I really like the way this article describes how Warren Buffett thinks about cash. I think of it similarly (see below), but I never thought of it as a call option. It says:
"Ms. Schroeder argues that to Mr. Buffett, cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates," said Ms. Schroeder, who followed Mr. Buffett for years before she became his biographer.
"He thinks of cash differently than conventional investors," Ms. Schroeder says. "This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price."
It is a pretty fundamental insight. Because once an investor looks at cash as an option - in essence, the price of being able to scoop up a bargain when it becomes available - it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.
Suddenly, an investor's asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?
This is a good insight. Holding some cash is not necessarily a bad thing. What's bad is holding most of your money in the form of cash. That is a nearly guaranteed losing strategy. The purpose of an investment portfolio is to serve as a place where you protect the wealth you've amassed. You achieve this by protecting it against the risk of permanent loss and the risk of purchasing power loss. Cash is guaranteed to avoid one (the risk of permanent loss) and guaranteed to lose the other (purchasing power). So having an excessive allocation in cash at all times makes no sense. There's no point investing if you're doing that (unless you're investing it in yourself or in something other than an investment portfolio which is a totally different matter).
On the other hand, if you've designed a portfolio that is properly allocated across different strategies in a risk managed macro approach then you can achieve not only protection against purchasing power, but also reduce the risk of permanent loss. But an important feature of investing is maintaining the plan and capturing opportunity when it is confronted. This might mean dollar cost averaging for some investors and for others it might mean more actively buying depressed assets (or other approaches). Having a steady cash flow or a cash hoard is essential to being able to achieve this.
That's why, the other week, when I discussed this portfolio building concept, I mentioned that you should never view your investment approach as being investment portfolio centric. The best investment you'll ever make is in yourself and in your primary form of output, i.e, how you generate the cash flow that then gets invested. As I said last week, an investment portfolio is actually a residual of your primary cash flow. So it's all about understanding how the portfolio is a stock from your primary output flow. Build that cash flow and it's like having a perpetual call option machine at your disposal. Of course, you need to actually design the portfolio correctly, but that's a slightly different matter.