Summary: Cash provides a low-risk, fixed interest ballast to your portfolio that gives you options all-year around.
Key take out: Cash can be a source of liquidity, a buffer against volatility and a ‘call' option on opportunities.
Key beneficiaries: General investors. Category: Fixed interest.
Record low cash rates pose a challenge for investors – does such a low return asset class continue to have a place in a portfolio? I would argue strongly that the answer is yes – that the core role of cash is not in fact in its returns, but in the way that it dampens portfolio volatility, provides liquidity and it acts as a ‘call option’ on any investment opportunity that comes along.
The way that you use cash in a portfolio is of significant importance – an income planning approach, where an amount of cash held in a portfolio is determined based on medium-term cash needs, emphasises the importance of cash even when facing historically low interest rates.
It is, of course, a crucial discussion because the lower interest rates go, the more likely investors will try to find 'cash-like' investments offering higher ‘interest’ returns. The relatively recent history of Fincorp, Westpoint and similar investments should provide a reminder to be extremely careful taking risks with opportunities promising high interest.
The income planning approach to portfolio construction
A key decision for an investor is that of asset allocation, the mix of assets held in a portfolio at any one point in time. Models of asset allocation often see investments split between ‘defensive' assets (low return, low volatility) like cash and fixed interest investments and ‘growth’ assets (high return, high volatility assets like shares and property). With an income planning approach an investor decides how much income they need to withdraw from a portfolio over a timeframe that makes them comfortable, for example the next seven years, and invest that money in cash and low-risk fixed interest investments so that they know it is readily available.
As an example of how this might work, let us consider a retiree with a portfolio of $1 million. After research, they decided that a sustainable withdrawal rate from their portfolio is 4.5 per cent per year, or $45,000 per year. That retiree might decide that holding seven years of withdrawals in cash and low risk fixed-interest investments gives them peace of mind that their medium-term spending needs are looked after, so they set aside $45,000 x 7, or $315,000, in cash and low-risk fixed interest investments. Importantly, they have another $685,000 to invest in growth assets that offer higher returns and, importantly at the moment, access to higher yield investment classes like Australian shares with an average gross yield above five per cent per annum.
That cash holding is there to provide certainty about the next seven years of spending. Sure, it will be topped up by interest, rent, dividends and distributions received, however its main focus is to provide certainty and peace of mind for the next seven years (or five years, or 10 years – wherever the investor feels comfortable). Because the role of cash is to meet medium-term spending needs, the actual interest returns are not that important. Sure, it would be better to get 7 per cent p.a. over the next seven years rather than 2 per cent, however the reality is that even a 7 per cent p.a. return is not going to make a huge difference to a diversified investor using cash to meet short-term withdrawal needs.
Other roles of cash
The focus on cash meeting short- to medium-term spending needs provides the liquidity that a portfolio needs. If the retiree in our case study invests $315,000 in cash and term deposits, that money is quickly accessible for any emergency or opportunity that might come up.
A modest holding of cash also provides a buffer against volatility. Compare a 1970s, 1987, 2007-2009 style downturn where Australian shares fell in value by 50 per cent. An investor with all of their $1m in shares will have see that fall in value to $500,000. An investor with $315,000 in cash and the rest in shares will have seen their portfolio fall in value to $657,500 – still a challenging situation, but clearly preferable to a $500,000 portfolio balance. This demonstrates the important role that cash has in dampening the volatility in an investment portfolio.
Finally, cash provides a ‘call’ option (a right but not an obligation to buy) for any opportunities that come along. Consider the scenario around a 50 per cent market fall – there would be significant share buying opportunities available, as there were in 2009. A person with a $500,000 portfolio that has halved from being worth $1m and has no cash holding has no real way to take advantage of this opportunity. The investor with the higher portfolio balance and a significant cash holding of $315,000 can use some of that cash to invest in the share buying opportunities presented by a 50 per cent market fall.
These three roles played by cash – providing a source of liquidity, providing a buffer against volatility and providing a ‘call option’ on buying opportunities – are all rolls that do not rely on the interest rate offered by a cash investment. Of course, 8 per cent would be better than 2 per cent, however there are rolls that cash plays beyond just returns.
'Cash lets you sleep, shares let you eat'
For those who use cash as a strategic asset, providing medium term liquidity needs in a portfolio, dampening volatility and providing access to funds for investment opportunities, the importance of cash in a portfolio goes well beyond the interest paid. There is a quote about asset allocation that I came across some years ago, "Cash lets you sleep, shares let you eat". Cash and true defensive assets are about funding the medium term. Growth assets are about a higher rate of return over longer periods.