Cash not only holds its value in the short term when nothing else will, it’s a powerful tool to buy other assets.MicroStockHub/iStockPhoto / Getty Images
Cash, considered to be a drag on portfolios when stock markets are booming, turns out to be not just a lifesaver in bear markets, but a tool to buy assets when their prices crumble. The trouble is that holding on to cash too long wrecks its value, making it a depreciating asset. For many financial advisors and investors, how much cash to hold on to is a question about the cost of waiting. It’s a tactical tool, but a potentially expensive one.
Warren Buffett wrote in his annual letter to Berkshire Hathaway Inc. shareholders in March that the company was holding on to US$137-billion in cash, waiting for opportunities to pounce on. For Mr. Buffett, cash is a zero-cost option. It not only holds its value in the short term when nothing else will, it’s a powerful tool to buy other assets.
Alternatives to cash as sources of bedrock value don’t always work. For example, gold is a commodity that wobbles in value – lately between US$1,600 and US$1,700 an ounce. And interest-bearing low-risk assets such as government bonds may yield more than cash if they have long maturities. The default risk of sovereign bonds such as U.S. Treasury and Government of Canada issues is considered to be zero. Yet, bonds’ value can fluctuate before maturity, rising when interest rates fall and dropping when interest rates rise. All sovereign bonds provide shelter from stock market chaos, but issues with maturities of more than a few months are subject to price vulnerabilities. They’re not cash.
Cash can be considered an asset class of its own with zero volatility. A dollar is a dollar, after all. But there are other ways to hedge the risk of changes in an asset’s price than tying up huge sums in cash, says Chris Kresic, head of fixed income and asset allocation and portfolio manager, fixed income, at Jarislowsky Fraser Ltd. in Toronto.
“The cost of holding cash is an insurance charge that you only realize if other asset classes gain on cash. That is a volatility cost because it puts a price on doing nothing with your cash. You can hedge volatility with the volatility index, the VIX, adding to that index position when volatility is low and the VIX is cheap and selling the position when volatility and the VIX are high, but if you get that wrong, then you lose money,” he says.
Still, cash has its seasons just like other assets. Its value depends on the rate of inflation. If inflation is high, cash loses value rapidly. If it’s low, cash loses value slowly. And if prices should decline in deflation, then cash gains buying power and becomes a very desirable asset not just as parking spot, but as an investment of its own.
“Deflation creates an incentive to save more,” says Avery Shenfeld, managing director and chief economist at CIBC Capital Markets in Toronto. “Bond yields are so low now that having more cash than what one might usually have is attractive.”
But if inflation, currently at 0.9 per cent in Canada, picks up again, as many experts are predicting, then cash will start to depreciate. That means the opportunity cost of doing nothing will turn into a real loss of power to buy consumer goods or conventional investments like stocks and bonds, says James Orlando, senior economist at Toronto-Dominion Bank in Toronto. “Over the long term, cash is not a zero-cost option. It’s a money losing asset.”
Jeremy Siegel, an economist at the Wharton School at the University of Pennsylvania, has shown that for periods of just one year, stocks outperformed U.S. Treasury bills, a proxy for cash, 62 per cent of the time in the 200-year period ended 2012. That includes the stock market meltdown that took place during the financial crisis in 2008-09. For periods of 10 years, stocks beat Treasury bills 69 per cent of the time. And for periods of 30 years, stocks beat Treasury bills 91 per cent of the time. Clearly, time is the measure of value in portfolio management.
The question comes down to how much cash to hold on to for given periods. That can be answered by an investor’s own asset allocation policy, says Charles Marleau, president and senior portfolio manager at Palos Management Inc. in Montreal. “If you have a 25/75 bond to stock allocation, you should stick with it. If you get some cash, invest it according to your allocation.”
In his view, cash is a tool to maintain asset balance in portfolios. Seen in that light, the opportunity cost of cash ceases to be a cost of foregone investments in other asset classes. It becomes a way of putting money into other classes that have outperformed cash over decades.