One of the most important traits that an investor can have is patience. Everyone knows this and it makes perfect sense. Patience allows you to be opportunistic and only choose the best opportunities for your portfolio. Despite this common knowledge nearly all investors ignore the most important asset in their portfolio. The most important asset in every portfolio is Cash. Cash is an asset that gives investors optionality and helps improve returns in the future.
When we say cash, we don’t specifically mean the U.S. Dollar, Euro, Yen or Treasuries. We’re using it as a general term for anything that can be quickly deployed to purchase an investment. As much as my readers would like to discuss the viability of the U.S. dollar or the implosion of the Euro this isn’t that article. Investors can keep cash or cash equivalents in whatever currency they view as the most stable.
Cash Misconceptions
As we have said before, cash gives investors optionality. Optionality allows investors to choose the best opportunities and outperform the market. Seth Klarman’s hedge fund Baupost, one of the most successful hedge funds of all time has used cash to maintain optionality. A letter from former Baupost employee Brian Spector highlights how important cash was to the success of their firm.
“One of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk-adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when we enter a tide market and great opportunities become widespread.”
Academics and Institutions typically view cash as a drag on the performance of a portfolio. Given our prior experience as institutional investors we have seen the pressure that CIO's place on portfolio managers to cut their cash allocations. Every month when portfolio managers review their attribution against benchmarks cash and cash equivalents can either be positive or negative. In a rising market no CIO wants to see their funds underperforming benchmarks due to cash allocations.
Absolute Returns Matter Most
Unfortunately, this flawed institutional logic typically makes its way to individual investors. Institutions compete against a benchmark. A Fidelity portfolio manager whose portfolio only declines 25% while the market declines 30% is considered extremely successful. For the individual investors, only absolute returns matter. Individuals realize that when a portfolio declines 25% it takes a 33% increase to get back to even. They don’t have the advantage of investing other people’s money and skimming 1 – 2% off the top.
We even found a ridiculous article that talks about how “dangerous” cash drag can be on performance. This article, What a (Cash) Drag: Institutional Investors and ETF Cash Equitization describes the trend of institutional investors using ETF’s rather than holding cash. Institutional investors do this because they don’t want to lag benchmarks because of cash. The article begins by asking “why aren’t more retail investors using ETFs to equitize their cash?”. The simple answer is because it is a terrible idea. Measuring against benchmarks creates terrible incentives which is an advantage that individual investors have over institutions.
Cash the Call Option
Having a significant portion of your portfolio allocated to cash is like having a call option on all available opportunities. If you had even a minimal amount of cash available in 2008 and 2009 you would have had endless opportunities to deploy your cash and earn extremely high returns. The opportunity cost of cash far outweighs the potential drag on performance. Cash is the perfect call option because it costs nothing yet gives you the opportunity to purchase any available asset. This is the view that Warren Buffett has of his cash allocation. According to Buffett biographer Alice Schroeder,
“He thinks of cash differently than conventional investors. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”
Having this type of mindset and ability to hold cash in your portfolio will set you up for success.
Cash and Financial Repression
Another reason to allocate more of your portfolio to cash is because of the current macro environment. Investors in Europe and Japan face negative interest rates. Faced with the choice of paying a government to own its debt as opposed to holding cash the choice seems easy. While most short-term debt is easily convertible into cash investors should never pay governments to hold their debts. Our modern age of financial repression means that investors should seriously consider holding larger cash allocations.
Cash is King
Financial portfolios and individual investors benefit from holding cash. Cash gives investors optionality to purse every available option. Holding cash will give you more piece of mind because you will be ready when the perfect investment appears. Let the institutions who compete against benchmarks always be invested. As Warren Buffett and Seth Klarman show us, successful investors consider cash one of their most important assets.
Originally published at BoomBustMarket.com