How much of your portfolio should be in cash reserves?


All traders should have cash reserves. And when I say “cash reserves”, I’m not referring to spare cash that you’re looking to invest into the market today. I’m referring to cash that you should not touch unless the worst case scenario happens. This cash is your lifeline.

  1. It is supposed to help you make ends meet at home if you run out of income.
  2. It is also supposed to save your portfolio in the worst case scenario. For example, this is useful if you completely fail to predict a bear market and your portfolio falls off a cliff.

In other words, you need cash reserves to help you get back on your feet after the worst case scenario happens. Do not plow all your life savings into the markets. Only trade with what you can afford to lose. If you lose your job, have no income, and the market tanks, you will be forced to sell your holdings at what could possible be the bottom of the market!
Here are a few factors that will determine how much of your portfolio should be in cash reserves.

Your strategy and its volatility

You must consider your trading strategy and its volatility when deciding how much cash you should hold.
Every trading strategy has different volatility characteristics. Likewise, every market has different volatility characteristics.
Traders who employ strategies that are more volatile should have a larger percent of their portfolio in cash reserves. Since these volatile strategies naturally yield larger week-to-week gains and losses, holding more cash will decrease the strategy’s impact on your portfolio.
This is especially true if you’re trading futures or on margin. Trading strategies that involve futures tend to be more volatile.

  1. You don’t need to worry about being margin called if you trade ETFs and stocks (even leveraged ETFs). So the worst case scenario = your portfolio goes to $0.
  2. With margin, your portfolio can go negative. In addition, margin calls can force you to cut your position at the worst price possible, just before the market reverses. So you need more cash reserves to prepare for this scenario.

The problem with volatile strategies is that mathematically speaking, losses are worse than gains. Here’s an extreme example.

  1. A low volatility strategy = your portfolio falls 10%, then rises 10%. At the end of the day, you are down 1%. (1*0.9*1.1=0.99)
  2. A high volatility strategy = your portfolio falls 50%, then rises 50%. You are down 25% at the end of the day. (1*0.5*1.5=0.75)

So here’s how to much cash you should hold based on your trading strategy and its accompanying volatility.

  1. Day traders who trade without margin don’t need to have large cash reserves. Day trading is a less volatile strategy.
  2. Day traders who trade with margin need to be larger cash reserves in the event of a margin call.
  3. Long term traders should have more of their portfolio in cash. Traders with longer time frames will sit through larger losses in the short term. This is why Warren Buffett always holds so much cash. His time frame is extremely long term (decades). He’ll use that cash to buy assets during bear markets.
  4. Strategies with wide stop losses (such as contrarian strategies) need more cash reserves, in the event of a big drawdown. Strategies with close stop losses need less cash.
  5. Strategies that “average in” need less cash because the averaging in prevents a large loss. Strategies that go all in on the first BUY/SELL signal need more cash.
  6. Traders who trade highly volatile markets like commodities and crypto need more cash reserves. Traders who trade low volatility markets like stocks need less cash.
  7. Generally speaking, people who trade complex financial products (e.g. derivatives) should have more cash, while people who trade simple products (e.g. stocks and ETFs) should have less cash.

Your experience in the markets

You must also consider your experience in the markets when deciding how much cash you should hold.
You’ve probably read various trading rules such as “don’t risk more than 2-5% of your portfolio on any one trade”.
This rule is generally meant for beginners: traders with little experience and don’t know what they’re doing.

  1. Generally speaking, the less experience you have in the markets, the more cash you should hold. You don’t want to blow up your portfolio just because you lack experience and trading skills. Losing money is not just about the monetary loss. Blowing up your first portfolio will psychologically scar you. First impressions can be lasting impressions, and if you blow up your first portfolio, you might never want to do trade again.
  2. But keep in mind that knowledge and skills are more important than experience. Some people can trade for years and still have no idea what they’re doing. Learn from your own experiences and the trading experiences of others. By learning from the experiences of others, hopefully you can avoid making the same mistakes that they have made. Walk on the shoulders of those before you.

Financial Situation

And lastly, you must consider your financial situation when deciding how much cash you should hold.
Here is what you should ask yourself when considering your financial situation. This is essentially one big question that can be broken down into multiple components. The question is:

How much can I afford to lose?

The more you can afford to lose, the less cash you need to have in reserve.

  1. If you have a stable or successful career and trading is just a side project, then you don’t need large cash reserves! A big loss in your trading portfolio will have a minimal impact on your life. You can afford to take more risk by lowering your cash reserves.
  2. If you’re barely making ends meet at home, then you should have a decent-sized cash reserve. If you lose your job, you don’t want to sell your holdings while the market is crashing (i.e. the worst time possible).
  3. If you have a well diversified portfolio in e.g. short/long term bonds or real estate, then you don’t need to have a big cash reserve. You can always sell some other assets to make ends meet in the event of a financial emergency.
  4. If you’re retired or approaching retirement age, you should have more cash. This is especially true if your trading strategy is volatile. Trading is a long term game. There are no guaranteed short term results. But if you’re on the verge of retirement, you cannot afford to lose e.g. 40% of your money in the short term! You don’t have the TIME to make a comeback.

Conclusion

So there you have it. There is no exact formula for how much of your portfolio should be in cash reserves. It depends on combination of multiple factors, and the “best” answer” for every single person will be different. To summarize, consider these factors when deciding how much of your portfolio should be in cash reserves:

  1. Consider your trading strategy and its corresponding volatility.
  2. Consider your experience in the markets.
  3. Consider your financial situation.

Take care, and I will see you all next time.

19 comments add yours

  1. Troy I know you’re all in on UPRO which is 3x leveraged, why do you consider this a better option if in this article you say losses are worse than gains with higher volatility?

    • Because the U.S. stock market has a long term bullish bias. It goes up on 60% of days. So although a 50% loss is worse than a 50% gain, the odds of a 50% loss are far lower than the odds of a 50% gain.

      • I get so much criticism for doing 3x leveraged, but it makes perfect sense to me.
        I have the emotional intelligence to not cry if I am red, since I believe in the investment, and eventually when I am green, I blow all my friends away.
        I feel like 3x leveraged ETF has so much hate towards it, along with the parrots that begin to shout decay.

        • Decay depends on the market. Decay isn’t really a problem for less volatile markets like stocks. But for volatile markets like gold miners or silver (NUGT & USLV), decay is a huge problem.

  2. Very interesting Troy. I’m pretty conservative and tend to have more cash on hand than necessary. Being a buy and hold investor (like Buffett), I now know at least it also fits with my investing strategy. Another great post. Tom

  3. You could be margin called on ETFs; especially leveraged. It’s happened to me many times.

    • Really? We’ve never been margin called on UPRO (unless you use margin when buying UPRO).

          • Reasonable in terms of not getting margin call often.
            Even when I was up by 40%, I’d get margin called, and requested to add more money.
            I think the platform I am using had bugs in their margin logic.

          • Yes, that doesn’t sound right. I was not aware that leveraged ETFs had margin call problems. What brokerage do you use?

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