Monday, February 18, 2013

Cash in your Portfolio-It has a Purpose

Cash, defined as holdings of Money Market Mutual Funds, or short term US Treasuries can be an important part of your investment portfolio, particularly in times of uncertainty.  Unfortunately, the value of this asset class is often misunderstood and underappreciated by the non-professional investor.  Cash is not “lazy money” and the correct understanding of it’s strategic purpose and value is a major part of wealth management.
An investment portfolio is a collection of assets held in an account or group of accounts with the goal of achieving a certain targeted, long term rate of return, with a corresponding level of acceptable risk.  The management of the portfolio involves the selection of an appropriate asset allocation and the selection of individual securities fitting that allocation. Another name for asset allocation is the identification and selection of the appropriate investment categories, classifications, and/or types.

Most people understand simple  types of asset allocation, for example one popular “conservative” allocation is referred to as 60% stocks and 40% fixed income.  However, effective asset allocation involves the assignment of allocations to a much larger list of investment categories.  In other words, even in a simple portfolio, the allocation of stocks involves assignment to domestic, global and international as well as various business sectors, size or capitalization, investment categories like growth and/or value as well as geographical areas. The allocation of fixed income involves assignment to domestic, global, and international, categories like government and corporate as well as maturity dates and credit ratings. It is much more complex than just a certain % of stocks and % of bonds. (Cash is a part of the fixed income allocation with high credit rating and short maturity.) Picking the correct asset allocation has proven to be more important than the actual selection of individual securities in most cases. Academics vary in their opinions with some saying 90% of the return is determined by asset allocation; others claim that securities selection and asset allocation are equally important. In any case, asset allocation, including how much is allocated to Cash at any one time is very important.
Cash is the only asset in the investment portfolio that does not fluctuate in value. (It can decline in value over time if the interest earned does not exceed the rate of inflation.)  Generally, all forms of fixed income investments are thought to be “stable” in value.  However there are periods (like now) when fixed income investments are subject to significant fluctuations in value. An appropriate amount of Cash during these periods becomes even more important.

In addition to its role of providing a stable component of the fixed income part of a portfolio, Cash also is a tool to be used to increase expected returns by buying during periods when markets are undervalued.  The more volatile the market and the more uncertainty there is—generally the more appropriate it is for a higher level of cash.
Rather than getting too deep in the weeds with an academic discussion, let’s examine the use of cash by arguably one of the most successful investors of all time: Warren Buffet.  During the period from 2010 thru 2012, the average amount of “cash” held by Buffet’s Berkshire Hathaway in their “investment portfolio”  has been reported to have ranged from 19-23% of the total portfolio.

The decision to use cash for purchases of securities is particularly critical when new funds are added to the portfolio—now the decision of when to buy in the short term becomes essential and critical to achieving the investment goals for the long term.  Hence,  portfolios with “new” cash will tend to have a higher level of cash for a time.  And, generally,  more mature “fully invested” portfolio’s will tend to have a relatively lower level.  Managing a portfolio is always a matter of making the judgment of Buy, Sell or Hold.  Sometimes in uncertain environments, the status quo or “HOLD” is the best course of action.
It is sometimes difficult to create a truly useful analogy in order to illustrate a point, but in this case I like to remind investors that professionally managing an investment portfolio is very much like being the Captain of an ocean liner.  The sea can be a dangerous place, but reaching the ultimate destination is generally worth the risks.  Sometimes, when he senses danger or uncertainty, a wise Captain decides to run at less than full throttle—maybe a speed of 10 knots instead of 22.  Despite a series of warnings from other ships of drifting ice in the area, the unwise Captain of the infamous Titanic was sailing at maximum speed of 22 knots, in the dark at night, just before hitting the iceberg and sinking. (The Captain of the Titanic was managing performance and was neglecting the important aspect of also managing risk and uncertainty.) Keeping some Cash in the portfolio is a little like running the ship at less than full throttle during periods when the Captain senses there is risk and uncertainty—perhaps that is when he produces the greatest value to the passengers (investors).  

The ocean liner analogy also helps illustrate the value of a higher level of cash being held for a period just after “new” cash is added from a rollover or transfer.  It is well known that ships can handle big waves once “out to sea” but exiting the harbor during a big storm can be particularly dangerous. So, a wise Captain runs the ship a bit slower while in shallow waters near the shore and typically does not run the ship at top speed until it is well out to sea. 

Hopefully we are soon approaching a period of less uncertainty and perhaps lower risk. But we are not there yet.  Be cautious but not too cautious.

This paper is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. Opinions provided are exclusively those of Wayne Strout and are not the opinions by any financial institution. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.