Cash reserves: Tailoring your portfolio's liquidity

As you build and maintain your portfolio over the years, you probably want to know how much of it should be liquid in cash or cash-like investments you can access quickly—holdings like savings, checking and money market accounts and short-term investments.

The answer isn't a simple formula or percentage and instead depends on several factors. Your liquid cash and long-term assets should work together to create a portfolio that's ideal for you and your goals. This mix may change based on the favorability of the economy, on how close you are to reaching your goals and on your comfort level.

Let's dig into those factors and other considerations for allocating your percentage of liquid cash as well as the risks of holding too much cash. Understanding what influences your portfolio's holdings can help you find the right answer for you.

The liquid cash assets in your portfolio should mirror your planned near-term spending on your financial goals. It's generally best to hold enough liquid investments to cover between two and five years' worth of planned spending. When interest rates are high, holding closer to five years' worth of cash can make more sense because you likely won't give up as much in the potential gains your money could generate.

The remainder of your portfolio should remain invested in assets for the long term, such as stocks, equity ETFs and mutual funds. It may be OK to shift some money away from more volatile investments or long-term bonds and into stable, interest-bearing investments when rates are higher.

With this starting point in mind, you'll want to consider other influencing conditions to tailor your ideal cash holdings to your situation.

The primary consideration for how much liquid cash to have in your portfolio are your financial goals. The whole purpose of having cash investments is to be prepared to finance your goals when the time comes. Keep at the forefront how soon you expect to reach your goals—if they're coming up quickly, then you'll want more cash investments; if they're far in the future, then your investments don't need to be nearly as liquid.

One factor that will inevitably influence your plans and goal achievements is the economy. Depending on economic elements like market volatility, interest rates and inflation, there are times when holding more liquid cash can be more or less advantageous than others.

When the stock market experiences large fluctuations over a short time (weeks or months), it can tempt you to move your investments to liquid cash. If your financial goal is near, this could be a wise move—you don't want to risk your money not having time to recover from big losses. But if your goal is far off, you may be better off waiting for the market to inevitably self-regulate.

Depending on what interest rates are, holding large amounts of cash investments can reduce your overall portfolio's growth potential or help give it some stability.

When rates are low, it may be better to hold the minimum amount of cash you need to cover spending on your most immediate goals. The rest of your money should be directed toward other investments like stocks, mutual funds and ETFs.

However, when interest rates are high on liquid investments—such as CDs, money market accounts and bonds—it may be wise to use them to park money you're going to use soon so it's stable but still growing.

You also may want to consider your appetite for risk in the first place. If you have a low risk tolerance and don't like the ups and downs of aggressive assets, it can make sense for you to hold more cash or other stable investments. Higher interest rates can allow you to hold a more conservative investment allocation with a larger cash balance because those types of investments will pay more.

The same may not be true of long-term, interest-bearing investments like bonds. Interest rates change over time, and so will their values. If rates go even higher, bond prices will fall. However, it's usually less of an issue if you plan to hold them long-term. Bonds—unlike stocks—are debt obligations that return the full amount of the principal at maturity regardless of how their prices change in the market.

When inflation is high, your cash investments may not gain enough earnings to keep up. Especially if you're holding cash in high inflation conditions for a long time, your purchasing power will fall. However, when cash investments are paying out at a higher rate than the inflation rate and your goal is coming up soon, it could be smart to increase your portfolio's liquid cash percentage.

Where should you keep your cash?

Regardless of market conditions, some of the most popular account and asset types for holding your cash tend to stay the same.

Explore the best options

Here are a few situations to illustrate how all of these factors could come together to influence your decision about how much liquid cash to hold.

Start your evaluation with your goal in mind. Let's say your teenager is headed to college next year, and you want to pay for their education. The market's been volatile and inflation spiked and then cooled, but interest rates on cash-like assets are high at the moment.

In this case, you'd likely want more liquid cash in your portfolio both because economic conditions are favorable and because you're close to needing to tap into your money. You'll likely want to have stable, liquid investments this close to college time because in the market, your money may not have time to recover from big losses before tuition comes due.

Let's say another of your major goals is saving to buy vacation property about 20 years from now. The part of your portfolio dedicated to that goal generally can stay less liquid based on the longer time horizon. However, assume again that markets are volatile, inflation has fallen following a peak, and interest rates are high. You may be tempted to shift more of your investments to cash-like options. But if you make this decision for your far-off future based on short-term economic conditions, you may lose out in the end.

Staying the course with investments designed for the long-term ups and downs of the market may be better than limiting your holdings to cash. That's because long-run returns on more volatile assets tend to be better than the interest you can earn on cash. For example, the historical average return of the S&P 500 is a little over 10%.

Planning for retirement income is different from other types of financial goals because it isn't a one-time expense. Your savings for this may need to last for decades. So it's important to plan carefully and balance your investments in a way that supports both your short- and long-term spending needs. It's one reason the classic 60/40 portfolio tends to be a good fit for retirees. Holding 60% in stocks (less liquid and sometimes more aggressive) and 40% in bonds (more liquid and sometimes more conservative) can provide a sense of balance.

Holding cash and cash-like investments has some significant benefits. It can provide a stable buffer against fluctuating investment values. While your market investments may have drastic gains and losses in the short term, cash stays fairly steady. It's also readily accessible, so you don't have to sell anything and wait for funds to settle when you need to move it or spend it quickly.

Even though cash investments can provide stability and a sense of security, they aren't without potential risks. These are the key drawbacks:

• Regardless of how high interest rates are, liquid cash investments are not likely to perform as well as other investments over a long time. Most people need some of the growth that equity investments can provide to reach their savings goals or ensure their portfolio lasts throughout retirement.

• Interest rates change continuously. If you hold a large cash balance and interest rates drop, your savings will not pay as much as they might have earned elsewhere.

• Certain cash holdings with banks, such as CDs and high-yield savings accounts, come with FDIC insurance protection. This can provide some assurance your money isn't at risk, but the FDIC limits coverage to $250,000 per person, per account type, per institution. If your cash balance is too large, it may not be fully covered.