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  • Nicholas Pihl

Should I Invest My Cash Reserve?

For any money you'll need within a year or less, I wouldn't recommend investing your cash reserve in anything riskier than very short term (less than one year), very high quality bonds. Treasury Bills are a good example. But given the short timeframe, and the fact that yields on these assets are pretty low, there's not a huge dollar benefit from investing this money in anything vs leaving it in cash.


Conversely, for money that you want to invest aggressively, I'd recommend a 5-7 year holding period (depending on your situation) to increase your likelihood of getting a good result. Over shorter time horizons, higher return assets like stocks and REITs can be really volatile, and carry no guarantee of a good return over this timeframe. They typically do great over the long run, though.


Where you arguably have a bit more wiggle room is in that medium-term 2-5 year window. Now, not everybody has a 2-5 year cash reserve so this might not affect you if you plan on working for the next 2-5 years, or don't have any major purchases planned over this time horizon.


The value of investing this money comes from the fact that these funds may not be needed for several years, or maybe ever. This can result in a large supply of "safe money," held for opportunities or pitfalls that may never materialize. This uninvested money creates a drag on the growth of their net worth, and almost certainly lags inflation.


This is most relevant for people who do foresee a major purchase or cash need in the next few years that will take more money than they can come up with on short notice. Often, the timing of this event is a little uncertain, depending on life circumstances and market conditions. This potentially includes a broad range of people, including business owners, real estate investors, prospective retirees, and anyone who wants to take a prolonged sabbatical from their work, whether to change careers, travel, or spend a few years as a full time parent.


In other words, this could be interesting for anyone who needs to keep a large amount liquid for 2-5 years (or indefinitely).


Throughout this 2-5 year window, it is important that the money is liquid and available for you. At the same time, it's enough money that leaving this amount uninvested over the long term leads to a pretty big gap in net worth, as well as loss of purchasing power due to inflation. Here's a comparison illustrating the impact of keeping $300,000 invested at 5%, vs keeping it in cash at 0%.


This chart assumes a 5% nominal annual growth rate for the invested portion, and a 0% growth rate for the uninvested portion. The value of investing this money, even if not at the 10% historical rate of return for stocks, should be apparent as the investor ends up with over one million dollars more ($1,037,266.17) than they would have had otherwise! The profits from investing this cash reserve can be used to scale up the cash reserve as the business grows, or reallocated to other investments like stocks and real estate for even higher returns.


Returning to the investment allocation discussion, the possibility that this money might be needed in the next 2-5 years means it should be invested fairly conservatively. At the same time, investing it too conservatively risks having insufficient assets later on. Exactly what risk/reward profile to select will depend on a nuanced and holistic understanding of the business owner's situation. This is best developed through thoughtful, personal, conversations with a financial advisor, like Nicholas.


Again, this may not be for everybody. But there are some people who have this cash on hand, for whom the fear of volatility and potential loss of value is outweighed by their desire for growth that keeps pace with inflation.


For these people, you can craft a portfolio with low volatility (not zero volatility), that offers a decent rate of return over this window.


Here's what that performance has looked like historically. Going forward, I expect slightly lower returns with similar volatility. I'd assume 5% vs the 5.81% CAGR referenced here.

In terms of risk, the key points here are a "max drawdown" peak-to-trough of -8.46%, and a "worst year" (any 12 month period) -2.34%. Those reflect the amount you might expect to lose at any point along the way, though of course, this is no guarantee of future performance.


These results reflect the portfolio below, rebalanced monthly, in which historical risk and return data were used as inputs to a Monte Carlo simulation. This means these projections are more likely to hold up across a broad range of future scenarios, compared with a "hindsight-based" backtest. But again, this is no guarantee of future results.

Here's the portfolio:


As you can see, very little is invested in risky assets. Roughly 75% of the portfolio is held in cash and long term treasuries. These tend to hold their value even when the stock market declines. The remaining 25% of the portfolio is invested in a mix of stocks, real estate, and gold.


Bonds have slightly more risk and higher returns than cash, but substantially less risk and return than the riskier assets in this portfolio.The idea here is that 25% of this portfolio is invested for growth, while 75% is held as ballast against future stock market declines. The result is a portfolio with shorter, shallower drawdowns, and more consistent results than an all-equities portfolio would provide. It sacrifices higher returns for greater predictability.


For a medium-term portfolio, this could be worth exploring. Again, the appropriateness of this strategy depends almost entirely on your individual circumstances and preferences, and I would not recommend implementing this on your own or without consulting a professional. This is just an illustration of a model portfolio, not an investment recommendation.


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First off, let me say, this isn't advice tailored to your individual situation. HSAs aren't a good fit for everybody, as I discuss at the end of this article. But if it's a good fit, HSAs can be prett