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How much cash is too much in your portfolio?

Maintaining a high cash balance is not rational when you do the math, and most investors move into cash holdings at the wrong time due to emotional reactions.

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Cash is certainly useful when you're buying fruits and vegetables at the farmer's market – or anywhere else that doesn't take debit or credit. But in your investment account, how much is too much?

It's a question worth pondering. It also has the potential to divide the opinions of financial experts.

While many agree that having a rainy day fund, or emergency cash on hand, is a smart move, committing to too high or too low an allocation of readily available cash in your portfolio is a different matter.

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The problem is that the yield on cash is virtually zero. Andrew Torres, chief investment officer for Lawrence Park Asset Management in Toronto, says it's hard to say exactly how much should be held in a portfolio, whether it's 10 per cent or 25 per cent or more. Clients should, however, give some thought to exactly when they might need it, and in what form they are holding it.

"There are better things out there than money market accounts," he says. "There are products that have low volatility and have 30-day liquidity."

The key is finding a balance between being too cautious – in other words, having cash sitting there doing nothing – or the opposite, in which clients scramble to get their money working for them through riskier plays.

"Then suddenly you find that all your assets become correlated and everything is down 10 or 15 per cent at once," he says. "That never feels good for anyone."

Investors should look for what Mr. Torres calls the "sweet spot of liquidity versus volatility." That can be found when clients think long and hard about how quickly they might need money for a particular thing and act accordingly, finding investments that are not as risky as the stock market but not as liquid as pure cash and that can still offer some reasonable returns.

The best decision, however, might simply be whatever the investor is most comfortable with.

Ken Lee, executive vice-president and director of Sherbrooke Street Capital Inc. in Montreal, says his clients prefer that he maintain their cash holdings in the 10- to 25-per-cent range.

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"Having cash on hand is an absolute, given today's market conditions," he says, noting that volatile markets can offer buying opportunities to those with the cash to seize them.

This is not a universally held opinion, however.

Patrick French, director of financial and retirement planning for Edward Jones in Mississauga, believes that too much cash can be a drag on a portfolio.

"We philosophically don't believe that having an allocation to cash – on a long-term basis to take advantage of these short-term swings in the market – makes a lot of sense for people," he says.

Holding too much cash results in missed opportunities to earn higher returns on good-quality stocks, Mr. French says. "The market historically has gone up far more often than it has gone down, and it goes up for much longer periods of time than it's gone down," he adds.

He recognizes that most people will hold some cash, but his magic number falls between 0 and 10 per cent, probably in the midpoint of that range.

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Cash should not be held specifically for capitalizing on market volatility, he insists. Instead, it's the rest of the portfolio that should fulfill that role.

"It's the rebalancing activity of either selling stocks to buy more bonds or selling the bonds to buy more stocks, on a long-term basis, that gives you the opportunity to take advantage of market swings," Mr. French says.

Those who count on a pool of cash to enable them to jump on opportunities also need to take other considerations into account.

First, they need to look at what else is happening in the broader context of a portfolio. As an example, he uses the financial meltdown of 2008. That downturn generated more questions than simply where to deploy cash in the markets; investors likely had more pressing economic issues to think about.

Investors also should monitor their own emotional responses. The greatest opportunity to use the cash usually coincides with the greatest point of market discomfort.

"It is incredibly difficult to make the decision to invest money when the market is falling," he says.

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