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 (BRK.A, Financial) (BRK.B, Financial) 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.
Read more here:
- 4 Key Warren Buffett Lessons for Life
- Berkshire Hathaway's Key Size and Reputation Advantage
- Keeping Rational in a Rising Market: Thoughts from Seth Klarman
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