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The Science of Hitting
The Science of Hitting
Articles (447) 

Some Thoughts on Holding Cash

As markets reach record highs, investors have questioned whether it makes sense to continue holding cash

July 12, 2017

The S&P 500 continued climbing in the first half of 2017, with a total return of 9.3% (according to Morningstar). Over the past five years, the compounded return for the index has been nearly 15% per annum (enough to double your money). It’s been a wonderful time to be long U.S. equities.

As a corollary, it’s been a tough time if you’re holding dry powder. Instead of double-digit annualized returns, cash and equivalents have earned a pittance. As I’ve communicated previously, I’m holding a significant amount of cash and short-term bonds (just to clarify, I don’t own any long-term bonds). The combination of rising stock prices (which brought certain positions closer to fair value), a lack of enough new ideas at valuations that justified large initial purchases and continued contributions to my investment accounts has pushed the balance even higher. In the short term, the opportunity cost of holding a large – and growing – pile of cash has been sizable.

Despite this, I still maintain that holding cash is a reasonable position. I’ll use the remainder of the article to try and explain the role cash plays in my investment portfolio.

What’s your goal?

In order to determine the “right” path, we first need to decide where we’re trying to go. What is your investment objective? Personally, my goal is attractive long-term rates of return.

Let’s unpack that. The “long term” part is pretty obvious. It alludes to the fact that I have no idea what the market (or any individual stock) will do tomorrow, next week or next month. While I’m happy when my investments outperform the market, I try to focus on short-term performance as little as possible. Importantly and I think this is often overlooked the noise from short-term price swings can distort my thoughts on the long-term fundamentals. For this reason, I try to check stock prices infrequently. I also try and avoid the constant horse race against Mr. Market.

The second part of my goal – “attractive rates of return” – is a bit messier. The first hurdle to clear for “attractive” returns is a relative measure: what could I achieve if I invested in a low-cost index fund? I personally view the S&P 500 as a reasonable benchmark. Historically, the return for the index has been around 9% to 10% annualized. The second hurdle is an absolute measure – albeit a somewhat arbitrary one. My definition of “attractive” is a few hundred basis points more than I could achieve by investing in the broader market (I see no reason to assume that equity returns over the next 50-plus years will differ greatly from the returns over the last century).

Admittedly, the distinction between the two is somewhat flimsy. For example, I’ve reduced my absolute return requirement over the past few years to account for the current interest rate environment as well as to account for less attractive forward rates of return in the ensuing five to 10 years than have historically been achieved in equity markets. Said differently, I’ve tried to maintain the size of the gap between my hurdle rate and reasonable short-term (five to 10 years) market expectations. You could argue I’m giving in to the fact that Mr. Market is offering less attractive opportunities. Another way to frame it is I’m being realistic about the current environment. I’ll leave it to you to decide whether this is a pragmatic compromise or a breakdown in process.

Anyway, here’s the point: My bogey is somewhere between a relative and absolute metric. What I’d argue is that the relative hurdle – the index return – moves closer to an absolute hurdle as you expand your time horizon. While I’m willing to be somewhat flexible in the short term, there are limits. Buying – or continuing to own – securities that offer expected returns that are well below my hurdle rate is something I’m not willing to do. That alone guides my investment approach. When I find opportunities that exceed my return requirement, I’ll invest. When I can’t, I’ll wait.

Howard Marks (Trades, Portfolio) believes that “patient opportunism – waiting for bargains – is often your best strategy.” This approach resonates with me. Instead of forcing my hand, I'll be patient. My default assets in that scenario are cash and high-quality, short-term bonds.

Here are your other options if you’re not going to hold cash: (1) have your default position be to an equity index like the S&P 500 or (2) increase the weightings of your current holdings.

Here’s my issue with the first approach: if I go out and analyze every company in the S&P 500 and none appear particularly attractive (the return potential is not sufficient relative to the assumed risk), where’s the logic in deciding to own all 500 of them? It simply doesn’t make sense to me.

While I find the second approach more appealing, it comes with its own issues. Is the answer to a generally expensive market (as indicated by our bottom-up research) to go all-in on whatever’s least expensive? Is today's relative valuation all that matters? Unsurprisingly, even the attractive securities in the current environment (or at least the one’s I’ve found) are not clear bargains. Most of them only clear the return requirements I discussed above by a thin margin. While I can see why some people go this route, I still get the sense it’s not something I’m personally comfortable with.

Conclusion

I don’t think the current opportunity set appears particularly attractive, broadly speaking, for stocks and bonds alike. It is what it is. As Peter Bernstein once said, “The market is not a very accommodating machine; it won’t provide high returns just because you need them.”

As I see it, here are our two options from there: commit to owning securities priced for subpar returns, or move to the sidelines and wait for better opportunities. I prefer to do the latter.

On the other hand, there are “professionals” in the industry that have (and will) stay invested. There’s career risk associated with missing the late stages of a bull market. If you live in a world of short-term, relative performance, Mr. Market largely dictates how you act – not the other way around.

Of course, this all comes with my usual disclaimer: That’s not to say stocks will fall anytime soon. This quote from Marks is spot on:

“Most of the time, assets are overpriced and appreciating further or underpriced and still cheapening.”

If you are influenced by the price action of the overall market – either by your own “choosing” or an external investment mandate - holding cash may not be a viable option. If you’re focused on the short-term performance of your portfolio relative to the market, holding cash is likely to be a source of pain for much of your career. If you’re in this position, it’s probably not worth it.

But if you're cognizant of these considerations, the current “cost” of holding dry powder really isn’t that taxing. I’d argue the cost is falling as market values climb at a faster rate than intrinsic value. While painful in the short-term, I think it's likely to work out in the long-run.

I’ll close with something Seth Klarman (Trades, Portfolio) wrote to investors in his year-end 2004 letter:

"Some argue that holding significant cash is gambling, that being less than fully invested is akin to market timing. But isn’t a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can’t or won’t say no forgoes perhaps the most valuable tool available to investors.

"Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)’s long-time partner, has counseled investors, 'Look for more value in terms of discounted future cash flow than you’re paying for. Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.'

"Investors expect corporate managements to make carefully reasoned decisions, such as whether or not to commit their capital to build new factories, hire additional staff or acquire a competitor. A corporate management that invested capital at low expected returns just because they had the funds at their disposal and nothing immediately better to do would inevitably arouse investor ire.

"Why, then, should any investor (hedge fund, mutual fund or individual) always deploy 100% of their capital into marketable securities, applying none of the analytical rigor or intellectual honesty they would demand of the underlying corporate managements? As we said last year, why should the immediate opportunity set be the only one considered, when tomorrow’s may well be considerably more fertile than today’s?"

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.7/5 (18 votes)

Voters:

Comments

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

Hi science interesting topic and article

As for my objective: achive good long term absolute return by investing in few great companies buyed at great price and then sitting on for the long run.

Any 5 and 10 year period my return should be > 12%/year AND > 10year tresury+5%.

Until now i m meeting these objective and - equally important - i m doing that by having fun, enjoying my jurney and sleeping really well at night.

As for cash position: i dont have any target and/or any limit.

In 2009 and 2011 i was ~95% invested.

Now is a bit different... I ve bought my last holding more than 1 year ago and the second last more than 2.

I dont reinvest any dividend.

I let the cash in my bank account. Im not interested in bond.

Im not interested in being fully invest.

I like to invest only when i see what i think is a really fat pitch. I can do nothing for months ... I ve done that many time...No problem for me.

I remember buying rec.mi in 2009 at 5€, dia.mi in 2012 at 22€ or tip.mi 18 months ago at 3€.

I still sitting on my holdings and their are building up in value but i m not deploing new cash.

Someday (i dont know when... but i m a patient guy) will raining gold again.

When i will find something that i think is really another exceptional opportunity i will come hunting again.... Until that i will patiently sitting on my asset (and let my holding growth and compound).

This year i ve deployed some cash in wedding and honeymoon...

Hope that these will be my most long term and rewarding investment !! :)

Sorry for the long comment. Hope to have added something interesting. With friendship snow.

"Patience and boldness"

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Snow,

As usual, we are on the same page. Be patient and wait for the fat pitches!

Congrats on the wedding!!! Great to hear from you as always :)

jtdaniel
Jtdaniel premium member - 2 months ago

Hi Science,

Strong article. I am right with you and Snow in holding a significant cash position, including 100% of my 401(K). My dream scenario would be an opportunity to buy Core Labs and either Visa or Mastercard at bear market valuations. Short of that, I would like to average down on my Wells Fargo and CH Robinson Worldwide positions. It always helps to know what you are looking for.

Hi Snow, congratulations on your wedding! Thanks for sharing the great news.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Glad you enjoyed the article; thanks for the kind words!

P.S. I'll be there to buy some WFC and V with you :)

fung9815
Fung9815 - 2 months ago    Report SPAM

Great article. Just wanna share an excerpt of Seth Klarman (Trades, Portfolio)'s last annual investors letter:

“I must remind you that value investing is not designed to outperform in a bull market. In a bull market, anyone, with any investment strategy or none at all, can do well, often better than value investors. It is only in a bear market that the value investing discipline becomes especially important because value investing, virtually alone among strategies, gives you exposure to the upside with limited downside risk."

Simple yet full of punch.

Not being fully invested at most times, if not all times, is the most misunderstood philosophy in investing. Being fully invested at all times is an act of arrogance, it is akin to telling the world that "I've picked up ALL of the most compelling bargains in the world and I'm definitely not wrong!" (saying that in 2008 is another different story though).

Patient opportunism, i.e. to sit on cash and wait for the 50-cent-for-a-dollar fat pitch(es), is very much a philosophical thinking. The good news is, most people don't buy it. They see it as a weakness, while some of us see it as an edge.

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Fung9815,

Nothing to add :) Thanks for the kind words!

I hope to hear from you again on future articles.

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

I ve much respect and admiration for seth klarman ... I m impressed and shocked of his return (both absolute and relative) achived with an incredible ~40% of cash ...

That sayd i dont even try to emulate seth

Personally i more in line with phil fischer... That in an old 1987 forbes interview after saying he thought the market was high he added he didnt even try to be the smartest guy in the room... He was just sitting on his holding (~80% of his asset) but with a good 20% cash position to be able to buy if and when the market would crash...

Best snow

Evan Bleker
Evan Bleker - 2 months ago    Report SPAM

Hi Guys,

Science of hitting - great name! I picked up the book.

I have a different take on holding cash, though:

Whether someone should be fully invested or not really depends on how much they're managing and what sort of restrictions they have on the type of investments they have to buy. Large investors managing billions or even 100s of millions are better suited for holding cash but small investors with a long time horizon should be fully invested at all times. It's not arrogance, it's math.

Large investors sit in cash because they can't find anything good to buy. They're also forced to play a different game than small investors are because the amount of money they have to invest prevents them from buying most companies (there are many more tiny companies than big ones). Small investors have a massive number of companies to pick from... and there's always bargains available.

In fact, holding cash acts as a massive drag on returns by keeping investors out of profitable strategies. Cash provides low or no returns while specific stock strategies provide massive returns. By sitting on the sidelines, your money is compounding at much lower rates... Plus, those sitting on the sidelines expecting the market to drop are market timing....

https://www.brokenleginvesting.com/should-value-investors-hold-cash/

...and missing out on a great year for stocks can drastically lower investment returns. I can't remember the stats, but a good chunk of stock returns come from a small number of great years. Those are hard if not impossible to predict in advance. Don't like this market level? There's a world of stock markets out there, many excellent and priced at much cheaper levels.

In short, sitting on the sidelines in cash is one of the most destructive things a small investor can do to erode long term investment performance. (The second would be thinking that you can or should invest like WB does now: http://www.netnethunter.com/have-you-been-sucked-into-the-warren-buffett-trap/ )

Cheers,

Evan

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

@evan really interesting suggestion but i dont buy it

We live in the real world ... So:

Your small private investor wich enter in 2008 already fully invested will have the fortitude (having is entire net worth going down 35% in few months) of not selling in panic ?

Onestly no one of the small investors i know who enter a big crisis already fully invested stay the course at 100%... Quite difficult to have courage in general... Even more without having cash...

And if in any of the thousand 2009 companies restructuring your private investor lose his job for some months ... Being fully invested doesnt he have to sell at crash market price? (No body with no job can have finance in 2009)

Or if his private /wife or family business need some cash (these thing tend to happen during recession...) would he not be forced to sell at distressed price?

You say is matematically better (without proving it) to be always fully invested but in wich time orizon ... You simply make all the investments in day one ? Make some difference if day one is 31/07/2007 or 30/04/2009? And how you choose wich stock buy? Or you make all the investments in a week ? Or progressively when you find the best opportunities (months / yers) ?

Matematically are you really sure is the same if you have any months / years new money to invest or you are a retired/ widwow that after has made the total investments has no new money to add at all?

"Make thing as simple as possible but no simpler

Where baron rothschild - phil fisher - munger and co really bad matematicians?

Best snow

Evan Bleker
Evan Bleker - 2 months ago    Report SPAM

Hi Snow!

Thanks for the great questions.

With your question of watching your portfolio sink, I'll paraphrase Munger: If an investor can't watch his holdings drop by 50% once or twice a lifetime then he deserves the terrible results he'll inevitably get.

https://www.youtube.com/watch?v=PbOzfJK-XYk

You're right - a poor temperament costs investors dearly. But that doesn't change the fact that being fully invested produces better long term returns.

And, you're definitely right that people should have a cash buffer saved up for emergencies - but this misses the point. We're talking about portfolio strategy... not daily living expenses. All small investors should be able to survive a layoff. That money should not be part of your stock portfolio because you may need it in a crisis and you can never tell in advance when it'll hit. This does not change the fact that within a portfolio, cash is a significant drag on returns.

I have in fact shown strong evidence for my point by sharing this link previously:

https://www.brokenleginvesting.com/should-value-investors-hold-cash/

I'll post another link for you with strong evidence for my point about a fully invested portfolio beating marketing timing or "holding cash":

http://www.netnethunter.com/dont-sweat-the-coming-market-crash/

"You say is matematically better (without proving it) to be always fully invested but in wich time orizon ..."

I gave evidence above but you can also refer to: https://thetaoofwealth.files.wordpress.com/2013/01/10-ways-to-beat-an-index.pdf

The evidence is pretty overwhelming... though it's not common sense. That may be what got your back up.

"You simply make all the investments in day one ? Or you make all the investments in a week ? Or progressively when you find the best opportunities (months / yers) ?"

Good point. Ideally, you would make investments in stocks and then remain fully invested after that. Given how hard it is to invest in suitable stocks within a day or a week, you need some time to fill your portfolio initially. After that, hold as little cash as possible.

"Make some difference if day one is 31/07/2007 or 30/04/2009?"

Yes, it definitely would... but I don't know anybody who can call large market drops in advance, so it's kind of begging the question, right? Certainly no superinvestor made their money this way and I don't know of anybody who has done it consistently (though a pundit may call the occasional coin flip correctly).

"And how you choose wich stock buy?"

This is actually very simple: you pick the ones that best suit your strategy. I am a net net investor, and love deep value. It's a simple and straightfarward way of earning large outsized returns. This is backed by a mountain of evidence and any retail investor can impliment the strategy. The stocks I would buy would be the ones that best fit my scorecard. You could select other strategies if you'd like. There are a few out there that can really crush the market without having to have WB-like skill.

Evan

stephenbaker
Stephenbaker - 2 months ago    Report SPAM

Very good article, as are all of your posts that I have read. My question, however is that regardless of broad market levels there always seem to be at least a few reasonably priced or cheap stocks. Are you unable to find ANY equities that meet your criteria? Also, doesn't a low interest rate environment affect overall stock valuations? Thanks and keep posting.

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

@evan i onestly apprecciate your response well written and articulate

I definitly rest my case and i will contine my journey as a focused long term investor who made only few - infrequent - high convinction - big investments.

This fit my temperament i m enjoying it and having strong result

https://m.youtube.com/watch?v=bLjoL5zhBxA

But if you are enjoying and having good result as fully invested net net hunters that great and really the best for your investments journey

Snow

Dealerdeb1
Dealerdeb1 - 2 months ago    Report SPAM

I vacillate between NOT being invested and collecting dividends which I personally reinvest BUT I have started to see the folly in that. Reinvesting when the market is so obviously overvalued isn't all that smart. While my goal is share count that can be achieved when you hold sizeable amounts of green and buy more of the cheaper cost shares with the cash on hand. Letting the market decide how many shares you get has become counterintuitive to me .

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Evan and Snow - Thanks for the thoughtful comments! A lot to address, but this comment section is already running long. Maybe Evan's comments (and the links) will be the starting point for another article. Thanks again for taking the time to share your thoughts!

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Stephen - I've found it much more difficult to find attractive opportunities as of late. You must remember that my opportunity set is constrained by (1) my ability to understand the business and (2) my desire to only own companies that I'm happy holding for a long, long time. That narrows the investable universe pretty significantly. Also, as noted in the article, I'm not sure the answer to (what appears to be) expensive markets is to go all-in on the 3, 4, or 5 names that seem more reasonable.

For example, I think WFC is a decent value at current levels. Should it be a 20% position (as opposed to 3% - 5%) simply because I can't find anything else that's cheap? I'm not sure that's an approach I'm comfortable with.

Hope that helps; thanks for the comment!

Billrad
Billrad - 2 months ago    Report SPAM

Great article. I recently cashed out. 90% in cash. I am not Buffett and could not find anything with a margin of safety that compelled me to stay invested.

That said, my philosophy is to sit patiently and wait for elephants to cross my path. The upside is pennies but the downside is a potential 50% loss of capital. I know I'll miss out on some additional run-up but I sleep like a baby

snowballbuilder
Snowballbuilder - 2 months ago    Report SPAM

I finally suggest a new pabrai lecture

https://m.youtube.com/watch?v=bLjoL5zhBxA

Few bet infrequent bet big bet

I found it straightforward and interesting

He also restated the importance (that rick guerin and charlie munger share) of always have cash for when a really great opportunity will present.

Best snow

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Billrad - Those are the key questions to answer. Do you have an investment philosophy that you can stick with in tough times? Do you understand the potential costs associated with your approach? And are you comfortable paying those costs? If the answer is "yes" to all three, I think you'll do just fine. Thanks for the comment!

The Science of Hitting
The Science of Hitting - 2 months ago    Report SPAM

Snow - I'll listen to the Pabrai lecture today. Thanks for sharing!

billups7383
Billups7383 premium member - 1 month ago

100 shares at $100/share equals $10,000. Market crashes 50%, now your 100 shares are worth $5000. Your stock will need to go up 100% just to get back to even.

70 shares at $100/share equals $7000 with $3000 in cash. Market crashes 50%, now your 100 shares are worth $3,500. Buy $3000 at $50 stock price (60 more shares) now makes your position 130 shares at an avg cost of $77 versus the fully invested 100 shares at $100.

Now if the stock goes back up to $100 your not just breaking even you are roughly 30% in the money. Compund that over 50 years...yahtzee!

Valu2day
Valu2day premium member - 1 month ago
Evan,

With all due respect, I believe you are misquoting Charlie Munger (Trades, Portfolio). Munger is referring to the stocks he owns. It's not a reference to being fully invested. Also Graham was not an advocate of being fully invested unless the market was ripe with value, even then he exercised some caution. If you can watch your stocks go down 50% and also have cash to buy more, thinking they are stll great and on sale, you'll be happy to be holding cash.









Evan Bleker
Evan Bleker - 1 month ago    Report SPAM

Hi Valu2day,

I think I had an accurate paraphrasing of Munger and you can check the link I posted below for consistency.

I don't invest 100% the way Graham did - think that evidence supports some adjustments - and being fully invested is one of the differences. I agree with Buffett that it's probably better to be fully invested when managing small sums.

Also, while you can buy more if your stocks go down and have cash, you're still market timing and that cash will still drag down your returns long term.

Evan

jtdaniel
Jtdaniel premium member - 1 month ago

Hi Science,

It was a good feeling to have cash available yesterday to take advantage of the post-earnings report smackdown of Starbucks. I was caught completely off-guard by the Wall Street over-reaction and sensed the need to move quickly. As Starbucks the business is not in decline or at risk of failure, it was an easy decision to add more shares to my position.

Now if I had been fully invested, I would have had to sell at least part of another position to buy more Starbucks. That would create a decision tree that I prefer to avoid: I have 17 good stocks from which to choose -- which one gets jettisoned? Should I take profits in Southwest Airlines or take an insignificant capital loss in Express Scripts to buy more Starbucks? I purchased shares in all three companies because of their long-term potential. Who knows whether LUV or ESRX will return more over the next decade? Is it inconceivable that both could out-perform SBUX? I can reasonably project that in the aggregate they will produce a worthwhile return. In working through the decision tree, I could create a chain link of errors with a wrong move or blow my opportunity in Starbucks. From my perspective, the optionality provided by cash is worth the potential opportunity cost of temporarily under-performing a fully-invested portfolio. Best, dj

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