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Saturday, December 21, 2013

Handling Cash Within Personal Portfolios

This article is the follow up to this article about money and uncertainty. In the previous article, I discussed how money was used to reduce uncertainty for spending decisions. In this article, I discuss the role of cash within investment portfolios.

This article discusses cash instruments based on rules of thumb. As I discussed previously, uncertainty means that we need to be cautious about the use of optimisations in portfolio construction.

It should be noted that cash instruments are the short end of the bond curve. As such, short-term bonds can viewed as near-cash instruments, although they will probably earn a small risk premium over time.

Rule Of Thumb: x% Of Your Portfolio Should Be In Cash

I have also seen suggestions that you should hold 5-10% (or even more) cash within your baseline or policy portfolio. (See this article for the definition of a policy portfolio.)

The exact percentage of cash holdings depends on the individual; I cannot endorse any particular rule of thumb. However, the role of cash within the portfolio is to hedge against uncertainty: the uncertainty whether the current level of assets makes any sense.

In the past couple decades, stocks and (government) bonds have had returns that tended to move in opposite directions ("negative correlation"). As such, bonds have acted as a good complement to the equity component of portfolios; they have had good returns during equity bear markets. However, we have had periods when both bonds and equities have sold off at the same time (notably, the 1970's). Holding cash acts as a hedge against that scenario.

If you have decided to run your personal portfolio like a hedge fund and use products like futures and leverage, you need to approach cash management like an institutional investor. You may need a much higher level of cash to deal with the potential cash draws that you will face. There are a lot of relative value investors who were ultimately correct on valuations, but were forced out of their positions as a result of liquidity squeezes before they could realise profits.

However, just because you can do something (act like a hedge fund) does not mean that it is a good idea. Unless you have other people acting as a backup, how will your portfolio survive if you are suddenly incapacitated for 3 months? Someone who has loaded up on levered inverse ETF’s or futures could be in for a rude shock if their portfolio was left unmonitored for a period of time.

Rule Of Thumb: “Cash Is Trash”

This is in contradiction to the previous, and is an expression that is often repeated in bull markets (like now, in fact). The thinking is that every other asset offers a risk premium over holding cash. If you do not have liquidity management issues (for example, within a long-only tax shelter that you cannot touch until you retire), it makes no sense to hold assets that do not earn some form of risk premium. I think there is an element of truth to this, but I still think you need a liquidity buffer (outside of tax shelters, which you may not be able to tap into easily anyway).

Rule Of Thumb: Liquidity Backup Should Not Distort Policy Portfolio

In the previous article, I noted that you can use your portfolio holdings as a liquidity backup. But if you are holding cash instruments in your portfolio to do so, be careful with the interaction with your policy portfolio.

For example, when you are just starting investing and your money market fund is your liquidity backup, it may be that it will represent a high percentage of your total portfolio, say 30%. However, you only need a certain number of months of living expenses in cash instruments. Therefore you should not keep that 30% weighting in your policy portfolio as your portfolio grows over time.

Rule Of Thumb: Cash Is Not Where You Take Risks

I would not recommend attempting to “optimise” returns via dropping the quality of your money market securities. It is much better to take risks in financial instruments that have much longer maturities. For example, if you buy a 3-month corporate instrument with a spread of 40 basis points (0.40%), you are exposed to default risk on 100% of your capital in order to enhance your returns by a maximum of 10 basis points. (One quarter of the annual spread, since 3 months is one quarter of a year.) Whereas if you buy a corporate bond, you earn the spread over the life of the bond. You at least have the chance of an appreciable capital gain in exchange for taking the risk of default.

Cash And “Paying Yourself First”

Rather than attempting to have a budget for your personal expenses, many people advise using the strategy of “Pay Yourself First”. (In Canada, the idea was popularised by the book The Wealthy Barber (Affiliate link).

The idea of the “Pay Yourself First” strategy is that you automatically transfer a percentage of your salary to an investment account as soon as possible when your paycheque arrives. You then spend the remaining cash however you wish, without worrying about saving out of the remaining pool. (This is how I handle my personal finances.)

One downside to this strategy is that if the transfers went into something like an equity fund, I would end up with 26 purchase transactions, all at different prices, during the year. If this is a taxable investment account, if you do not automate your bookkeeping, selling any of that mutual fund would generate an ugly mess of calculations to determine the capital gain or loss.

As such, the path to reduce headache is to put the transfer into a money market fund. These funds are normally allowed to keep their unit price at a fixed level, which means that there will be no capital gains or losses on exit. (However, in a crisis, these funds could have to drop the value of a unit; in the U.S., this is known as “breaking the buck” since the normal unit price is $1.00. In fact, during the financial crisis, there were funds that were forced to “break the buck.”) Regulators have targeted the ability of these funds to use accounting to keep the unit price constant. This may or may not be useful for financial stability, but it will be a pain from a bookkeeping perspective if they change the rules.

I personally wanted to avoid the bookkeeping hassle, and so I used a money market fund as my target for transfers. However, what I found is that my holdings there were always creeping up too high relative to my target level. As a result, “cash drag” (lower portfolio returns due to holding above-target levels of cash) was one of the clearly avoidable errors I made during the management of my personal portfolio. (I probably should have bit the bullet and automated my record-keeping, allowing me to transfer the money into a fund with higher expected returns.) In order to avoid this, you need to monitor your portfolio periodically to see whether your cash weighting has drifted up too far.

Finally, another issue with the “pay yourself first” strategy is that you can often be hit with large lump sum payments. This can either be the result of not doing a budget exercise, or it can be due to unforeseen events (uncertainty). You have no choice but to dip into your pool of savings to meet the lump sum payment. You then need discipline to stop this from drifting into continuous raids of the money that was supposed to be set aside for long-term goals.

(c) Brian Romanchuk 2013


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