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  • The Role Of Cash In A Portfolio 0 comments
    Aug 22, 2013 9:39 AM

    We believe that cash is an important asset class within portfolios. The proper cash allocation is driven by two main factors: (1) liquidity management and (2) opportunity risk management.

    Liquidity management is fancy term for a simple concept, making sure withdrawals over the next year sit in a liquid form and ready to go. Liquid form means cash in an account or a U.S. Treasury money market funds transferable out to other banking institutions; it does not mean a 'safe stock' or bond fund. (For the purposes of this article we will refrain from discussing the requisite 'emergency fund' most financial planning articles cover.)

    The liquidity necessary to meet known withdrawals (living expenses, taxes, insurance payments, etc.( over the next one year period should replenish continually so that at least twelve months of withdrawals are available. Secondarily, assets to meet the spending needs in the 12-36 month timeframe should also be part of liquidity management. We place the incoming interest and dividend payments from underlying stocks and bonds into the secondary portion.

    "If you have trouble imagining a 20% decline in the stock market, you shouldn't be in stocks." John Bogle, founder of Vanguard. Over the last 35 years, the Russell 2000 Index of small caps stocks declined 20% or more 9 times, or about once every four years.

    (click to enlarge)

    Source: Aurum, Informa Zephyr

    Relying on systematic withdrawals from stock portfolios to fund spending needs is not a prudent approach, since being a forced seller into a weak market is not the side of the trade one would prefer.

    ---

    "More money has been lost reaching for yield than at the point of a gun," said Raymond DeVoe Jr., financial market historian. This quote typically serves as a warning to bond investors about downgrading credit quality or extending duration, thereby increasing the original risk target and 'reach' for the yield they 'need.' Nonetheless, it applies to the liquidity management side of portfolio construction.

    The New York Fed just put up a great post, highlighting the 15 largest bond selloffs since 1961. Using a zero-coupon 10 year note, the bond selloff through July ranks 13th out of 15 with the often cited 1994 selloff as the 5th worst. It provides important context about the shakeup in the fixed income world the last few months and the dangers of reaching for yield.

    bond_drawdowns_nyfed

    Understanding the historical volatility of bonds provides more reason for a strategic cash allocation.

    The pushback against our argument for cash as an asset class is easy, "cash earns nothing" and thus should be invested. If one believes this mantra, then extolling the virtues of liquidity and opportunity risk management probably do little good.

    Take a real life example of a couple planning on spending $200,000 of their $5 million portfolio. One might say that the $200,000 should be invested along with the rest of the portfolio. With expected 6.5% expected return over the cycle, investing the spending needs over the next year and systematically monthly withdrawals, one could earn an extra $10,000 (given that the $200k would not be invested for the full year). Conversely, the portfolio has a one in five chance of losing money over the next year, and the 95% confidence interval puts the drawdown potential at negative 15%. So on the extra $200,000 that 'needs' to be invested, the portfolio stands a potential impairment of $30,000. In this scenario, because the couple needs the cash for withdrawals, they must realize the losses on the portfolio and became a forced seller. This impairment of capital would not be permanent had the time horizon for investment correctly matched the duration of the underlying assets. Meaning, had the $200,000 been in cash, an on-demand asset class with zero duration, then the assets and liabilities match would be in unison.

    Combining "opportunity" and "risk" into a single phrase for holding cash boils down to one reason, because the price paid for an asset matters. When valuations of assets are too high, the expected future returns are low. When valuations are too low, the expected future returns are high.

    An example of this below is the Shiller P/E. Named for Professor Robert Shiller, but originating from Ben Graham (Warren Buffett's value investing mentor), the Shiller P/E seeks to average out the ups and downs of the business cycle by normalizing the past ten years of earnings.

    shillerpe

    Source: Asness, Shiller[1]

    It has some efficacy in predicting future returns, but most interestingly, it shows when the starting P/E (valuation) is low (left), historical returns are higher (Average Real 10 Year Return). When the starting P/E (valuation) is high, historical returns are lower.

    "Investing is simple - but not easy." - Warren Buffett

    After a period of outperformance above expectations is typically when values are high and thus future returns low, and thus when one would should trim or sell. Still, this is also the time when our behavioral investing shortcomings as human beings come in to play and makes it difficult to sell. Conversely, after an asset class underperforms dramatically and has news stories saying how terrible of an investment it is, future expected returns are above average. The rational economic agent should buy or increase holdings, but the brain reacts to the danger of losing in the short-term and tells us to stay away.

    Cash should be the default holding when an asset class becomes fully or overvalued, as holding it expecting it to go higher is not investing, but speculating on whether a "greater fool" will come along and buy the asset at an even higher price.

    Hence, cash serves as a risk management tool for portfolio construction. In the same sense, it serves as the dry powder for future opportunity. Waiting for the 'fat pitch' to come down the plate, cash offers optionality to respond to attractive valuations served up by an asset class that falls out of favor for other investors.

    During periods of instability in capital markets, asset prices tend to converge and go down together, precisely when a portfolio needs the diversification benefits of multiple assets. The chart below is the correlation of asset classes with the S&P 500. Distressed periods are months when the S&P 500 fell more than 3%, or the 15% worst performing months.

    (click to enlarge)

    In contrast to many asset classes, a great attribute of cash its zero correlation with other assets - in both normal and distressed markets. This provides the liquidity necessary to take advantage of an attractive 'option' when presented.

    Today, with U.S. equity markets hitting all time highs and large inflows into bond funds the last few years, money markets as a percentage of total assets are at all time lows.

    (click to enlarge)

    This, alone, is not a reason to increase cash as an allocation. Nonetheless, if asset classes deviate from the initial portfolio's target policy ranges, then prudent investors should adhere to the investment process. Holding cash as an opportunity risk management tool makes sense to us as investors with a long-term valuation focus.

    [1] Asness, Clifford, Ph.D., AQR. "An Old Friend: The Stock Market's Shiller P/E." November 2012.

    Important Disclosures

    This material is based on public information as of the specified date, and may be stale thereafter. We make no representation or warranty with respect to the accuracy or completeness of this material. Aurum Wealth Management Group and/or Aurum Advisory Services has no obligation to provide updated information on the securities or information mentioned herein. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Aurum Wealth Management Group and/or Aurum Advisory Services does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation, any particular investment, or any tax advice.

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