Summary: Even with interest rates at historically low levels, cash still has an important role to play in portfolios beyond providing a return. Cash dampens volatility and provides liquidity. It helps with income planning and allows an investor to be an opportunistic buyer. Holding cash also stops an investor from being a forced seller in a downturn.
Key take-out: As the investment slogan goes, shares let you eat, while cash lets you sleep.
Key beneficiaries: General investors. Category: Cash.
One of the key determinants of your overall investment return is the asset allocation that you choose – and perhaps the biggest challenge for investors at the moment is around the cash investments in their portfolio. With cash returns at record lows, the question is whether cash should be part of an investment portfolio when returns from cash barely keep up with inflation – before tax. Even with historically low interest rates I am of the opinion that cash still has an important role to play in portfolios – because it serves a number of different purposes beyond just providing an investment return. Adam Carr looked at some alternative options to cash last week (see Exploiting low rates 1: Finding alternatives to cash), while Bruce Brammall examined the case for gearing in a low rate environment (Exploiting low rates 2: Good numbers for gearing), Philip Bayley considered listed bonds (Exploiting low rates 4: Playing the listed bond market) and I explained debt recycling (Exploiting low rates 3: Debt recycling ... a rare opportunity).
Role 1: Dampening volatility in portfolios
Having seen the value of Australian shares halve between late 2007 and early 2009, we have a recent reminder of how volatile share investments can be. Holding part of your portfolio in cash dampens this volatility. If a portfolio invested 100 per cent in shares falls by 50 per cent, a portfolio that is 50 per cent cash and 50 per cent shares will only fall by 25 per cent. Holding cash in a portfolio reduces the “worst case” fall in value of a portfolio if there is a drop in the value of the growth assets (shares and property) in the portfolio.
Role 2: Liquidity
Cash in a portfolio provides immediate and easy access to money – it provides liquidity. We are fortunate in the Australian environment that there is no greater guarantee of being able to access funds than to have cash in the bank – except maybe to have banknotes in your possession. If you are relying on loans (for example a redraw facility for a mortgage or a credit card), it is worth keeping in mind that these can be cancelled or modified by the credit provider (usually a bank). While this does not seem likely, keep in mind that often the time when you are looking to access extra money is at a time of financial pressure – which is exactly the same time that banks might be reluctant to extend you credit. For liquidity – cash is king.
Role 3: Income planning and a good night’s sleep
For people who are retired, and funding their retirement from their portfolio, cash has a great role in income planning – if you set aside, say, the next five years’ worth of your income needs in cash, and your cash account is also topped up by dividends and distributions that you receive from your other investments throughout that time, it is likely that you will never need to sell your growth assets.
Role 4: Opportunistic investments
Holding cash lets you be an “opportunistic buyer”. During the bottom of the market in 2009 you could buy Commonwealth Bank shares for under $30 and Telstra shares for around $2.50. Disciplined investors who held well thought out cash levels at the top of the market in 2007 had the falls in the value of their portfolio cushioned by their cash holdings, and then had cash to buy assets at much lower prices.
Role 5: You don’t have to sell in a downturn
One position that you don’t want to be put in is to see your shares halve in value over a period like the Global Financial Crisis, and have to sell some of these assets at depressed prices to raise money. Holding cash stops you being a forced seller in a downturn – you can always turn to your cash assets for liquidity. When you have to sell in a downturn, you have to sell more shares because of their lower share prices. This makes it harder for a portfolio to recover its value.
Holding cash, even at very low interest rates, has a surprisingly modest impact on the overall portfolio return. Let's assume the future return from Australian shares is 10 per cent a year, and cash continues to return 3 per cent pa. A portfolio that is 100 per cent shares has an expected return of 10 per cent pa. A portfolio that is 75 per cent shares and 25 per cent cash (ie with a nice cash buffer) has an expected return of 8.3 per cent pa. Sure the return is lower, but so is the volatility of the portfolio, there is improved liquidity in the portfolio, and more chance to be an opportunistic buyer rather than a forced seller in a down market.
The great mistake: wading into higher yield investments
There is a great investment slogan that I have heard from time to time. “Shares let you eat, cash lets you sleep.” All of the roles of cash outlined here let you sleep better at night, and don’t distract from the crucial role that growth assets play in portfolios. One thought of caution to finish with – it is often at times when there is dissatisfaction with traditional asset classes that “alternative” investments become more popular. The collapses of investments such as Fincorp and Westpoint are probably fresh enough in people’s minds that they won’t chase high yield returns too aggressively – the profound financial relationship between risk and reward mean that anyone paying you a high rate of return is only doing it because the underlying risks mean they can’t raise that money paying someone less.
Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.