Why have a Short-Term reserve in a portfolio allocation?
09 Dec 2016
Several of my conversations recently have abounded around efficiently deploying capital in a portfolio and the role of a short-term reserve. If you are familiar with us, you know that we subscribe to the “Bucket Strategy”. Keeping in mind that the bucket strategy is really just an organizational system for your portfolio, it makes sense that people at different stages will have different structures. Below I have outlined a couple of major differences occur during the Accumulation and Distribution phases of your portfolio.
Here you are focused on two buckets. Specifically, on the short-term reserves as well as the growth bucket.
“Why on earth should I have a Short-Term Reserve? I should be focusing on investing and growing my funds as much as possible! Money in cash is money that isn’t working for me!”
The Short-Term Reserve in this phase is simply an insurance policy. Don’t expect to earn anything on it. It is here in the event the unexpected occurs. The amount held inside the reserve will be a function of current lifestyle and any insurance deductibles that might need to be met. A single individual or a single breadwinner family will need to have a larger cushion than a dual income household.
In this phase, you are much more sensitive to market fluctuations, particularly downturns. The short-term allocation again acts as an insurance policy. In this case though, it is insurance against bad investment behavior.
The most basic concept of investing is “Buy Low, Sell High.” However, there are mountains of research that show that investors are continually behaving opposite. When in the accumulation phase, the swings in a portfolio don’t have the emotional impact as when those funds are being drawn for income. Downturns during distribution tend to have a larger impact due to the real and perceived need to preserve portfolio value.
Having a Short-Term Reserve in place puts a “buffer” in place instead of needing to liquidate positions for income. When the rest of the portfolio is not performing well, individuals in the distribution phase can pull assets out of the cash reserve, and then replenish those reserves when the portfolio recovers. This will also allow you combat the natural reaction to sell when the portfolio value drops, as there are already reserves in place to meet income needs.
Clearly the Short-Term Reserve plays an important part in portfolio construction. It is a tool to allow the efficient use of other funds. It also acts as a mechanism to temper those bad behaviors we are all prone to.