Cash deserves an allocation within portfolios. In our blog last week, Aurum Access: The Role of Cash – Part 1, we covered "why" for liquidity management reasons, but its importance extends to opportunity risk management.
Combining “opportunity” and “risk” into a single phrase for holding cash boils down to one reason, because the price paid for an asset matters. When valuations of assets are too high, the expected future returns are low. When valuations are too low, the expected future returns are high.
An example of this below is the Shiller P/E. Named for Professor Robert Shiller, but orginiating from Ben Graham (Warren Buffett’s value investing mentor), the Shiller P/E seeks to average out the ups and downs of the business cycle by normalizing the past ten years of earnings.
Source: Asness, Shiller[i]
It has some efficacy in predicting future returns, but most interestingly, it shows when the starting P/E (valuation) is low (left), historical returns are higher (Average Real 10 Year Return). When the starting P/E (valuation) is high, historical returns are lower.
“Investing is simple – but its not easy.” – Warren Buffett
After a period of outperformance above expectations is typically when values are high and thus future returns low, and thus when one would should trim or sell. Still, this is also the time when our behavioral investing shortcomings as human beings come in to play and makes it difficult to sell. Conversely, after an asset class underperforms dramatically and has news stories saying how terrible of an investment it is, future expected returns are above average. The rational economic agent should buy or increase holdings, but the brain reacts to the danger of losing in the short-term and tells us to stay away.
Cash should be the default holding when an asset class becomes fully or overvalued, as holding it expecting it to go higher is not investing, but speculating on whether a “greater fool” will come along and buy the asset at an even higher price.
Hence, cash serves as a risk management tool for portfolio construction. In the same sense, it serves as the dry powder for future opportunity. Waiting for the ‘fat pitch’ to come down the plate, cash offers optionality to respond to attractive valuations served up by an asset class that falls out of favor for other investors.
During periods of instability in capital markets, asset prices tend to converge and go down together, precisely when a portfolio needs the diversificaiton benefits of multiple assets. The chart below is the correlation of asset classes with the S&P 500. Distressed periods are months when the S&P 500 fell more than 3%, or the 15% worst performing months.
In contrast to many asset classes, a great attribute of cash its zero correlation with other assets – in both normal and distressed marekts. This provides the liquidity necessary to take advantage of an attractive ‘option’ when presented.
Today, with U.S. equity markets hitting all time highs and large inflows into bond funds the last few years, money markets as a percentage of total assets are at all time lows.
This, alone, is not a reason to increase cash as an allocation. Nonetheless, if asset classes deviate from the initial portfolio’s target policy ranges, then prudent investors should adhere to the investment process. Holding cash as an opportunity risk management tool makes sense to us as investors with a long-term valuation focus.
 Asness, Clifford, Ph.D., AQR. “An Old Friend: The Stock Market’s Shiller P/E.” November 2012.
Aurum Wealth Management is ready to help you manage your funds, understand performance cycles and position you with a solid financial foundation. For more information, contact us at 440-449-6800 or visit us online at aurumwealth.com