One of the things I like about investing is that there is no one way to do things. Part of the fun of this vocation is that you get to learn about what works for you and tailor your investment style to what fits your personality. As my martial arts instructor used to say, “There are many paths up the mountain.” I’ve written about this before. One of the ways that I may differ from some other (better, more successful ;) investors is that I often hold a lot of cash - like 20-30% of my portfolio in cash. In most “normal” market situations, I hold a large slug of cash.
My preference for cash is unusual in investing circles. I once participated in a breakout session with hedge fund managers. I asked them what they thought of cash as a position in a portfolio. To a person, they responded that they did not maintain a large allocation to cash. Some of their responses:
“Cash is a drag on portfolio performance over time.”
“Clients make cash allocation decisions outside of our accounts.”
“Clients pay us for a certain asset class exposure (or factor, etc.), and we need to deliver on that mandate.”
“If we are concerned about the market overall, we can hedge.”
And my absolute favorite:
“We have great LPs, and if there is a market decline, we are confident that LPs would step in and deploy more cash in our fund.”
I mean, how cool is that? You don’t have to carry any cash and suffer performance degradation, then when the market drops, you call up some clients, and they give you more money to invest. It is literally a call on cash. I can’t imagine that you could use it very often, but that is a huge structural advantage if you are running a (good) firm. I try to remember this when I read about how a certain fund is positioned.
During the same conversation, I asked them how they felt about cash in their personal finances. The answers were more circumspect. Most admitted to significant cash holdings. A few claimed very small cash holdings, while others suggested large ones. Their earnings are tied to the market and could fluctuate broadly over an investing cycle. So prudent cash management outside of investing seems like a reasonable financial strategy.
I’m not a fund manager. And I usually hold lots of cash. I consider this a barbell strategy - on one side is a very conservative cash allocation - and on the other is a very aggressive investing strategy. I’ve written about the importance of emergency cash before, but this goes well beyond that. I use cash as an investment position. Here are a few thoughts on why this works for me:
Age & Time Horizon: When I worked with clients, I often referenced what I called the “Earn it Back” model. It is explained easily with an example. Assume you are 30 years old, making $150k per year, and have a $100k investment portfolio. If you lose half of your portfolio, you can probably “earn back” the loss in 2-3 years. It’s not fun, but it’s not the end of the world. Now assume you are 60 and have a $2 million investment portfolio. If you lose half your portfolio, it will take many years to earn it back. And you may not even have time to earn it back and still hope for a reasonable retirement. I am neither 30 nor 60. But I am much closer to 60 than 30. I don’t want to head back to “Go.”
Cash is No Longer Trash: The return on holding cash was close to zero for much of my investing career. With short-term ultra-safe investments yielding nearly 5%, cash is a much more attractive holding.
Cash is Anti-Fragile: As a stock picker, nothing sucks worse than seeing a significant market drawdown and not having any cash to invest. I have been fully invested a few times and lived through a significant drawdown without having any cash to deploy. It sucks. You have to sit there and take the pain. On the other hand, I have lived through several instances where I had significant cash going into the event. It is much more fun! A sale! Look at all these great companies I can buy for a fraction of their value just a few months ago.
Not only is it more fun, but it is also a return booster during a market event. If you are down 50% and wait for your portfolio to come back, you return to where you started. If you deploy cash during a drawdown, you come out with more money than you went into the event. Of course, the price you pay for this potential outperformance in down markets is that you will underperform what is possible in up markets due to cash drag. This is a price I am comfortable paying at this point in my career (see point one).
It’s (Not) Market Timing: When I talk about this, I often get a lot of: “But you can’t time the markets!” Or: “Market timing never works!” Like this is some sin. Who cares? I’ve written before about the idea of preparation versus prediction. Acknowledging that markets decline from time to time is not a cardinal offense. Being prepared for a market drop is just prudent planning. They happen. I don’t claim to be able to predict when they will happen. That doesn’t mean we shouldn’t prepare for them to happen.
You must be able to put the cash to work in down markets. This can be tough to do. Many investors like the warm comfort a cash blanket can provide. It can be particularly seductive when the rest of your portfolio is melting down daily. Through past actions, I have proven to myself that I have the resolve to deploy the cash. Incidentally, this is what Charlie Munger does. He’s said: “I didn’t get where I am by going after mediocre opportunities.” Charlie holds cash and waits for the best investment opportunities.
I hope sharing my views on cash as a holding helps you think through your investment strategy. To be clear: I am not giving investment advice. What I do might not be appropriate for you, your situation, or your temperament. Hopefully, sharing my philosophy may help you think through yours as well.