Aurum Wealth Management Blog

Aurum Access: The Role of Cash – Part 1

We believe that cash is an important asset class within portfolios. The proper cash allocation is driven by two main factors: (1) liquidity management and (2) opportunity risk management. 

Liquidity management is fancy term for a simple concept, making sure withdrawals over the next year sit in a liquid form and ready to go.  Liquid form means cash in an account or a U.S. Treasury money market funds transferrable out to other banking institutions; it does not mean a ‘safe stock’ or bond fund.  (For the purposes of this article we will refrain from discussing the requisite ‘emergency fund’ most financial planning articles cover.)

The liquidity necessary to meet known withdrawals (living expenses, taxes, insurance payments, etc.) over the next one year period should replenish continually so that at least twelve months of withdrawals are available.  Secondarily, assets to meet the spending needs in the 12-36 month timeframe should also be part of liquidity management.  We place the incoming interest and dividend payments from underlying stocks and bonds into the secondary portion. 

“If you have trouble imagining a 20% decline in the stock market, you shouldn’t be in stocks.” John Bogle, founder of Vanguard.  Over the last 35 years, the Russell 2000 Index of small caps stocks declined 20% or more nine times, or about once every four years.

 
Source: Aurum, Informa Zephyr

Relying on systematic withdrawals from stock portfolios to fund spending needs is not a prudent approach, since being a forced seller into a weak market is not the side of the trade one would prefer.

“More money has been lost reaching for yield than at the point of a gun,” said Raymond DeVoe Jr., financial market historian.  This quote typically serves as a warning to bond investors about downgrading credit quality or extending duration, thereby increasing the original risk target and ‘reach’ for the yield they ‘need.’  Nonetheless, it applies to the liquidity management side of portfolio construction.

The New York Fed just put up a great post, highlighting the 15 largest bond selloffs since 1961.  Using a zero-coupon 10 year note, the bond selloff through July ranks 13th out of 15 with the often cited 1994 selloff as the fifth worst.  It provides important context about the shakeup in the fixed income world the last few months and the dangers of reaching for yield.

Understanding the historical volatility of bonds provides more reason for a strategic cash allocation.

  The pushback against our argument for cash as an asset class is easy, “cash earns nothing” and thus should be invested.  If one believes this mantra, then extolling the virtues of liquidity and opportunity risk management probably do little good.

Take a real life example of a couple planning on spending $200,000 of their $5 million portfolio.  One might say that the $200,000 should be invested along with the rest of the portfolio.  With expected 6.5% expected return over the cycle, investing the spending needs over the next year and systematically monthly withdrawals, one could earn an extra $10,000 (given that the $200k would not be invested for the full year).  Conversely, the portfolio has a one in five chance of losing money over the next year, and the 95% confidence interval puts the drawdown potential at negative 15%.  So on the extra $200,000 that ‘needs’ to be invested, the portfolio stands a potential impairment of $30,000.  In this scenario, because the couple needs the cash for withdrawals, they must realize the losses on the portfolio and became a forced seller.  This impairment of capital would not be permanent had the time horizon for investment correctly matched the duration of the underlying assets.  Meaning, had the $200,000 been in cash, an on-demand asset class with zero duration, then the assets and liabilities match would be in unison.

Next week’s note will discuss factor number two driving cash allocations, opportunity risk management.

http://www.aurumwealth.com/news/weekly-access/151-aurum-weekly-access-080713

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