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Portfolio construction or asset allocation questions are often given less thought than they deserve. What people do with their disposable income, especially early in their careers, has a very meaningful impact on their income and net worth later in life. Disposable income requires a decision between competing choices; between making a down payment for buying a house or renting a house, how much to invest and how much to save for a rainy day. Once disposable income is created (not all income is spent) and a decision is made to invest part of that money with a long-term view, the next problem is all about portfolio construction or asset allocation.

A lot has been written about asset allocation, and several rules of thumb have been developed to help guide investors. One of the most common, at least until bond yields became so depressed, was the "fixed income allocation should equal age" rule. This rule suggests that the percentage of fixed income assets in a portfolio should equal the investor's age. If you are 40, then 40% of should be your fixed income allocation; the rest is assumed to be "riskier" assets such as stocks. I will leave the discussion about the riskiness of stocks for some other time. So leaving the "risk asset" side of portfolio construction aside for now, another determination is how much cash should a portfolio hold.

Cash is a terrible asset to have as part of almost any long-term investment portfolio, except for liability driven portfolios, which cannot handle downside volatility well. In order to assess any portfolio's allocation as adequate, the portfolio objective must be known. Vague portfolio objectives are usually the cause for so much divergence between allocation strategies. In the most general sense, investment portfolios exist to seek return. So it follows that holding any cash runs counter to the objective in mind when creating a portfolio in the first place. In addition, cash is not a very good asset at all given it commonly yields something less than inflation, making it a consistently poor long-term "store of value," which is one of money´s characteristics, according to economic theory.

Yet many sophisticated investors consistently allocate large portions to cash. To name one, Warren Buffett usually keeps about $20B to $25B in "excess" cash, or cash above the level deemed necessary to support operations.

The usual reasoning around holding cash is about volatility reduction, and it does serve that purpose very well. But volatility is not necessarily bad (prices go both ways, up and down) and, especially with equity concentrated portfolios, downside volatility is a good thing. In part, volatility is the reason excess returns are possible and consistently achieved in equity portfolios. In particular, downside volatility gives cash an option-like value that can be far greater to the "cost" of holding it for a period of time and gradually losing to inflation. It is another characteristic attributed by economics to cash that makes it valuable to a portfolio, its role as a "medium of exchange"; that is, to capitalize on the rare opportunity of exchanging it with a distressed seller of a security.

Cash on hand becomes very valuable when (not if) the next panic, crisis, meltdown arrives. Market crashes are unavoidable because they are the result of human behavior. So are market recoveries. Since human behavior won't change, it is wise to prepare for the next irrational episode by holding some amount of cash. In other instances, opportunities present themselves on individual securities suffering from some event that, upon detailed analysis, reveals to have created a mispricing. In financial theory this security-specific volatility is called idiosyncratic risk. To the investor with cash on hand, it can look like idiosyncratic opportunity.

So, how much cash should a portfolio hold? The usual answer is that it depends on the expected return on competing risk assets (bonds and equities), and obviously, the objective of the portfolio.

I believe the answer to the question of cash allocation can be reduced to this: the cash a portfolio holds should be equal to the amount that the investor or portfolio manager is willing to commit to one or two special situations deemed to have extraordinary risk vs. return profile(s). In Buffett's case, these opportunities materialized in a few lifelines to financial institutions in distress. He was able to negotiate an attractive deal with low risk because he got preferred coupons that would have continued even if dividends got suspended or shareholders got diluted, and high potential return because he also got "equity kickers" or warrants that would greatly enhance returns should the outcome turn out to be less than catastrophic, which it did.

Clearly investing in these special situations carries extra risk, and to the individual investor opportunities will present themselves as mispriced securities; not a call from Goldman Sachs (NYSE:GS) or Bank of America (NYSE:BAC), but having the ability to act quickly when the opportunity is perceived is precisely what holding cash is for.

Because these situations may carry extra risk and because they may take a long time to play out (sometimes years), cash from a margin loan is not an adequate funding source. In the case of general market fallout, margin loans will be largely unavailable anyway.

Disclosure: I am long GS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The Role Of Cash In Portfolio Construction