Cash is widely considered as one of the safest investments available to investors, especially when we consider the case with U.S. dollars. Investors with piles of cash were able to benefit during market downturns by picking up stocks of high-quality companies at bargain prices.
While there is no arguing about that, Ray Dalio (Trades, Portfolio) believes holding on to cash at present is one of the worst mistakes an investor could possibly make. In an interview with CNBC last week, he commented:
“Cash is trash. Get out of cash. There’s still a lot of money in cash. The depreciation of the exchange rate and the printing of money over the next few years is going to be the biggest thing”
This statement contradicts the portfolio positioning of Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial), as the conglomerate had approximately $124 billion in cash at the end of the third quarter of 2019. This cash pile has grown consistently in the recent past.
Buffett’s portfolio allocation
Source: GuruFocus
The contrasting opinions of two of the most-followed investors could lead to confusion, resulting in investors making decisions that are not the best for the long-term performance of their portfolios. In light of this, I will discuss the implications of these two opinions.
Demystifying the risk-free nature of cash
Excess liquidity in a portfolio is often considered a risk-free component as the face value of dollars would neither decline nor increase. However, this is not entirely true from an economics perspective because inflation could significantly reduce the purchasing power of any currency. This is one of the reasons why cash as an investment leads to erosion of the real value of a portfolio.
Source: Hands-on Banking
In the United States, the Federal Reserve has set the long-term inflation target at 2% and in the last decade, policymakers have been successful in achieving this. Even though the depreciation of real value would not be as spectacular as is shown in the above graph, inflation in the U.S. will still continue to reduce the buying power of cash in the future. Therefore, the notion that cash is a risk-free investment is not entirely true.
As contrasting as it might sound, both Dalio and Buffett seems to be correct
When a hedge fund manager as successful as Ray Dalio (Trades, Portfolio) issues a warning to investors, it can usually be backed up with economics theories. This remains true for his latest advice as well, which is to throw away cash. Equity investments have far outperformed all other asset classes in recent years on a real return basis. As evident from the below illustration, the alpha returns provided by stocks have tended to be more significant in the long term.
Source: Barclays
Over the preceding 20 years up to 2015, equities have provided an alpha return of 1.4% per annum over government bonds. While this might sound meager in isolation, consider the growth of a $10,000 investment made in the first year in each of these two options.
Source: Author’s calculations
It’s evident that a small difference per annum could churn up to a massive amount at the end of a long investment term. This is precisely why investors need to look at the bigger picture and not the short-term outlook for any asset class.
According to the Shiller price-earnings ratio, the S&P 500 Index looks very expensive, which is one of the reasons why some investors are waiting on the sidelines for better opportunities.
Source: GuruFocus
However, this doesn’t mean that investors should distance themselves from equity markets for good. In each sector, some companies are unloved, and as a result are trading at very cheap multiples. A contrarian approach involving these companies has the potential to provide attractive real returns in the next few years. On the other hand, there are many opportunities in international markets. According to popular analyst Lyn Alden, below are the markets that are trading at very low multiples in comparison to their historical levels.
- Russia
- Poland
- South Korea
- Singapore
- Spain
- Turkey
- Brazil
In other words, investors seeking value should look for opportunities outside the United States rather than avoid equities altogether.
When Dalio says cash is trash, he is, in particular, addressing retail investors. Empirical evidence suggests that cash hardly provides positive real returns even if held for an extensive period of time. He suggests that investors maintain a diversified portfolio that can provide attractive returns under various macroeconomic and geopolitical conditions. At Davos, Dalio reiterated his bullishness on gold as well.
Warren Buffett (Trades, Portfolio), on the other hand, is no retail investor. The decision-making process of the "Oracle of Omaha" is a complete contrast to that of a common investor, which needs to be factored into the analysis before jumping on to conclusions regarding his recommendations. According to data from GuruFocus, Berkshire Hathaway likes to acquire a sizeable stake in the companies they deem attractive, often ranging from 10-30%. This makes it practically impossible for the company to make investments in small-cap stocks without creating a significant impact on the market price. Therefore, even if attractive opportunities are available in small companies, Buffett might be forced to hold on to cash.
In the 2018 annual letter to shareholders, Buffett wrote, “Prices are sky-high for businesses possessing decent long-term prospects.”
While acknowledging this fact, Lori Calvasina, head of U.S. equity strategy at RBC, wrote in December, “U.S. equities remain highly overvalued relative to non-U.S. equities. We aren’t looking for much multiple expansion in 2020.”
It’s clear where growth is predicted in 2020 - outside the United States and many developed regions of the world. Warren Buffett (Trades, Portfolio) might not find opportunities, but retail investors can look for them in small companies and outside the U.S. The legendary investor’s primary duty is to Berkshire Hathaway shareholders, and as a conglomerate that carries out large-scale investments, it makes sense to wait for a better time to invest.
Takeaway
It’s important to differentiate between Ray Dalio (Trades, Portfolio)’s advice for retail investors and the strategic moves of Warren Buffett (Trades, Portfolio), who makes billion-dollar investments in companies. Empirical evidence suggests that allocating a higher portion of a portfolio to cash will lead to disappointing returns in the long term. While it might make sense to strategically hold on to cash to purchase stocks when they are cheaper, timing the market cannot be executed with any degree of precision.
Therefore, while both these legendary investors are correct from their perspectives, a retail investor would likely be better off following in the footsteps of Dalio when it comes to his advice regarding cash. Even though there will be ups and downs, short term movements of equity prices should not worry value investors. There are opportunities outside the U.S., and a diversified portfolio will yield acceptable returns, as it has for centuries.
Investors need not look beyond the advice of Peter Lynch on this subject. “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
Predicting the next move of the broad market will likely prove a fruitless task. It makes more sense to identify companies with strong fundamentals, bet on these companies and remain oblivious to the movements of the market until the shares converge with their intrinsic value. A correction might or might not come, and when it happens is something that we have no clue of in advance.
It seems appropriate to end this analysis with another quote from Lynch:
“I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”
Disclosure: I do not own any stocks mentioned in this article.
Read more here:
- A New Stock Pick of Warren Buffett's for Growth Investors
- Apple Is Overvalued, and Rupal Bhansali Thinks It's Time to Short
- Outlook for REITs in 2020, and 2 Companies Backed by Gurus
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
