July 2011: The Cash Paradox

 

When is the best time to hold cash reserves in your portfolio?  When interest rates are low, like now, it’s the most attractive time to hold cash.  Why? When interest rates are low, asset valuations are high (expensive) and future returns on investments with high valuations are poised to deliver below average returns. Holding cash reserves when valuations are high (as they are at present) provides an opportunity to buy investments in the future at lower prices.

This seems counter-intuitive to most investors.  They mistakenly think that holding cash in an ultra-low interest rate environment, like now, is a poor decision because the interest they’ll receive is minimal. That would be a correct conclusion if only considering interest earned.  But, what if you also consider what that cash will do for you in the future?  Having cash available for investment is necessary if you want to be able to take advantage of low prices that arise in the course of normal price fluctuations and especially when economic shocks temporarily push prices to abnormally low levels.

Opportunities to buy stocks and bonds cheaply are of no useful benefit to you unless you have cash reserves to buy and seize those opportunities when they arise.

When is the worst time to hold cash in your portfolio?  When bank CDs and money market interest rates are high it’s the least attractive time to hold cash.  Why?  When interest rates are high it means valuations are low (prices are cheap) and it’s a great time to put cash reserves to work, buying investments at cheap prices and with a likelihood of providing high future returns.

This, too, is counter-intuitive to most investors.  They look only at the interest earned and overlook the far more lucrative opportunities available from buying stocks and bonds cheaply to capitalize on potentially far superior returns over multi-year periods.

 

How Much Do You Hold In Cash?

Asset Allocation Advisors’ typical managed portfolio has about 16% in cash.  This is double the amount of cash currently held by the typical moderate balanced mutual fund (Morningstar Moderate Allocation Category, an index of 800+ balanced mutual funds with 50-70% in stocks and the remainder in cash and bonds).

In light of continued worldwide economic weakness and, more importantly, elevated valuations, we view cash balances of 16% as being a prudent, cautious strategy.  It provides ample firepower to take advantage of lower prices when they become available (for the patient, they always become available.)  At this time we are more concerned about capital preservation and waiting for opportunities than we are about possibly missing out on slightly higher returns.

It is important to note that your “cash holdings” are not limited to just the money market fund balance on your monthly brokerage statement.  The overall cash balance of your portfolio also includes the cash held within each of your mutual fund investments.  Restated, if you constructed a spread sheet categorizing the holdings of each of your mutual fund investments (percentages in cash, stocks, bonds, etc.), then summarized them, your overall cash holdings would come to about 16% of your portfolio.

Of course, as the managers of the various mutual funds in your portfolio raise additional cash by selling investments, or redeploy cash into other investments, your overall cash balances will increase or decrease accordingly.

 

Investing In a Fragile and Uncertain World: What Should I Do Now?

“We cannot direct the wind, but we can adjust our sails.” -- Anonymous

Today’s world of economic and political uncertainty poses challenges to all investors seeking profits and protection of their capital.  The issue is how to cope with these uncertainties.  How should prudent investors position their portfolios when the possible outcomes of these uncertainties and their impact on investment markets could vary significantly?

The dynamics of today’s fragile and rapidly changing world have taken us into uncharted waters.  Government and central bank efforts to accelerate global economic growth have been unsuccessful.  They have tried bold, untested and extremely costly fiscal programs (stimulus, aka spending) and monetary programs (ultra-low interest rates and “Quantitative Easing”; see our October 2010 Commentary: Quantitative Easing Explained) without achieving the desired results.  Nonetheless, as investors, we must make decisions to position our capital despite today’s uncertainties, conflicting data, and wide range of possible outcomes.

While some proclaim they can predict exactly what the future holds and, therefore, know the exact outcomes and what will be the most profitable investments to own, the truth is no one knows for sure the exact course of future events.  More importantly, assuming a single outcome with certainty creates a dangerous situation for risk-averse investors; betting on a single outcome means you might potentially be 100% correct and garner outsized profits, but it also means you might potentially be 100% wrong and incur substantial losses.  Moderation is important.

Our task is not to “fix” the world with policy prescriptions.  There are more than enough politicians and pundits to spin their wheels on that task.  Our task is to invest wisely and prudently in light of today’s unknowns.  We believe that investors must be prepared for a wide range of possible outcomes.  This is not a typical phase of economic expansion and contraction.

More than ever, the best preparation for the unknown and a wide range of possible outcomes is embracing an all-weather portfolio that holds a diversified mix of investments that includes all asset categories --- foreign and domestic stocks, bonds, convertible bonds, cash, and even precious metals and commodity sensitive investments.  A broadly diversified balanced portfolio means you’ll give up the chance of ever having 100% of your portfolio in the best performing investment category, but it also means eliminating the possibility of ever having 100% of your portfolio in the worst performing asset category.  That’s a trade-off that every prudent investor willingly makes.

 

Investment Plans

Our near-term plans include the possibility of further reducing portfolio stock allocations below 50%.  (In fairness, adding or trimming stocks, or any other investment, is always on the table.)  We continue to explore ways to make money without being dependent on the stock market.  So far, our investment in a foreign bond mutual fund has achieved this objective.  This investment helps insulate us from gyrations in the stock market and, more importantly, benefits from Federal Reserve policies that continue to weaken and debase the U.S. dollar.  (As an aside, if the Federal Reserve was trying to weaken the dollar, they could not do a better job than they have the past two years.)  As the dollar weakens against foreign currencies, foreign denominated bonds and currencies are worth more dollars when sold and repatriated in dollars.

We believe our investment strategy --- focused on balance, diversification, moderation and patience --- provides what prudent investors need in today’s uncertain and rapidly changing world.  Our strategy is not glamorous, nor is it entertaining.  However, we believe it is an effective path to tackle the investment challenges of today’s world.

 

Closing Thoughts…

Managing your nest egg is a serious matter.  We frequently remind ourselves that it is a privilege and an honor that you have entrusted us to manage your investment capital.  We appreciate you and the opportunity to serve you.  Thank you! ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2011