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Rupert Hargreaves
Rupert Hargreaves
Articles (1265)  | Author's Website |

Why It's Impossible to Place a Value on Cash in a Portfolio

Some thoughts on cash as an asset class

July 09, 2020 | About:

The idea of holding cash in an investment portfolio has sort of become demonized in media over the past few years. Earlier this year, Ray Dalio (Trades, Portfolio), the founder of Bridgewater Associates, declared that "cash is trash," and many other analysts seem to agree.

Analysts and investors across Wall Street have been encouraging companies to follow a process of "balance sheet optimization." The exact details of this process vary from business to business, but it mostly requires companies to run down their cash balance and take out debt to increase shareholder returns without jeopardizing the financial stability of the enterprise (somehow). Ultra-low interest rates have enabled many companies to follow this process without negative ramifications.

Companies that have not pursued this course of action have been penalized. Even Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) has been repeatedly criticized for holding too much cash on its balance sheet.

But it is not just companies that have followed this course of action. Investors have also been running down cash balances. This is because there is no alternative investment vehicle to stocks right now. Cash and risk-free bonds offer non-existent returns, which means investors have virtually no alternative but to invest in stocks if they want to achieve a positive return on their money every year.

However, over the past few months, we've seen why it is crucial to have a cash allocation in a portfolio. Investors who had no cash at the beginning of the market downturn at the end of March wouldn't have been able to take advantage of opportunities when they presented themselves. Cash would have also provided a cushion against potential unemployment or business problems.

The same goes for many companies. Many businesses have been bailed out by the government and central banks' efforts to calm capital markets in the first half of the year. Unfortunately, many others have not been so lucky, and the crisis isn't over yet. Companies that once thought they were doing the right thing by following the balance sheet optimization trend may find themselves struggling to find the funds to keep the lights on in the near term.

The coronavirus crisis brought to light why it is essential to hold some cash in a portfolio to deal with uncertainty. Even though interest rates are at rock-bottom levels and savers have to make do with minimal returns on their money, the optionality that cash provides is far more critical.

This optionality and opportunity cost is difficult to quantify because it will vary from situation to situation. The qualitative factors are also difficult to calculate. Can you put a price on having enough savings to last you for a year if you lost your job tomorrow?

This is one of the reasons why it is so difficult for some investors to have a lot of cash sitting around. When you look at the stock market, gaining around 10% a year, it isn't easy to stand by your cash, earning almost nothing in the bank. The fear of missing out and the "there is no alternative" trade presses investors to act.

But what's that 10% a year worth if you lose your job? The prospects for employment and the stock market tend to be correlated. People start losing their jobs when the economy deteriorates, and that usually means the stock market is falling as well.

With cash on the sidelines, there's the freedom to act and make a move when you see fit, not when the market lets you. As many investors might have discovered recently, you can't place a value on this freedom.

So, while cash might not seem like a good investment right now, holding cash is never bad. It's impossible to quantify the optionality it provides.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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Rating: 5.0/5 (6 votes)



Dunyuliu - 1 month ago    Report SPAM

Hi Rupert, another nice article. It echoes my recent reading of Benjamin Graham's <The Interpretation of Financial Statements>'s Chapter XVII CASH. It reads "Where the cash holdings are exceptionally large in relation to the market price of the securities, this factor usually deserves favorable attention. In such a case the common stock may worth more than the earnings record indicates, because a good part of its value is represented by cash holdings which contribute little to the income account. Eventually, the stockholders are likely to get the benefit of these cash assets either through their distribution or their productive use in the business." I think a large cash holdings on the balance sheet is actually a good thing when the management knows what they are doing. As you said, opportunity cost is hard to quantify. People talk about opportunity cost by saying you would lose 10% a year if you don't invest your cash right now. But in such arguments, people typically don't give the probablity of the opportunity being materialized in the future. Cordially, Dunyu.

Rupert Hargreaves
Rupert Hargreaves - 1 month ago    Report SPAM

Hi Dunyu,

Thanks for the comment and highlights Graham's sage words, he made a great point, which I'd not considered at all for the article, although as you say the value of cash is important if management/investors "know what they're doing." that's the biggest issue in my opinion, many investors and managers are not good capital allocators.



America First Investment Advisors LLC
America First Investment Advisors LLC - 4 weeks ago    Report SPAM

This is a very good piece, Rupert. Putting something aside for a rainy day is a traditional bit of wisdom that has been made to seem foolish. Why bother when the government can always be counted on to come through with a bailout? And try teaching a child the miracle of compound interest at a zero or negative rate on a savings account.

When times are good, cash doesnt seem to do anything. Its the lazy, good-for-nothing that lies on the couch all day and barely scrapes together anything for the rent.

Things change when the market tumbles.

Bruce Flatt, CEO of Brookfield Asset Management, neatly summarized the case for cash:

Bottom line: Cash only matter when it matters. And when it matters, it really, really matters.

I wrote a short post recently that also highlights the benefits of cash:

Rupert Hargreaves
Rupert Hargreaves - 3 weeks ago    Report SPAM

Hi Barry, thanks for the comment and for sending your post over. There's some valuable information in there. Rupert

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