How much cash should you have in your portfolio?

When the markets began to tank last fall, investors fled to cash and cash-like investments. No one cared if yields were paltry. The return of principal rather than the return on principal was the biggest priority.

The result today is that you may hold more cash in your portfolio than during the years leading up to the bear market. According to a recent survey of 401(k) plans by Hewitt Associates, investors added 11% to stable-value funds in 2008. (Stable value funds invest in short-term bonds that carry an insurance “wrapper.”)

But with the immediate crisis out of the way (let’s hope), how much cash do you need going forward?

Steven Romick, manager of FPA Crescent Fund, recently stopped by Money’s offices. He says FPA Crescent, which invests in both bonds and stocks, currently has little more than 20% allocated to cash, down from roughly 40% back in September. Romick’s shift makes sense from a long-term perspective. Consider: Today, the average rate on bank money market accounts is only 1.33%, according to Factor in inflation, and cash doesn’t give your portfolio the growth it needs.

But Romick also says this: “The idea that you’re invested at all times [in say, equities] presupposes there is no better deal coming down the road.” In other words, cash gives you flexibility, which you need if you want to be able to pounce on investment opportunities as they arise.

So how much cash should you have ? As always, you’ll have to consider your goals, time horizon and risk tolerance. You’ll also want to look at how much cash is held in the mutual funds you own. Many fund managers, such as Romick, loaded up on greenbacks last year.

If you need to scale back and build up say, your equity or bond allocation, make the shift gradually. And promise yourself you won’t abandon cash altogether during the next market boom.

Finally, remember that separate from your portfolio, you also want emergency savings to cover at least six months of living costs. That money should be kept in a safe, liquid spot, such as a bank savings account.

-Carolyn Bigda

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