for everything from paying routine expenses like college tuition bills or capitalizing on an emerging business or investment opportunity,” says Colalucci. Without sufficient liquidity you might have to sell investments that you were counting on for growth, perhaps at inopportune prices if markets have temporarily declined. Yet keeping too much cash in your portfolio poses risks of its own. From 1926 to 2023, cash produced an after-inflation return averaging just 0.4% per year, compared with 10.3% for stocks and 5.1% for bonds.¹

Your advisor can help you find the proper balance by conducting a thorough review of your current and recurring expenses, debts and the level of liquidity you need. “Other factors, including your tax situation and how you feel about risk, could help determine a level of cash that’s right for you,” Colalucci says.

Taking a strategic approach

The next step is to deploy cash efficiently for various needs. A good approach may be to think of your cash across three “tiers”—transactional, reserve and tactical—each able to assume slightly greater risk than the previous one. “When you’re no longer looking at cash as a single, homogenous layer of capital, you have the opportunity to make it more productive,” Colalucci notes.

Tier 1: Transactional cash. This is the money you need to cover groceries, monthly bills, dinners out and small expected or unexpected expenses. “You don’t want to wonder whether this money is available; it just needs to be there when you need it,” he says. Your checking account will likely be the hub of your transactional cash. But you might keep some part of that cash in instruments paying a slightly higher interest rate, such as a money market mutual fund or an interest-bearing checking or savings account.

Tier 2: Reserve cash. You don’t need this money today or tomorrow, but you’ll use it for some larger expenses on the horizon, such as tuition, a down payment for a new car or renovations on your kitchen. Liquidity and stability are important, so a portion of your reserve cash may belong in a money market mutual fund or interest-bearing account. But because you don’t need the cash immediately, you could also seek a higher return in exchange for slightly less liquidity, through short-term certificates of deposit (CDs) or short-term U.S. Treasurys timed to mature when a renovation or other expense is scheduled.

Tier 3: Tactical cash. “This is the money you’ll need for future deployment,” Colalucci says. Say, for example, a business or investment opportunity comes your way, or you’re passionate about 19th-century American art and always on the lookout for the next acquisition. “You still need to protect your principal,” he adds, “but you have some flexibility to take on greater risk in exchange for a higher return.” That could include buying U.S. Treasurys with a longer duration and a higher yield. Or you might look beyond Treasurys to high-quality, short-term corporate bonds or asset-backed securities. Depending on your tax situation, you might also consider municipal bonds, whose interest is generally free from federal income tax, or U.S. agency notes, many of which offer interest that is free from state and local taxes.

A working asset

Keep in mind that however you invest it, cash cannot replace growth assets when it comes to pursuing your long-term goals. “Stocks, despite their short-term volatility, historically have outperformed cash and bonds by a wide margin,” says Colalucci. “So it’s important to put excess cash to work.” An approach such as dollar-cost averaging, which involves investing predetermined amounts at regular intervals, could help ensure that you continue to invest excess cash for the future without dipping into cash you need for liquidity.

Yet for the portion of your assets that belongs in cash, taking a strategic approach could help ensure you have the liquidity you need for each “tier” while optimizing your overall performance. 

Speak with your advisor about assessing your liquidity needs and exploring the best ways to deploy your cash.