Asset allocation refers to a strategy that aims at creating diversification within a portfolio in order to balance risks. By dividing assets across certain categories such as stocks, real estate or bonds, you are reducing your risk exposure to a single asset. Each asset has a different level of risk and returns, which means that one asset can hedge the movement of an asset.
Portfolio rebalancing is essentially a reshuffle of the asset allocation. For example, stocks performed very well while gold had a disappointing run. Based on your outlook, you could either cut your losses in gold and pour more money into stocks. Alternatively, you could also take the profits from your stocks and double-down on gold.
When you decide to rebalance your portfolio, you also need to think of the remaining time you have left in the market. If you are young and stick to shares, you can ride the stock market for a very long time without significant consequences. If you are approaching retirement, the traditional advice is to dial back your exposure to equities for the benefit of bonds and government-backed debt as they are deemed to be safer. The outlook overtime shifts from capital growth to capital preservation.
Cash is also an asset and will be featured in your asset allocation. From discussions with asset managers, investment bankers, colleagues, and even friends, most people will tell you that holding cash is a mistake. In the long term, I tend to agree. Unless your savings account has a very high interest rate, your cash will slowly lose its value because of inflation.
As a result, cash usually represents less than 10% of someone’s portfolios. The rest is a mixture of equity and bonds. More sophisticated investors – or people who think that they are smarter – will dabble with options and futures.
Yet, currently, less than 5% of my net worth is currently invested or at risk. The rest is in cash. Clearly, I can’t pretend that I don’t understand the economics. Also, I don’t detest capitalism, the stock market, and financial institutions. After all, more than anyone, I understand leverage and debt due to my professional background. So why am I taking the risk of holding so much cash?
Holding Cash May Only Be a Temporary Strategy to Invest Significantly More Later
People who hold a lot of cash generally don’t try to time the market. They simply hold cash because they have a significant expenditure or investment coming up. They know it’s coming and, quite rightfully, they make sure to be prepared. In a way, there are holding cash despite them and their best intentions.
The most common reason to hold cash is to build a down payment for a property. First-time buyers in London are completely priced out of the market and the down payment is, for many, unaffordable. Based on recent data from the ONS, London first-time buyers can expect to spend 13 times their salary to purchase a home. Kensington and Chelsea was the least affordable area in 2017, with median house prices being 40.7 times median workplace-based annual earnings.
In short, you need a lot of cash laying around to even come up with a down payment. Real estate is a well-known asset class and nobody will question the logic of purchasing a property. To get there, you might need to park cash and that is fine.
Holding Cash May Be the Only Option to Open Specific Savings Accounts
If you want to hedge currency risks with your savings, then you have little choice but to hold cash. You could hold U.S. Treasury bills or other government debt (i.e. which are cash equivalents) denominated in the currency of your choice, but you would still be subject to the fluctuations of bond prices unless you decided to hold until maturity. Even if you held until maturity, inflation would erode your returns in the same way as it would for a savings account. In this scenario, holding cash is the simplest way to set up your currency hedge. It is true that you could also open an account with a broker and start trading currencies. My concern is that the brokerage fees and the lack of interest (or de minimis interest) would end up being too costly in terms of fees and time. For this reason, it is probably best to stick to boring savings accounts.
In addition to holding cash in different currencies, there are certain accounts that are only available in cash. One example is the Help to Buy ISA. Based on a limited review of available offers, there is no stock and shares option for the Help to Buy ISA. As a reminder, the Help to Buy ISA is a tax-free saving account for the down payment of your first home. You save money into the account and the Government will top up your savings by 25%. As an example, for every £200 you save, the Government will give you a bonus of £50. The government’s bonus is capped at £3,000. Due to the tax incentives, this account is extremely popular. Having your savings in cash because that’s the only way to contribute to your Help to Buy ISA is completely acceptable.
Holding Cash To Have Some Peace of Mind
If I offered £2,000,000 in cash, I would expect you to take it. If I offered you £2,200,000 in the form of a £3,000,000 house with a mortgage of £800,000, I believe that most people would choose the cash over the house. Finally, I believe that most people would still choose the cash over the house even if they did rent their primary residence. Although I am offering you 10% more money with the house option (and I don’t count money saved on rent), I am ready to bet that you would take the cash offer. I probably should do a survey to test that theory! Feel free to disagree with me in the comment section.
If you are arguing that the amounts are so large that people in those situations probably already make good money to afford such a mortgage, you are missing the point. Divide the numbers by five if it makes it more realistic.
The point is that most people will prefer cash because servicing £800,000 over for another 5 to 10 years is incredibly stressful. You need a continuous source of income and that income cannot fall below a certain level or you risk forfeiting an asset in which you have already poured a lot of money. This assumes that you have a fixed-rate mortgage. If not, you will have to refinance your mortgage without knowing what future market conditions will be like. With yields creeping back up across the United States and other major economies.
Even if you don’t have assets beyond the £2,000,000 in cash in your bank account, it is a great feeling to know that whatever the emergency, you will be in a strong position to deal with it. There is no reason to fear a costly medical bill or even the loss of employment. While some stress can be a positive catalyst to overcome some of the challenges thrown at you, I believe that stress caused by money tends to take a toll on someone’s health. Therefore, taking the cash to avoid that stress at all costs is sensible.
Holding Cash to Make Bank in a Downturn
If you already own your main home and are hoarding large sums in cash, there is a good chance that your outlook on the stock market or the world economy is reasonably bleak. As of this post, the Nasdaq is down 4%. Congratulations.
Warren Buffet famously said that “only when the tide goes out do you discover who’s been swimming naked.” In other words, one might appear to be asset rich when the economy is booming but if that person cannot service that debt in a downturn, then it wasn’t really that person’s money but the bank’s. When a recession hits the economy, it won’t take long to see the people who were over-leveraged and the rest who is sitting on cash and fully paid assets.
Unless inflation spirals out of control, sitting on cash during a recession feels great because the same pot of money can buy a lot more assets without doing any work. Therefore, if your net worth is mostly cash, you do not even have to short the market to increase your purchasing power. You won’t have made money until you act, but theoretically speaking, you are richer than you used to be in terms of purchasing power.
A stable financial position and an increased theoretical purchasing power are already nice things to have in a recession but they are not the real prizes.
The most important benefit of holding cash in a recession is that people are willing to pay a lot of money for your cash. Of course, they won’t give you cash for cash as this would make no sense. Instead, they will take your cash and give you shares, stock options or other instruments so that you can recoup your investment.
Don’t believe me? Check out that deal made by Warren Buffett and the venerable investment bank Goldman Sachs in 2008, at the height of the financial crisis.
Buffett gave $5 billion in late September 2008 to Goldman Sachs. In exchange, Goldman agreed to hand over (i) $5 billion in preferred shares and (ii) warrants that allowed Warrant Buffett to purchase an additional $5 billion shares at a price of $115. At the time, the shares were still trading at $125 so they were in the money on day 1. Presumably, Buffett expected things to get worse and wanted to have a cushion (as it turned out, he was right, the stock price of Goldman continued to tank). It also doesn’t stop here.
Goldman Sachs also agreed to pay Berkshire – Buffett’s holding company – a yearly 10% dividend, with the option of buying back the stock at any time for 10% more than what Berkshire had paid. Goldman did so for $5.5 billion in April 2011. The estimated dividend over the period is $1.3 billion. So $1.1 billion of dividends and $500 million of capital gains, Buffett made a return of $1.8 billion on the preferred shares. Then comes the warrants.
In 2013, the warrants were exercised at approximately $147. If you are interested, you will see that there were wild swings in the stock price of Goldman and the warrants were under water for while. Warren Buffett netted about $1.4 billion. Even better, according to news reports at the time, he did not have to front the $5 billion to Goldman to purchase the 43.5 million shares it had a right to purchase at $115. Goldman gave Warrant Buffett the difference in stock.
In the end, Warrant Buffett walked with $3.2 billion profit, which amounts to a return of 64% in only four and half years. Not bad.
This example illustrates that desperate people or companies will pay you a lot of money if they really need short-term liquidity. Of course, not everybody is Warren Buffet. Part of the reason why Goldman paid so dearly was to obtain the Buffet “stamp of approval”, which is always a public relations win. And that’s what Goldman needed most in the midst of the financial crisis.
However, if you do your due diligence correctly, there will be people or entities that are profitable in normal conditions but that require additional liquidity when under stress. There is no need to come up with an elaborate term sheet. Scoop up some cheap shares and wait. Avoid options at all costs as markets are likely to be distorted and timing the recovery is as risky as timing the recession.
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