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.
