"Cash rallied big time yesterday!" This was my standard greeting for a fellow investor during the last bear market. "Yep," he would reply glumly, "about 2%." It became the tag line of our meetings at the club workout room. Bystanders looked at us as if we had lost our minds.
What we meant was that the stock indexes had dropped another 2%. That was the amount our stock portfolios had fallen, and the increase in the amount of stock our cash reserves could buy. Cash, of course, doesn't rally. It also doesn't crash. Stocks rally and crash. Bonds rally and collapse. The value of your home goes up and down, sometimes a lot more and a lot faster than you would think. Gold goes wild on the upside or downside or sits doing nothing for years for no rhyme nor reason that I can discern. But cash doesn't go up and down. It is always worth what it says on the face of the bill. Cash is what other things are measured against.
Cash doesn't rally or crash, but then again it does, in a way. On the one hand cash is nothing but...well, you can buy things with it. You can't eat it or drink it or use it for shade. It's just like gold except that you can hammer gold into jewelry and maybe feel better about yourself. Cash is just a store of value or a medium of exchange, but nothing in itself. But that's not quite true. Cash is nothing and cash is everything. With a little inversion - like the dialogue with my friend in the weight room - you see that cash does in fact go up and down in value when measured against everything else - including the markets. Think about people who were holding a good bit of it in 2007 and 2008, then think about people who weren't. Cash rallied furiously against stocks for about a year and a half, and you were much happier if you had quite a bit of it. You never really know what stocks and bonds are about to do, so you need to hold at least some cash in your investment portfolio. But how much? And in what vehicle?
Accept It: This Is A Weird Rate Environment
We are living in an unusual time for money rates - as if you didn't already know. The first abnormal thing is that you can't earn anything to speak of on cash. The 1-year rate on T-Bills is .12%, and it is reflected in most short term rates, such as bank CDs and money market funds. You can't earn squat on short term money invested safely. This makes for a hard decision for folks who badly need to do exactly that with some of their money - old folks or folks with a big liability hanging over their heads pretty soon (kids' college costs). The situation doesn't get much better even if you go out three years - just .62%. That's truly a parking place for money, not a source of return.
But there's another oddity. The yield curve is actually quite steep, not because long term bonds offer a high rate (it's 2.77% on the 10-year Treasury, 3.55% for 20 years, and 3.84% for 30 years - all as of yesterday's close as I write). Yet all of these rates are below the long term average. A steep yield curve usually means businesses and individuals are motivated to borrow and things are looking up in the economy - and this may be true to a very small degree - but the main reason the current curve is steep is that the Fed is able to step on short term rates even harder than it can step on long term rates. For some thoughts about how this situation came to be and what it may imply for the future I refer you to my earlier article, titled Investment Advice For An Abnormal - And Very Tough - Time.
The important thing for the income investor is that this situation creates some difficult decisions. The obvious problem is that neither cash nor bonds offer anything close to the normal expected return of that asset class. This throws everything off. What should that do to your asset allocation? That is a hard question, and it cannot be answered in a few sentences, if it can be answered at all. The true answer is that you should open the question of asset allocation by understanding that we live in an abnormal environment in which short term and long term investment assumptions may not coincide.
A second consideration, touched upon in my earlier article, is that quite a bit of long term equity return is a result of changes in interest rates. It comes as a shock to many people that quite a bit of the wonderful annualized stock market returns from 1982 to 2000 (about 18%) actually came from a rising P/E highly correlated to a falling interest rate. How do we know this? Well, here's a suggestive fact. You would have done almost as well in 1982 by buying a Zero-Coupon Treasury Bond as by buying stocks, and without the equity risk. Stocks added just a bit in the manic run-up to 2000, but bonds more than caught up by continuing to rally through the 2000-2002 and 2007-2008 crashes. You could have bought Treasury Zero Coupons and comfortably taken a 25-year snooze.
This is a movie which can run backwards as well as forward. What should we suppose might happen if the opposite took place? What if bonds steadily lost value and rates crept up for forty years or so as they did beginning in the 1940s? There is a debate about what happens to stocks as rates creep up. Nothing bad may happen for quite a while, if the rise is gradual, but ultimately the same force that lifted stocks as bond rates declined will present a headwind as rates rise and provide more competition. That much, I think, is more arithmetic than opinion. The real question is whether history will exactly repeat the past (1941 to 1957) or if small differences of circumstance will make the adjustment more abrupt and painful.
The answer to this question is uncertain. We may analyze and have opinions on it, but we must ultimately acknowledge the uncertainty. Uncertainty is the primary investment reason for holding cash. If the present condition were sure to be permanent you might go to zero cash and load up completely on solid dividend companies. At the current level of rates they look better than cash. Unfortunately, nobody knows the future.
In Praise of Cash
Cash is a lovely thing. More lovely yet is the fact that it produces a bit of a return, however slight that return may sometimes be. I can still remember my excitement when I learned that my first passbook savings account (I want to say about 1954) would take $100 from me and return $102 at the end of one year. Golly gee! Wow! Free money! Parking your paper route money for a year at the local Savings and Loan didn't seem like a bad thing at all.
Everybody needs a certain amount of ready cash. Personally, I like to pay actual cash for almost everything. I put a certain amount in my wallet, watch it pass from my hands to somebody else, and have a pretty good idea what I am spending and on what. It's not necessary to be as anal about it as I am, but everybody needs a little walking-around money. We also need a couple of kinds of reserves. One is an emergency reserve in case your boss calls you in for that uncomfortable conversation or some big unexpected problem or opportunity comes up. Unless you have a totally reliable income stream I suggest six months to a year of living expenses. I try to always have six months even though I have a pension. I'm sort of a conservative nut, but my pension happens to be paid by the state of Illinois (woe, woe).
The next step is the amount of cash you hold as a reserve in your investment portfolio. Do this: think of yourself as an insurance company. Insurance companies have a problem similar to yours and mine. They have to get through the moment and pay their bills and they have to pay lumpy bills as they go along (taxes, for instance). They also have to look ahead to payments they may be required to make to their policy holders at some point in the future - payments which are somewhat but imperfectly predictable. This sounds a lot like the situation of most individuals. The present moment is tough on insurance companies because of low rates. They have to offset future obligations which are only roughly predictable by buying safe assets that will come due when needed. The return on safe assets right now - as you and I know - is squat. It's tough on us too.
Think of Warren Buffett and Berkshire Hathaway (NYSE:BRK.A). I'll bet he walks around with about the same amount in his wallet that I do - enough that he won't look like Scrooge if he meets a friend for lunch. Neither of us is worth the trouble to mug. At Berkshire, however, he always keeps around 20 billion just in case Southern Florida is taken out in a tidal wave and he has reinsured most of it. Above that 20 bil, the amount of cash he holds at Berkshire reflects his ability to invest it in ways that he considers safe and likely to give a better return. He is good at this, you may have noticed.
Around the bottom of the market in 2009 he was buying stocks and companies and striking deals like crazy and telling people in editorials that they should do the same thing. This proved to be good advice. Right now he is still willing to buy things if he can get a deal that is just right, but he is slowing down on this and turning away deals that don't seem absolutely perfect. When asked on TV what he thinks of the market, he sort of squirms and hedges. He is holding more than 40 billion of - you guessed it - cash! And it is growing at more than 2 billion a month! His approach is clearly a little more balanced than it was in 2009. It's a good idea to pay attention to this. Buffett is frequently right.
Buffett is holding a fair amount of cash right now even though his investment opportunities in risk assets are better than yours and mine. This isn't just because he's a great stock picker but because these days he mainly buys whole companies which produce a cash flow that is more steady and more likely to grow predictably than the total return offered by owning a part of a company (shares of stock). Why is he willing to hold extra cash? One reason is that he expects a better deal may be offered by the market tomorrow. Another - and a really important one - is that the cost of holding cash is low at this particular moment.
Think back to the year 1980. It was about exactly as abnormal as the current year - except in the opposite direction. Stocks were selling at 7 or 8 times earnings - even great companies. The rate on T Bills bounced between 10% and 20%. Long term Treasury bonds offered the high teens. Great! The catch was that inflation was also in the mid teens. "Lock-in" was the big word. Should you "lock in" the current rates with long term bonds? A lot of people didn't think so. The yield curve was upside down (short duration at higher rates than long) and the economy looked awful. Earning 15% on your cash looked pretty good. Now here's the strange thing: the real return on cash in 1980 wasn't very different from what it is right now. You would have had to be pretty quick on your feet to catch the T Bill rate above 15%, so let's say you caught the low middle - 13%. The inflation rate was 14%. You were getting about 1% negative real return.
But what about today? The most recent Urban CPI was 1.18%. The most recent 1-year T Bill rate was .12%. You are getting - you got it - 1% negative real return. One thing this does is confirm a Buffett comment that inflation is the great enemy of investors, whether in cash, bonds, or stocks. Another insight is that market implications are counterintuitive. The year 1980 was close to the worst time in U.S. history to hold short-term cash. You should have been furiously piling your money into stocks and long-term bonds, buying them with cash hand over fist. The return on cash looked better than it was. Now, conversely, the return on cash isn't nearly as bad as it looks. Zero return isn't really so bad if the inflation rate is just over 1%. Stocks and bonds that have been massaged and caressed by these low rates may not be quite as good a deal as they seem to be. Anyway it doesn't cost you much to park some cash for future opportunities. The current situation provides cash with a low hurdle.
Two or three years from now this advice may look silly if stocks keep ripping ahead and rates go up only a little bit. You will kick yourself, I will kick myself. But good investors are always kicking themselves. If a part of their portfolios did well while other parts stagnated, they kick themselves for not being more heavily in the good parts. I do it every day. But we really don't know what the good parts will be - stocks, bonds, cash, gold, whatever. You can try to think intelligently about the future, but you can't predict it. People who say they can aren't being straight with you, or with themselves. Holding cash is your personal insurance policy against the wall of uncertainty you just can't get through.
How much cash? It depends - your age, your investment goals, your level of conviction about what's going to happen in the future. Buffett is holding a good bit more than he was happy to hold a year or two ago. I'll leave it at that. And here's some good news. You are able to do some things with your cash that Buffett can't do with his. Let's consider a few of them.
Some Clever Ways Of Holding Cash
The tough part of investing is to manage your asset allocation so that it solves the needs of several time frames and a variety of possible futures. At the present moment the return on cash looks absolutely horrible while stocks and bonds look decent by comparison, but in the future things may well look very different. It is important to remember that the present moment is rather odd, and likely to change over the longer term. A young working person in her twenties, for instance, will have a very different view of cash and investment return than a person in his 60s, 70s, or 80s who must live at least partly off of investment income right now. For that reason I will break down my suggestions to those that apply to young folks, old folks, and all folks.
1. For Millennials
(1) At the risk of sounding like a personal finance columnist I encourage you to keep enough cash in ready accounts for unexpected events or sudden job changes. Include a bit for things you will not have thought about. This isn't investment money. It's survival money.
(2) After doing that, most people in their 20s and 30s don't have to think about cash very much as an investment. Just find the appropriate cheap index fund or balanced fund and dump a percentage of your income into it every month. Don't even look at your statements. Young folks are fundamentally growth investors and income investors only in passing. Twenty or thirty years will pass, believe me they will, and you will possibly have gotten sophisticated and financially savvy. In any case when you start opening your statements, think of me for about two seconds. Send your good wishes in my direction, wherever I may be.
(3) Pay down expensive debt. You may not want to do this with your mortgage because the tax advantage makes it cheap debt, but whack any credit card debt or other expensive loans to the maximum you can afford. Is this a proper way of holding cash? Yes it is. Debt is negative cash with a negative monthly cost. Killing off debt is a means of getting your cash reserve positive and the return may be very lucrative.
(4) Prepay for things. If there are things you know you will have to have, you should buy them on sale. There is an obvious return on this. This suggestion doesn't apply to Gucci handbags.
2. For Everybody
(1) Do you belong to a credit union? Credit unions often offer better rates than banks. Mine does. Bear in mind that they are not quite as safe as banks. They are covered by various credit union insurance entities, but the guarantee is not as ironclad as the $250K per individual FDIC guarantee of bank accounts and bank CDs.
(2) I Bonds are a wonderful "parking place" for cash, mainly because they offer a small (but better than money market or bank) return with no risk and truly wonderful flexibility. They are a form of U.S. savings bond, thus risk free. They currently offer a rate that assures you will beat whatever inflation comes. The rate re-prices in May and November and was recently reset upward to a .20% fixed amount plus the increase in Urban CPI compounded semi-annually. They thus provide an inflation hedge, but also a current return of 1.38%. This is a far better deal than T-Bills, exceeding the return on Treasuries until you go out about four years.
But wait, there's a lot more to I Bonds. After one year if you want your money back, you can recover the value of your bonds with only a sacrifice of 3 months return; you'll still be getting more than any Treasury instrument of shorter duration than 4 years. And they insure against deflation as well as inflation. If we have deflation, the bonds simply freeze; they don't go down. If you don't like earning zero for a while, first remember that your real return is actually positive, and if you still don't like it, wait three months (no loss at all) and get your money back at the highest value of your bond. What can beat that? If inflation kicks up in a serious way, you just hold on for as long as 30 years as their return goes up with it.
So what's the catch? The only catch is the limited amount you can buy - $10,000 per individual per year, but, let's see, if you have a husband/wife, some kids, some grand-kids, etc, the amount goes up. You buy the bonds by going on-line to Treasury Direct and they walk you through it. Oh, and you can also put up to $5000 of your Federal tax refund into an I Bond which will be mailed to you as a paper bond. Buffett would probably do this for 10 billion or so if he could, but he can't. Ten or fifteen or twenty-five thousand bucks doesn't move the needle for Buffett, but if your assets are a million or less, even higher, it's a great place to park some cash. In fact, even if you have several millions, it's worth the tiny bit of trouble to put the first bit of your cash reserve into I Bonds. P.S.: You can defer the Federal tax if you choose to, and they are exempt from state taxes as Federal debt instruments.
(3) If you are sophisticated and have larger assets, you can take a shot at manufacturing yield by riding down the yield curve - buying Treasury Bonds about 5 years out and selling when the time until expiration comes down to about 3 years. Bill Gross of PIMCO, the "bond king," is a big proponent of this strategy. If you have never heard of Bill Gross, you may not be sophisticated enough to do this. You should certainly understand its full implications. It works best if rates stay about the same or go down.
Here's the trick. The five-year rate is 1.42% (as of last Friday); that's 7.1% cumulative over five years. The three-year rate on Friday was .62%, or 1.86% cumulative over three years. You sell the bonds when they hit this rate and pocket the higher return on the five year of 5.14% or 2.57% annualized. Not much, but a lot better than the .32% offered by buying the two year straight up. The worst thing that will happen to you is a general upward move in rates, in which case you would hold your Treasuries to maturity and get 1.42% over five years. You need to do this with a reasonable amount of money and be willing to hold for five years at the current rate if you are wrong. Otherwise you may take a small loss. It's the only one of these strategies that requires sophistication in awareness of risks.
3. For Old Folks, Or Folks Looking Quite a Bit Ahead (Old Folk Wannabes)
(1) If you are into your sixties but healthy enough that you expect to live to at least 83, you might choose to use some cash to live on and defer taking your Social Security until the year you turn 70 and a half. The Social Security system offers you a stupendous reward for doing this: 8% per year compounded from your age of full eligibility, or about 32%. This is an outstanding risk free return in the current environment. No less an authority than John Bogle recently suggested considering Social Security or other secure pensions as if they were actual assets, at least for the purpose of asset allocation. Looking at it this way, deferring Social Security adds to a valuable and very secure fixed asset with an inflation adjustment. It's a very smart thing to do if you don't absolutely need the income right now. Of course, if you die much before the age of 83 (the magic over/under actuarial number for Social Security), you lose the bet. At least you won't be around to kick yourself, and your dependents may do very well.
(2) If you are already 83 or older, have some assets, but are short on income, you should...consider dipping into principle. There, I said it. It made my fingers hurt to type it. It's exactly what we train ourselves never to do. But you know what? It's what I tell my older relatives, and there's a good reason. A lot of the stuff that elderly income seekers are persuaded or pressured into buying actually dips into principle anyway. They just don't tell you. MLPs, for example, often provide an income stream which is in part return of capital. Other things my elderly relatives keep running by me include gimmicky instruments like principle-protected vehicles with some promise of participation in an index return. Just be aware that they have high costs and seldom work out the way you hope; it's the company that puts them together and the broker who sells them to you who are dipping into your principle. In fact, income stocks which have the possibility of a drawdown may effectively risk dipping into principle when considered on a total return basis. Stocks can go down, even good ones. Sometimes you are forced to sell by circumstances you don't foresee. Why not just judiciously dip into principle ever so slightly? Take that cruise with cash from a maturing muni rather than reaching too hard for return.
Try to come to a reasonable perspective about what cash should be in your investment portfolio. Consider your age. Consider the times we live in. I can't tell you how large your cash reserve should be, but I can tell you that except for the very young all investors should hold some cash in their portfolios, even those with a very strong bullish view of the market. I will add that I am currently holding a bit more than I usually do, not an enormous amount but a bit, and so is Buffett. Don't think cash is trash. It doesn't go up, but it also doesn't go down. Learn to embrace it.
Additional disclosure: I own I Bonds and credit union CDs.