Warren Buffett's Lesson on How Much Cash You Should Really Keep in Retirement
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When he was CEO of Berkshire Hathaway, Warren Buffett was known for keeping billions of the company’s dollars in cash reserves.
The legendary investor has a conservative approach, keeping a cash buffer should the market fall. But he’s also indicated that he keeps so much cash on hand so that he can deploy it for the right opportunities.
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Everyday retirement savers aren’t dealing with as much money as Buffett, but they can use his investing strategies to better their financial plans. If you only have cash, your wealth is vulnerable to inflation. However, if you don’t have enough cash, you may be forced to sell assets during market downturns, which can lock in losses and prevent you from fully capitalizing on rebounds. Buffett has a balanced strategy that involves aggressively investing some money and leaving cash reserves that can help him withstand rainy days.
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Why cash isn’t always as safe as it seems
Cash can seem deceptively safe if you consider its nominal value instead of its real value. If you have $100,000 in the bank and don’t touch it for 10 years, it will still have a nominal value of $100,000.
However, that same $100,000 won’t have as much purchasing power in 10 years as it has right now. Asset prices continue to climb, and the prices of many goods and services continue to get more expensive. Food and housing are some of the things that have gotten more expensive over the past decade.
Not only does your cash lose purchasing power, but you will also miss out on promising investment opportunities. Getting an annualized 10% return, your $100,000 would turn into $259,374 over the next 10 years if you invested it. Many index funds can produce that type of return while having low expense ratios. You miss out on those potential gains by keeping your cash in the bank.
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Why too little cash can be dangerous in retirement
Having too much cash is dangerous, but that doesn’t mean you should swing to the other extreme and have no money in your savings account. If you put your entire net worth into stocks, you will likely have to sell assets to cover living expenses or unexpected expenses like surprise medical bills. That may be fine when the stock market rallies, but you might have to sell equities when the market is in the middle of a sharp correction. Then, you lock in losses and minimize how much you can capitalize on future rebounds.
There's also sequence-of-returns risk to consider as you construct your retirement portfolio. Essentially, if you have to sell more of your assets during a market downturn during the first year of retirement, it becomes more difficult to recover.
Ideally, the first few years of retirement will go smoothly, but you can’t predict the stock market’s performance. A best practice is to have enough cash available to cover one to two years’ of living expenses before you retire. That way, you can hold equities during downturns, giving your retirement portfolio more time to recover.
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What Buffett’s strategy suggests
Buffett’s strategy of keeping ample cash reserves benefited the famed investor for many years. The cash position gives his equities enough time to grow undisturbed, and he can invest in new opportunities without depleting his entire cash position.
It offers the optimal mix between safety and growth. Buffett’s liquidity can cover various expenses and give him the flexibility to stay committed to his positions. Retirees can embrace this mentality by having one to two years’ worth of living expenses in cash. You can also put that money into a high-yield savings account, certificates of deposit (CDs) or short-term bonds that can produce interest.
That buffer will give investors the confidence to keep some of their money in stocks, which can generate significant returns over time and help them support their retirement lifestyle for years (or even decades).