Dividends & Income Digest: How Much Cash Should You Hold?

by: Rebecca Corvino

Summary

Every issue, SA explores a dividend and income investing question and shares the responses, as well as highlights recent insightful pieces of opinion and analysis.

This week, contributors answer the question: "How much cash should you hold?"

Is there a topic you'd like to see covered in a future D&I Digest? Let us know by commenting below.

Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) has $90 billion in cash. Microsoft (MSFT) has $126 billion. Apple (AAPL) has over $250 billion.

I'm going to go out on a limb here and guess that most Seeking Alpha readers' portfolio cash reserves are in a different ballpark. But that doesn't make the ongoing discussion on this site about how much cash investors should hold (and why) any less interesting.

Aristofanis Papadatos opined recently that the only reason for dividend growth investors to hold cash "is to take advantage of the next bear market":

DGIs should not hold any cash. Instead they should try to maximize their profit from the compounding process by remaining fully invested. Of course, this does not mean that they should reinvest every single dividend they receive right away, as such a strategy would markedly increase transaction costs. However, as soon as they accumulate a certain amount of cash, they should invest it immediately in the most attractive stock or in S&P. If they try to continuously keep cash and time the market, they will engage in a money-losing, time-consuming endeavor, which will certainly not compensate them in the end.

In the comments for that article, Mike Nadel added that he holds onto some cash for the psychological benefits. "I do not hold a ton of 'investable cash' - which is to say cash I hold outside of my emergency fund," he wrote. "But I do have a little, about 6-8% of my portfolio. It gives me comfort to hold it. It frees my mind to hold a stock-heavy portfolio and it lets me give myself 'permission' to add to my investments when I see fit."

In a companion piece to this Digest, Bram de Haas laid out 10 "moving parts" to consider when determining your cash allocation, including interest rates, investment goals, and your expected return on investments, but he noted that it's an "extremely difficult" and possibly futile endeavor. "Getting it approximately right is important but getting it exactly right is often not worth the investment in time and energy," he wrote.

As for Berkshire's sizable cash pile, Warren Buffett told CNBC that he hates cash, calling it "a holding position until you find something else."

We're keeping the conversation going with this week's Digest question:

How much cash should you hold?

Here's what a few of our authors had to say:

Parsimony Investment Research

The short answer to this question is: It depends. Cash is an asset class just like stocks and bonds, and it’s often used to reduce the overall risk in your portfolio (as cash is essentially a risk-free asset). That said, the use of the cash asset class varies depending on your investment strategy. For example, a long-term buy-and-hold strategy may be fully vested at all times and will have no allocation to the cash asset class. Conversely, a more active investing strategy may try to time the market based on valuation (or some other metric) and may actively use the cash asset class to manage risk (i.e., increase cash when the market is perceived to be overvalued). The point is that there is no right or wrong answer to what level of cash an investor should hold. It all depends on your strategy.

All that said, we tend to carry relatively high cash balances in the Triple Income Portfolio (which uses a combination of high-quality dividend stocks and conservative option strategies, like cash-secured puts and covered calls). In fact, we will often have less than 50% of the portfolio invested in stocks (which implies very high cash balances of 50% or more). The goal of this strategy is to produce consistent income with relatively low volatility, and the use of the cash asset class helps keeps portfolio volatility in check. In this strategy, we have two buckets of cash: (1) cash securing our put positions and (2) cash available for new trades. These cash levels are constantly in motion as the option trades tend to be short-term in nature (30-90 days). As such, this strategy is a constant balancing act of risk and return. As long as we can find trades with a compelling risk/reward tradeoff, we try to put most of our “cash available for new trades” to work every month. As cash-secured put positions expire worthless, cash will move from the first bucket to the second bucket and we’ll start our whole process over again with new trades.

When all is said and done, our “cash available for new trades” balance tends to fluctuate between 0% and 50% throughout the month, and our use of the cash asset class is dependent on the trades available in the market.

In the current market environment, we have still been able to find decent option trades (despite stocks hovering around all-time highs and the volatility index hovering around all time lows). So our "cash available for new trades" level troughs around 0%-5% every month.

In summary, the use of the cash asset class is highly dependent on your strategy, and investors should stick to their plan at all times (and try not to be persuaded by the constant "fear-mongering" by the financial press).

To learn more about our Triple Income Formula, please consider enrolling in our new online course.

Colorado Wealth Management Fund

Cash allocations in the portfolio should vary. While some managers advocate for keeping a set percentage in cash, that negates the real benefit of cash. The goal of the cash allocation is to make it easier to buy investments when they go on sale and to fund limit-buy orders for accounts that don't have the margin capacity available for covering those orders.

For instance, in accounts that can't use margin, the cash provides a way to maintain limit-buy orders for illiquid securities such as preferred shares. Despite prices that are quite stable on a month-to-month basis, the lower liquidity causes spikes in the prices at which orders execute. For the patient investor, this can be an opportunity to catch a bargain. Whether the investor is looking for a quick capital gain or more income from acquiring more shares, the cash allocation is the simple way to be prepared.

Aside from limit-buy orders, I also find the cash positions are useful for being able to double-down when the market moves against me. The lower price in that case is stacking the odds in my favor and I want to be able to move when the opportunity arises. Consequently, I may use the vast majority of cash and then begin watching more closely for positions that are ready to be harvested to recover to a normal amount of cash.

In this market, I think anything in the 5% to 15% range can be quite normal, though I have exceeded those limits on both sides within the last couple of months. At the end of June, I had just completed a few dividend capture plays on preferred shares, and nearly 25% of my active portfolio was in cash while I waited for a few better options to develop in the space.

You can see Colorado's holdings (including cash allocation) as of the end of June 2017 here.

Bram de Haas

Poker players often have to decide between cash or long. Imagine a flop that’s 8s 9s 3h and you hold the Js Ts. You have to decide whether to get it in vs. another good player and you expect that you are a 53% vs. 47% favorite. Do you stay in cash (fold) or go long (at odds slightly better than a coin flip)?

It is a tough question with many dynamics. The shortcut is to ask yourself: Can I get it in soon with much better odds?

If the answer is yes, this opportunity where you have an edge may be better to pass on. If the answer is no you can’t pass it up.

Markets pose a similar problem to us all the time.

My ideal is to hold no or very little cash. If there are great opportunities to invest, cash is very unattractive by comparison. You want to be long with the odds deeply in your favor all the time.

But after this eight-year-long bull market brought the S&P 500 to the second highest CAPE ratio of all time, there isn’t an abundance of opportunity. Many signals point to low returns on equities for the foreseeable years. Treasuries are highly unattractive as well.

We are at a point where being long the market equals a coin flip with the odds slightly in your favor. If you sense the market is giving you as good an opportunity as it ever did, go long. If you feel like you have often invested in a more attractive set of opportunities, you want to keep more chips behind. If there is no action, don’t start gambling on the 50-50s - just keep folding, paying the blinds and wait for a better spot.

What do you think? How much cash are you hanging on to? Please chime in in the comments below!

If you enjoy the D&I Digest and would like to be alerted to future editions, don't forget to "follow" me! And please let me know if there's a topic you'd like to see covered in a future D&I Digest, either by commenting below or sending me a private message. I'd love to hear from you.

Finally, here's some recent Dividends & Income content you might want to check out (if you haven't already):

Is Dividend Growth Investing Doomed? by Income Machine

My Top 5 Dividend Stocks For Young Investors by Nicholas Ward

BDCs: Watch, Learn, And Take Nothing For Granted by SA Marketplace

Kinder Me Once, Shame On You; Kinder Me Twice, Shame On Me! by Mike Nadel

The Technical Case For Continuing To Love Municipal Bonds by Andres Capital Management

New Residential: Despite Big Risks, 12.5% Yield Is Attractive by Blue Harbinger

Self-Storage REITs: Is Now The Time To Buy The Dip? by Bill Stoller

Retirement Strategy From A Trader - Don't Laugh, Just Read by Arbitrage Trader

Bad Time To Invest In Junk Bonds by James Brender

Smart Retirement: I Can Stay Solvent Longer Than The Market Stays Irrational by George Schneider

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.