Despite the sharp losses in the stock market just a few years ago, and despite the fact that valuations on nearly all asset classes remain above average, investor sentiment is mostly quite positive on the potential for stock market returns. Given this general level of bullishness, the most controversial holding in many of our client portfolios is cash, which is usually held in a money market account.

If investors today seem to have put the difficult stock markets of 2000-2002 out of their minds, they also seem to have forgotten that cash should be an important part of their overall financial strategy. To refresh our collective memories, I will review the need for cash holdings outside of your investment accounts, the roles cash can play inside your investment accounts, and the circumstances that may cause us to adjust the level of cash holdings in your accounts.

The Emergency Fund
Fidelity's Peter Lynch says building a cash account should be the very first step in building any financial and investment plan. Lynch says: “Don’t invest in stocks before you've stashed some cash in short-term investments or a savings account — enough to cover short-term expenses (examples include: house down payments, tuition bills, weddings, vacations), plus an ample reserve for surprises and emergencies (examples include: home repairs, medical emergencies, losing a job). Having an emergency fund helps you to become a better investor. How? You won't be forced to sell a good investment at an inopportune moment — during a bear market, for instance — to raise cash to pay bills.”

How much cash should you keep in an emergency fund? Everyone seems to have a different answer, but most financial planners recommend enough to cover living expenses for a period of three to six months. I would argue, however, that because it takes longer to find a new job these days (and generally, the higher your compensation, the longer it takes), at least a year’s worth of cash is prudent. As usual though, it depends upon individual circumstances.

While all of this makes perfect sense when reading it on the page, when it comes to executing it in practice, it can be harder than you think. When the stock market is rising, the temptation to put even money you know you are going to need soon (for the above mentioned weddings, tuition bills, etc.) into the stock market, rather than “wasting” it in cash.

Obviously, sometimes this move would pay off. But in a year like 2002, it could have caused those wedding plans to be scaled back quite a bit as the S&P 500 fell 22%, while cash was up nearly 2%. In fact, over the last 5 years (through 7/31/05), cash is up 12.3% while the S&P 500 has lost 6.6%. This is one reason why you so often see me write about the importance of maintaining your investment discipline. Money for short-term needs should be in cash, period. Don’t succumb to the temptation to reach for a higher return —
the risks aren’t worth it.

The Role of Cash in Investment Portfolios
Inside your investment portfolio, cash is useful both as a way to engineer a portfolio to deliver an appropriate risk-return profile, and, from an individual holding standpoint, as a security that provides a consistent positive return.

Investors, especially these days, tend to focus primarily on the return potential of an investment. In that view, cash is generally not very sexy (except for those who were investing in the early 1980’s when money markets were yielding 17%!). But, an investment is a two-sided coin and the flip side of potential return, is, of course, how much an investment can lose. Cash wins this side of the coin, hands down as it has (essentially) zero chance of a loss.

In a portfolio construction context, cash serves the role of a significant risk reducer. Not only is volatility of cash quite low (only 3% of the volatility of the S&P!), its returns aren’t affected by the same factors as stocks, so it provides additional diversification benefits. This ability to reduce risk and smooth out returns in a portfolio, makes it easier for most investors to “stay the course” with their investment program, and thus increase the odds of achieving their financial objectives.

To summarize, while potential long-term total returns may be reduced by the addition of cash to a portfolio, risk-adjusted return potential is not necessarily reduced — and may, in fact, be enhanced — which increases the odds of investor success. If you need to get the field plowed, you don't necessarily need the fastest horse.

How much cash should one hold in their investment account? The answer, as it is with many investment questions, is “it depends.” It depends on an individual’s risk tolerance, investment objectives, time horizon, and other factors. Even for growth-oriented investors though, cash has its place. For example, the “classic” asset allocation for a growth portfolio over the ages has been 60% in equities, 30% in bonds and 10% in cash. Generally speaking, more conservative investors will even have more allocated to cash. Depending on the client, a typical range of cash holdings here at Kobren is 0-20%.

Why We May Adjust The Cash Levels In Your Portfolio
Renowned value investor Seth Klarman once said that he could understand why many investors would question paying a management fee for holding cash. He would answer that the managers were, in fact, being paid to decide when to hold cash and when to invest it. Recently, Klarman, along with many other famous value investors including Warren Buffett, were holding large stakes in cash given their overall concerns regarding stock market valuations.

As I have frequently discussed, we invest your money with the goal of generating the best risk-adjusted return consistent with your own risk tolerance and investment objectives. We are constantly evaluating the risk and reward trade-off offered by various asset classes, and like Buffett and Klarman, we too will tend to hold more cash in client portfolios when valuations cause us to be concerned about that risk/reward trade-off on conventional stocks and bonds.

Sometimes, you hear cash holdings referred to as “dry powder,” an old-time military metaphor. But staying in the financial arena, a metaphor I like better is that cash is as an “option on opportunity.” When valuations are high for conventional stocks and bonds, thus making their risk/reward trade-off less appealing, holding above-average levels of cash is like buying an option to purchase those stocks and bonds at more attractive valuations in the future.

Cash May Not Be King, But In A Low Return World
It’s Not Far From The Throne
Now that we have become reacquainted with the value of cash in your investment strategy, one last point bears reinforcement and that is its steady positive return — right now, around 3% per year. That may not sound very exciting, but as I noted in last month’s Research Perspectives, over the next 20 years we should expect returns from stocks to be in the mid- to upper single digits, and in that kind of environment, a safe and sure 3% doesn’t look all that bad.

Sincerely,

Rusty Vanneman, CFA
Director of Research
Co-Portfolio Manager