The Role of Cash in a Managed Portfolio
A portfolio that is actively managed will often focus on a particular asset class such as fixed income bonds, real estate assets such as Real Estate Investment Trust (REITs), equities or stocks listed on exchanges, open end mutual funds or exchange traded funds (ETFs). What is common about all these assets is that they are acquired with available cash when they represent inherent value from a perspective of future income streams. Warren Buffett, perhaps the most consistently successful investor in history, described his view of the fundamental role of cash:
“Cash, combined with courage in a time of crisis, is priceless.”
In his interviews, he indicates that there are relatively few periods in his investing career when he did not hold cash, as he did not know exactly when discounted assets might become available, and he wanted to be an acquirer of such timely bargains. Furthermore, Warren Buffett realizes that cash is one asset that is relatively free of short term market gyrations. Cash will not lose value overnight, though over a long period, it can lose value due to inflation, while in the short term, it pays little interest. Cash is, thus, the most stable of all asset categories. Finally, Warren Buffett realizes that just as markets have short term gyrations driving prices up and down, so too do they have long term cycles that can play out over months, years, decades, centuries and indeed, whole civilizations. In other words, one of life’s key problems is maintaining enough cash to meet the needs that a person, family or business confront. This is epitomized in the following Warren Buffett quote:
“Cash, though, is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent. When bills come due, only cash is legal tender. Don’t leave home without it.”
Cash is the necessary raw material to building a successful actively managed portfolio. If opportunities present themselves and you have insufficient cash, then you must either sell other assets that you consider less valuable to raise cash, forego the investment, or go into debt to finance the acquisition. For many investors, the latter two choices are either too risky or not acceptable, so rebalancing existing assets is the primary alternative. This means selling those assets at a less opportune time. Thus holding some cash as a resource of opportunistic purchases is a more planned approach to investing.
Cash is a form of ballast in a portfolio, acting to reduce volatility when short term market forces ebb and flow. It is an asset class with distinct characteristics of immediate liquidity and fixed short term valuation. Holding cash reduce one’s psychological anxiety about market upheaval. The more volatile the markets, the more cash one should hold.
Cash does not lose market value as equity securities do during a sustained downturn. Bear markets and corrections present the investor with a fundamental dilemma which is really impossible to know with any certainty: How long will the downturn persist, should I get out of certain holdings now to avoid further losses, or should I hold on and be patient based on the courage of my convictions? Holding cash does not eliminate the drop of market value during such downturns, but it can reduce the total portfolio fluxuations. Thus a gradual modulation of cash is a prudent strategy for portfolio wealth management. For instance, in an ideal investing world, as a bull market ages, an investor would develop a larger cash position, and as a bear market persist, that cash position would be expended on buying discounted assets. This is really the only systematic way that an investor can buy low and sell high. Otherwise, investing becomes more random with odds less in the investors favor.
Investor Profiles and Market Valuations Dictate Cash
Levels of cash in a managed account vary based on a person’s income, the stability of that income, the need to withdraw funds to meet expenses, the phase of life in terms of spending on goals such major purchases, education and family needs. Furthermore, the valuation and volatility of the broader markets, measured or determined by interest rates, average S&P 500 Index price-earnings ratio, general indebtedness, inflation rates and productivity will argue for more or less cash in any given portfolio. When a market is over-valued or highly volatile, the chances of a correction or bear market increase, while conversely, when a market is under-valued and relatively calm, the chances of positive investment returns increase. While these somewhat subjective measures are not guarantees, they can serve as inputs to the decision regarding portfolio cash levels. This is both art and science, so advisors rely on knowing the economy, their clients and their cash management experience to arrive at a proposed level for any given client.