How To Reinvent The Cash Component Of Your Portfolio

by: John Gerard Lewis

Some of the cash in your portfolio should remain as cash.

But "permanent cash" can consist of "near cash" for a better return.

Don't let your permanent cash rot in your broker's money market account.

“Dry powder” is generally considered to be cash patiently held to deploy when an investment opportunity presents itself. But not all cash is held for that purpose. Cash can and should be held as a category unto itself within an investor’s portfolio.

Now, for investors in their 20s or 30s, that allocation to cash might prudently be zero - there’s nothing wrong with young people, with long investment time horizons, putting all of their money into stocks. They can put, say, 80% in an index fund like the Vanguard Total Stock Market (NYSEARCA:VTI) or the SPDR S&P 500 (NYSEARCA:SPY) exchange traded funds, and then, with the remainder have some fun by allocating up to 4% in any given quality stock. Or if they don’t have the interest or time to study individual stocks, they can throw 100% into an index fund.

But they should remember that even in allocating all of their money to equities, they’re still making an allocation to cash as well. It just happens to be zero for the time being.

As they grow older, that cash allocation should grow. This is a concept that is largely ignored in conventional personal-finance advice, which tends to recommend the age-allocation rule, which instructs that after age 35 or so, the percentage of your fixed-income holdings should equal your age - a 45-year-old would therefore have 45% of his money in fixed-income and 55% in stocks, a 65-year-old would have 65% in fixed-income and 35% in stocks, etc.

The idea, of course, is that less money should be exposed to the more volatile stock market as you age. This unexposed portion is normally invested in bond funds and bank certificates of deposits (CDs), which are thought to be relatively “safe,” although I disagree as to bond funds because their prices will drop if interest rates rise. And while they’re probably not going to rise anytime soon, they can’t go much lower and the direction will someday be up.

So there we have the conventional portfolio - an allocation to stocks and an allocation to fixed-income. But what about cash? As mentioned earlier, it can be dry power standing by to be deployed. But I would argue that a portion of your cash should be non-deployable, permanent cash. It’s prudent to just hold some cash. Even if no rainy day ever dampens your life, it’s a psychological benefit to know that you have some cold, hard cash that’s not going to be tossed about by the financial market winds.

But that doesn’t mean your dedicated cash allocation has to sit in a broker’s money-market account earning a piddling 0.01%. It can be earning nearly 200 times that in short-term CDs and still be considered “near-cash.”

Remember, this isn’t cash that you’re going to be withdrawing to finance a trip or to buy a car. It’s there as a steady, regular component of your portfolio. By its nature, cash is “short-term,” which means it can be invested in a range from one-day money-market maturities to short-term bond funds with average maturities of three years. The problem with money-market funds, of course, is the almost zero rate of return. And the problem with bond funds is that they have duration exposure - a given short-term bond fund while yielding 2.25% could lose nearly 3% of its value if interest rates were to rise just 1%. If you want to sell, you’ll sell at whatever the fund price is at the time. You’re at the mercy of interest rates.

That’s why I like short-term CDs for the permanent “cash” component of a portfolio. There’s no interest-rate risk, because it’s effectively a fixed-maturity loan to the bank. You’ll be made whole at the end. And rates of 1.3% for a six-month CD and 1.7% for a two-year CD are available today.

Compare this to short-term bond funds. The iShares Short Maturity Bond ETF (BATS:NEAR), for example, has an average maturity of 1.46 years and yields about 1.6%, but its expense ratio of 0.25% shaves the yield to about 1.35% - and it does carry a small measure of rate risk. A one-year CD available from Goldman Sachs Bank, on the other hand, yields a 1.45%, has no rate risk and is FDIC insured. A two-year CD from the same bank yields 1.7%.

A permanent cash component is a prudent part of an investor’s portfolio, and most investors will accumulate cash regardless, due to dividends and interest. But if it’s not truly being kept as dry powder, don’t let it rot in your broker’s money-market fund. This is especially true in IRA accounts - what’s the point of getting a tax deferral on 0.01%?

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own the Goldman Sachs Bank two-year CD mentioned in the article.