The 10% Rule
One of the most controversial topics in personal finance is the role of cash and how much of your investment portfolio to keep in cash. Some people refer to cash as trash while others prefer the risk adversity of cash. I’ve read and debated both sides, but ultimately the strategy that I follow is to aim for 10% of my investment portfolio in cash at all times. The important thing to note here is that this is 10% of my investment portfolio so this is on top of my emergency fund. I’ll highlight the two main reasons (flexibility and psychology), but also explain tactically how I aim for 10% — aim is important because it’s impossible to get 10% at all times given how fast the market moves.
Cash is flexibility.
This is one of the most important levers that cash gives you and the main reason why I always have some cash to invest. While I never try to time the market, there are times when I see an opportunity to invest and I always want to have some cash to make that opportunistic investment. Having a cash position allows me to be more strategic and flexible when I may otherwise have all my funds tied up and have to sell something to buy something else. An example in my personal life was the market significantly traded off when Brexit was announced in 2017. I took the opportunity to buy companies that I wanted to invest in that sold off with the market, but had no financial impact of Brexit. It was a huge win for me because I had the flexibility to invest when the opportunity presented itself.
It’s wise for investors “to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffet
The 10% rule helps to achieve one of Warren Buffet’s most famous sayings because it will force you to save more cash during a bull run (when others are greedy) and invest more when stocks are declining (when others are fearful). As an example: you start with $90 in stocks and $10 in cash. If the market goes up 20% your stocks are worth $108 and your cash position is still $10. You would need to fund your cash position with another $1.8 to maintain your 10% rule. This rule prevents you from over-investing during times when the stock market is in a bull run. The opposite is true in a decline – you are forced to invest even if you are fearful.
How I execute the 10% rule.
Tactically, I review my portfolio every month to understand what my asset allocation looks like. If i am under allocated in cash, I’ll turn off my automatic dividend reinvestment through my broker. While I generally prefer to have my dividends automatically reinvested turning them off is a good way to build into a higher cash position without selling stocks and incurring taxes. I rarely (if ever) sell a stock just to build a cash position – I only sell a stock if my long-term thesis has changed and I am not longer interested in it. I will look for almost any other way to build a cash position that doesn’t require selling stocks.
It may sound simple (and it is), but executing any asset allocation strategy takes time and effort. In my opinion, this time and effort is what sets apart successful investors from everyone else. It’s also a good self-discipline strategy that will prevent you from chasing a market in a bull run.
