The case for cash

Holding excess cash is seen as laziness, as doing nothing. Few individuals hold cash, and fewer institutions. Gareth Brown explains why he's changed his tune.

Investors need to be careful what lessons they learn from the incredible and, in all likelihood, fairly unique market downturn of 2008/09. The stockmarket (and most investors’ portfolios) fell by more than 50% between November 2007 and March 2009.

Our lazy minds naturally seek the easiest-to-find lessons. Our brains' hardwiring tends to encourage us to prepare for the last war, so to speak, rather than soberly assessing future risks.

That’s why we have former property trust investors swearing off all listed property (as opposed to just overpriced and overleveraged property) and buying mining stocks or bank stocks instead. Meanwhile, those who lost on small mining stocks are mostly off doing other things, growth investors are seeking more dividends and value investors are questioning whether buy and hold is dead. 'Don't make the same mistake!' is often the lesson taken.

Overseas, Americans have left the stockmarket (currently fairly cheap) in droves and are ploughing into government bonds earning a few percent (and long overdue a bond bear market).

I’m trying hard to avoid the easy lessons and instead focus on the important ones. There are two in particular that I think will stand the test of time.

Firstly, I was under-diversified going into the last crisis. Compared with five years ago, I’m working much harder on having adequate, and thoughtfully uncorrelated, diversification. It’s perhaps a topic for another blog post.

The other lesson I’ve taken to heart is the strategic value of holding cash. I’ve written and spoken about this elsewhere in Intelligent Investor articles, podcasts and videos, but thought to cover the matter in one place today.

Prior to the crisis, I was a Peter Lynch ‘get caught with my pants up’ kinda guy, not so much by design but, in all likelihood, by ambition and a little greed. I figured stockmarkets go up over time, and so I’m better off having 100% of my wealth invested in my 10-15 favourite opportunities than just 75%.

That attitude and ambition really helped in my grubstake days where I’d, quite literally, reduce spending on such frivolities as eating breakfast or putting petrol in my car for a week or two in order to have another few hundred dollars to put in my favourite new stock idea. But the attitude never changed, and it should have at least a decade ago.

There are drawbacks to feeling the pull toward being fully invested at all times, many easily overcome by developing a willingness to hold cash.

Since the nadir of the crisis, I’ve switched to the Seth Klarman ‘in the absence of bargains I hold cash’ school of thought. It didn’t come naturally at first but I’ve gotten there.

Including unlisted investments in my overall portfolio, I’m about 25% in cash today. It was lower, perhaps 10-15%, when bargains where more plentiful in August-October 2011, and higher when bargains were rarer in early 2011. This excludes the ‘rainy day’ fund set aside in case of a family disaster, I’m talking about the potentially investable cash here.

Although it’s impossible to know for sure (who’s to say where that money would have been invested had I not opted for cash), I suspect I’m better off so far for this three-year experiment, one that’s likely to turn into a lifelong practice. Here are some of the advantages of a willingness to hold cash:

1.    It introduces real discipline when it comes to selling. As a value investor, I’m committed to keeping a portfolio of underpriced securities. But the reality was that I was giving leeway to fairly priced, even slightly overpriced securities if there were no alternative bargains to buy. Now, I ditch fairly valued securities from my portfolio and happily sit on cash instead. It needs to be cheap to stay in my portfolio. I’m more concerned with real loss than the fear of missing out.

2.    The willingness to hold cash also improves discipline when it comes to buying. Just because it’s the best opportunity I can find today doesn’t mean it’s a great opportunity. Reserving the right to hold cash allows me to consider tomorrow’s (unknown) opportunity set as a valid alternative.

3.    I have real firepower when true bargains emerge. I don’t have to ‘sell cheap to buy cheaper’ as I did in 2008/09. Panics and bargains tend to emerge at least every few years (although few will look like 2009). As in August 2011, I’ll be ready for them when they come. In the meantime, I’ll prefer cash to cheapish securities. I might not have all my money ‘working’ all the time, but market downturns now create more wealth for me today than in the past.

4.    Likewise, overpriced markets create more wealth through the ability to ‘cash out’ and sit on the sidelines for part of my portfolio.

The upshot of all this is that while I don’t have 100% of my wealth invested in growth assets all the time, the 75%-80% I tend to have invested is, on average, a cheaper and better constructed portfolio (the sell discipline in particular helps in this regard).

Add the benefits to overall returns of being able to take bigger swings when real bargains do emerge, and the tendency to be less invested into downturns, and the argument in favour of holding cash has won so far. It’ll be a different matter in a mindless 20-year bull market, but that’s something I’ll need to reconsider if we have another such anomaly in my lifetime.

Cash is seen as laziness, as doing nothing. Few institutions hold cash, and those that do risk getting fired when they inevitably underperform.

But that in itself is a lazy attitude. Analysing stocks, pruning overpriced investments and having the wherewithal to really swing at the true bargains isn’t laziness, it’s what value investing is all about. Some people want their money ‘working’ all the time, and I understand the viewpoint. But I’ve come to the conclusion that the smart money is the type that works hard when the risk/reward equation is compelling, and spends much of the rest of the time on the bench.

What are your attitudes to holding cash? Has your approach changed since the financial crisis?

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