My son is 10 years old and has a birthday coming up.  Behold, the wondrous note he left for me when I asked what he would like to receive on his special day:

The after-thought addition of “…Just kidding” you can see poking up at the bottom right corner was meant to be ignored, I’m sure, but it got me thinking about cash and investor psychology. Our relationship to this asset class is volatile: when things don’t look so good economically or in the markets, we frequently wish we’d ‘gone to cash’ before things turned sour.  And, when boom times arrive, we look at the allocation to cash in our portfolios and wonder, ‘why am I holding cash? I’m missing out on the good times!’ 

Dough.  Moolah.  Gravy. Cash is King.  Money makes the world go round. The love of money is the root of all evil.  As I said: our relationship to cash is complicated.

How much cash to hold in a portfolio is a decision equal in importance to how much fixed income or equity an investor should be holding.  And, like all allocation decisions, it is not a static percentage but can vary depending upon individual needs over both the short and long term, tolerance for taking on risk, and near-term market conditions.

Loss aversion amongst investors should not be understated: we hate losing money more than we love making it.  We also are biased toward looking at things in the shorter term. We know that over time, holding too much cash has consequences: after all, after taxes and inflation, this liquid asset provides negative returns. But the surety of short-term comfort can often times outweigh the possibility of future gain.  Many of us remember the market lows of early 2009 – I hear stories all the time from people who tell me they sold at or close to the bottom, and have yet to recover to levels where they were prior to the recession.  Indeed, such was the fear that surrounded that event, the subsequent US market marches upward since that time has colloquially been referred to as ‘the most hated bull market in history’, as investors struggled with the concept of committing cash back into equity markets.

At some point in time, however, the tipping point will usually occur.  Everyone has a hot stock tip, it seems like markets keep going up no matter what bad news hits the wires, and suddenly the fear of missing the party overcomes the fear of losing. Holding cash is a drag, both in terms of excitement and overall portfolio returns.  Pressure to mobilize the cash in the portfolio into a more dynamic growth asset class can lead investors to pay inflated prices – setting up the classic “buy high and sell low” cycle.

We believe cash has a place in all portfolios, and it is prudent to hold 5-10% of the overall portfolio value in this asset class no matter what is happening in the markets.  At times, it may be warranted to go as high as 20%, but in our opinion, this is not a wise long-term strategic move as over time this will have a significant effect upon overall performance.

Why do we say to keep cash in all instances?  There are three reasons.

• Lifestyle funding needs: your basement floods, your son’s birthday is coming up (see above), the dog needs surgery, or you really have your eyes on that shiny new Audi R8 (also on my son’s birthday list, by the way, even though he is years away from having his license thank goodness).  With cash available in the portfolio we are not faced with the unsavoury necessity of selling bonds or stocks to raise funds when the timing might not be optimal.
• Opportunities: our job is to invest people's capital to deliver a return that’s better than the risk they are taking. At times prices are elevated which translates to fewer opportunities where this is the case. In that situation, it's good to ‘keep your powder dry’ and be ready for when opportunities to add good companies at decent valuations once again present themselves.
• Mitigating volatility: roller coaster rides can be fun when we’re at the amusement park – not so much fun when the market is in a strop.  Having a reasonable allocation to cash and cash equivalent investments helps to smooth the daily and monthly ups and downs in the portfolio so that we can get a better night’s sleep.

So, in summary, it’s not rocket science. Cash can help in the shorter term, and cash can hinder over the longer term.  It’s all about finding the right amount to hold at any moment in time, given your needs and goals.  It has a place in every portfolio, and the degree to which it forms part of the allocation is unique to you.

I’m off to put a few loonies into a Ziploc bag and throw them in the freezer, in preparation for my son’s big day.  I’ll get chided for being too literal but in this case, I’m looking forward to it.