When people discuss their investing portfolios, they typically refer to the stocks, bonds, commodities and real estate they hold. The conversation might also include model weightings, tilt toward and away from different asset classes, and rebalancing. What we rarely hear about is cash.
Much of the traditional thinking about cash is well intentioned but unrealistic. Should you have six months of living expenses in the bank for emergencies? Sure. Do you? Probably not. In over 20 years of working in finance, I simply never see that sort of cash cushion among average investors of ordinary means. It is a luxury that only the wealthiest can afford.
We looked at a related issue earlier this year when discussing “How to get back into the market after you missed a big rally.” That also involved the issue of cash being a drag on portfolio returns. The context there was investors who had gotten skittish, had sold out of various positions and then found themselves unable to muster the discipline to redeploy cash back into risk assets.
That is not the cash matter I want to discuss today. It’s this: How much cash should there be in your investment portfolios? You may not have given it much thought. It seems to be coming up a lot among the ultra-wealthy. As mentioned before, many of the investment firms that service the wealthy have discovered that these folks are sitting on mountains of cash. Broad surveys from the likes of U.S. Trust, BlackRock, UBS, even American Express have shown that their high-net-worth clients are cash-heavy and, in many cases, asset-light.
Why the ultra-wealthy have decided to sit in an asset class that loses value by the second with even modest inflation can most likely be explained by psychology. Call it the “recency effect” — investors are still shellshocked by the four asset crashes in a decade. From their peak years, we had technology/dot-coms fall about 80 percent (2000-02). Housing dropped 35 percent (2005-09), including the related falls in home builders, banks and investment firms of 75 percent. Equity markets crashed 57 percent (2007-09). And, lastly, commodities are off their highs anywhere from 30 to 50 percent (2011-13). Is it any surprise that investors are skittish?
Perhaps the financial media bear some blame. There has been nonstop bubble talk. We read that stocks are over-valued. We are told they carry high cyclically adjusted price-earnings valuations relative to GDP. Earnings are at record highs, which is somehow a bad thing. The Dow, the Standard & Poor’s 500-stock index and the Russell 2000 keep making record highs, which also is somehow portrayed as bearish. As a side note, let me point out that markets averaged 30 all-time highs per year from 1982 to 2000. Although none of these issues is new, it has been a persistent condition among the commentariat since this bull market began in March 2009. I called this the most hated rally in Wall Street history that year; the vitriol has only gotten worse since.
Back to cash and how much to hold in a portfolio. It really depends on who you are, how you are investing and your investment horizon. A hedge fund manager whose clients demand monthly performance reports has different needs than any individual investors with a 20-year time horizon. The needs of that long-term investor differ markedly from someone who is retiring in three years.
Warren Buffett has patiently held as much as $20 billion to $40 billion in cash. He thinks of cash not just as an “asset class that is returning next to nothing,” but rather as “a call option that can be priced, relative to the ability of cash to buy assets.” He put that to good use during the financial crisis, scooping up deeply discounted bargains.
Most investors lack Buffett’s discipline. When markets are rallying, cash in the portfolio is a drag on performance, returning about zero. The argument I hear for cash in the portfolio is it doesn’t go down during market crashes, and it allows the purchases of cheap assets a la Buffett at attractive prices. But investors rarely can make that buy when markets are crashing. They are simply too scared, lacking the fortitude or the nerve to pull the trigger. Even those who managed to avoid the 2008 crash found themselves stuck with way too much cash in their portfolios as markets recovered. Up more than 150 percent since the 2009 lows, many are wondering what to do.
Exactly how much cash are we talking? BlackRock President Rob Kapito noted in a Wall Street Journal interview last month that “on average, more than half of portfolios are in cash, earning negative real returns . . . 48 percent of U.S. respondents’ investible assets are in cash deposit and savings accounts, and an additional 12 percent are in money-market accounts and certificates of deposit.”
About 60 percent is a shocking figure — and when we put this in dollar terms, it’s even more astounding. American Express’s survey of affluent Americans — those folks with at least $100,000 in disposable income — discovered $6 trillion in cash savings. Again, that is a stunningly large number.
The alternative to stocks for the skittish is, obviously, fixed income. Given the inevitable increase in rates, many investors have liquidated bonds, further raising their cash balances. Rather than try to time the bond market, the solution here is to hold a ladder of individual A-rated bonds — not a fund subject to redemptions — that will mature over the next three to seven years. As this paper reaches its maturity over time, you simply roll into a similar bond at what is likely to be a higher yield. That is a better strategy than holding cash for the next seven years.
The bottom line is this: Cash, in modest increments, has a role in any portfolio. But unless you are Warren Buffett, you should limit it to 2 or 3 percent. Otherwise, you are likely to miss the next bull market. Too many people have already missed this one.