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The role of cash in your portfolio

Posted by admin on October 27, 2008 in Investment Strategy

There’s been a recent flight to cash given the relative safety that cash affords to an investor in down-times. But, what is the proper role of cash in one’s portfolio in good or bad times?

Cash is like chocolate. Its great but having too much can be a bad thing. The downside of an over-allocation of cash in a portfolio is the erosion of its value due to inflation. $1.00 does not buy you the equivalent amount of goods the next year since that same bundle of goods now costs $1.00 + rate of inflation. Some may argue that with oil and real estate prices falling, inflation has not become as large of concern. While this argument may be true, the sample size is simply not large enough to say that inflation has been eliminated and let us not forget that the opposite effect, deflation, is generally marked by a long period of economic decline. Thus, inflation is a necessary evil in some sense since it is a tax on increasing demand (and associated economic growth).

Cash can be invested in high-interest bearing accounts and money-market funds to mitigate against the effects of inflation but, outside of tax-deferred retirement or other accounts, interest income is tax-inefficient and taxed heavily relative to dividends and capital gains. If looked through a tax-policy perspective, the government is encouraging you through its tax rates to invest in dividend yield stockand capital appreciating stocks. Thus, even the government doesn’t want you to hold too much cash.

So how much is too much?

1. The longer your investment horizon (or the younger you are), the less cash you should have on hand. This comes down to an opportunity cost argument. If you have an investment horizon over 10 years, you are forgoing opportunities by keeping too much cash on hand and a portion of that cash should be invested. Let’s take an example of opportunity cost. Bank of America is a widely held stock hammered lately. Accordingly to Yahoo Finance, its adjusted stock price (stock price accounting for stock splits and dividend) today is $21.07 (USD). 10 years ago it was $18.84 or a 11% return over that time.  BAC’s return doesn’t sound like much but expand the horizon to 15 years and the return is over 200% over that time. In other words, the longer you stay invested, the greater the spread between return on cash to return on cash invested in equity.
2. If you have a long investing horizon, you should keep cash around for emergencies. I tend to always have liquid enough cash equal to 3-6 months of fixed expenses which I can redeloy to emergencies instead of investment. Its a tough goal to reach but I also know since I have that cushion to play with, losses on the market don’t affect me emotionally as much  (and I have been pounded just like you) since I know I have cash around. It addresses the emotional aspect of investing.
3. Add to #2, an acquisition fund in buying times. This is where things tend to vary person to person. I have read some mutual fund managers have 40-50% in cash right now. I find pegging myself to mutual fund manager allocations to be a dubious proposition. They make MER no matter what so they have no disincentive to hold onto cash longer than possible.  Most mutual funds also have to keep 5-10% in cash in case of resumptions; they have forced liquidity issues. In other words, their context is different than you and me. Generally, target something you want to buy on the cheap and then calculate how much of a war-chest you need to purchase it and keep that in cash.
4. Balance #2 and #3 against #1. A personal choice. I tend to get anxious when cash positions are over 35%-40% in my portfolio. My peg is 5%-10% in good times and 15-20% in bad times (I am always around 15%-25% in fixed income as well). At my age, I can afford to take paper losses and don’t need to cash-out of investments to be in cash. What I do is separate #2 from #3. If there is excess emergency funds, I do not deploy unless there is an absolute great buying opportunity. Its a mind trick against myself. If it sits in the trading account, there is always a tendency to do something with it if there is a lot of cash sitting around.

Now, if you have large portions of cash lying around and are shell-shocked by the market, then perhaps use it to pay down debt. At least the rate of return is known and most likely higher than the return from a money market fund. Again, my point is the same- cash sitting around is lost opportunity cost when you could be having cash make more cash for you by investing or reducing your debt servicing costs.

These are really personal numbers which I freely admit is part science, part art, part personal preference. The key to me, like anything else in life, is to strike a proper balance.

What are people doing with their cash? Creating war-chest? Rainy day funds?