Having read the recent article by Roger Nusbaum regarding investing emergency cash, I decided to share the strategy that I use to organize my money as an early retiree. I will also include some variant views.
I organize my money into the following three pools:
1. Emergency cash
My view: This pool contains enough cash to cover approximately one year of living expenses. I do not invest this cash at all and keep it in a checking account for easy access. I agree with Roger in thinking that it is just too risky to take a chance of an even temporary depletion of this pool of cash due to fluctuation of security prices.
Variant view: Emergency cash does not have to be separated from the account which contains securities and can even be invested. With several brokerage houses offering "cash management accounts" that have debit card and check writing privileges, this may be the most convenient option for a disciplined investor. If this cash is not invested, an investor can simply withdraw it when it is needed. If more cash is needed than is available, some securities may be sold to raise it. For example, an investor may sell a losing position to simultaneously raise cash and receive a tax deduction (or offset a gain).
2. Dry powder
My view: I like to keep anywhere between 10% and 25% of my investment account as cash within the brokerage account, ready to be deployed. This cash tends to accumulate when there are few attractive investment opportunities, such as after market run-ups; it tends to run low during market corrections, when there are more securities on sale. These are not hard and fast numbers; if we have another 2008-style market meltdown, all dry powder cash may become invested. Conversely, if the market is grossly overvalued for quite some time, the cash balance may become higher than expected.
Variant view: Having dry powder may reduce performance during bull markets. Instead, an investor may replace cash with very high-quality holdings, such as Berkshire Hathaway. This way, during rising markets, an investor will capture market performance, or even exceed it. During market corrections, holdings like Berkshire Hathaway will probably decrease in price to a much lesser extent than many other stocks. One may then sell a high-quality holding and purchase beaten-down securities that stand to rebound much more vigorously during a market recovery.
My view: As an early retiree, I favor income-producing securities acquired at cheap or at least reasonable prices. I believe that it allows me to live off my investments without depleting the principal. I do allow some non-dividend payers in my portfolio, if I consider their future prospects to be excellent. Should these non-dividend payers become overvalued, I may sell them and exchange them for more attractively priced income-producing securities. I strongly favor companies that buy back their stock for cancellation, increasing the percentage of my ownership of these companies. I like to buy securities that other investors hate at the moment; I am not afraid to look abroad for interesting investment candidates. Occasionally, I may sell put options on stocks that I would really like to own at the strike price minus premium.
Variant view: Please post yours in the comments!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.