- Cash Is King
Most investors are either avoiding cash because of non-existent returns or have cash for the wrong reasons. The reason for holding cash is not because there aren’t good investment opportunities. There are many! But there are legitimate and important reasons to make cash king in your portfolio. Expensive bonds, event risk, and increasing correlation are important reasons to allocate a significant portion of your portfolio to cash.
Expensive Bonds
Interest Rate Risk is Why You Should Sell Bonds. Bonds are expensive. After 30 years of rising bond prices and falling yields most people believe investing in bonds should be a major part of their portfolio. They have, and are, being taught this myth. The reward for owning bonds is their yield, which is at historical lows. The major risk of owning bonds is when interest rates rise the price of the bonds fall. Therefore the reward for owning bonds is at record lows; and the risk of owning bonds is at record highs. Holding cash or a combination of cash and quality dividend paying stocks, in place of bonds, makes sense.
Event Risk
Event Risk is at a very high level. Our economy is moving forward but is fragile and moving at a snail pace. All it will take is an “event” to turn the economy and stocks down. It is possible governments will be able to prolong defaults in much of Europe; but the probability is uncertain and falling. Greece is gone (insolvent), forget it. Italy is the huge risk. If Italy is not able to stay solvent, the sheer size of their outstanding bonds will send reverberations throughout the global financial system.
Where does an investor “hide”? If these “events” begin to unfold, government will most likely flood the markets with liquidity. Holding all cash in an inflationary environment does not make sense. But holding too much in equities could produce large losses that could cripple a portfolio. The key is quality and balance.
Increased Correlation
A dangerous trend has developed since 2008 called the Risk On, Risk Off Trade where investors buy all risk assets (inflation bet) and sell all risk assets (deflation bet) at the same time. This has continued a long term trend, probably caused by index mutual funds, for asset correlations to become more positive. In other words, assets such as stocks, commodities, gold, and oil are highly correlated; they move up and down together. This is dangerous to investors who do not understand this trend because they falsely believe diversification will protect them from down markets. It won’t.
Cash is the only investment that has no correlation with risk assets. This makes the importance and value of cash to the whole portfolio great. Even at zero rates of return, cash can play in important role in portfolio asset allocation because of the increased correlation of assets.
Cash is King
I am not advocating all cash by any means. Having a 100% allocation to cash means you will probably have your assets devalued by inflation over time. But maybe cash should be the largest asset category in your asset allocation? Because bonds are expensive, event risk is high, and correlations are increasing; cash may be the most important investment in your asset allocation.
Today, Cash is King!
Disclosure: The Arbor Asset Allocation Model Portfolio (AAAMP) is 47% in Cash (11/15/2011)
Question: Do you think your asset allocation to cash is sufficient given today’s investment environment?
| AAAMP Blog by Ken Faulkenberry | |
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Ken Faulkenberry earned an MBA from the University of Southern California (USC) Marshall School of Business with an emphasis in investments. Ken has 25 years of investment experience and is dedicated to helping people with self-directed investment management through the Arbor Investment Planner. His asset allocation strategies have an outstanding performance record. |
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{ 2 comments… read them below or add one }
Hi Ken–whether anyone agrees with your advice, it is spot on. Bonds are a suckers bet right now–with interest rates at all time lows they have no where to go but up, and that could trigger a blood bath in bonds. Stocks will follow bonds down with higher rates; the only reason they’re as high as they are is precisely because low rates make them attractive. Since both stocks and bonds are running on the same catalyst, they’re in no way a true diversification from one another. A portfolio that’s 60% stocks, 30% bonds and 10% cash has 90% exposure to high risk investments!
The problem with a high cash allocation is that it doesn’t sound sexy in a world accustomed to double digit returns, and that means it won’t get us to a golden retirement, to say nothing of an early retirement. But the one thing it will do is keep us high and dry in a market crash, and given all the potential dominoes out there it’s really the only logical play right now. The interest rate game has been played to the hilt and is set for a reversal. When it does, cash will look like an island paradise!
Excellent thoughts. We need to spread the word and save at least some from the disasterous beliefs that the financial media spreads as the gospel truth. Thank you Kevin.
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