After being de-sensitised for many years by virtually zero interest rates, one can suddenly earn a positive yield on cash again in many major currencies.
While the rates may still not be terribly exciting – 12-month US$ Libor yields are now approximately 2.75 percent per annum, for example – these yields can be seen by some as credible competition to other investment asset classes.
Held up against inflation rates of 2 percent (in the US, HK or Singapore), though, a 2.75 percent yield would mean your savings would only just keep pace with the rising cost of living. Against this backdrop, it is pertinent to ask – do some of us hold too much cash?
Surveys suggest there is a high chance the answer is yes. Legg Mason’s last Global Investment Survey noted that cash holdings accounted for a third of individual investor portfolios.
Interestingly, on a regional basis, cash’s share in overall holdings was amongst the highest in Asia, while demographically, Millennials held the largest amount of their savings in cash. At first glance, a one-third allocation to cash does seem extraordinarily high.
The survey notes rather pointedly that the high cash holdings were likely to be a key reason preventing investors from reaching the investment return targets they had set themselves. However, we can also answer the question a little more systematically.
A common approach to cash is to break it into two broad buckets. One is the role cash plays as a necessity - either to meet day-to-day expenses or as a provider of immediate liquidity in an emergency. In our view, this is distinct from cash’s role in an investment portfolio, which is the part we’ll focus on here.
Within an investment portfolio, we see cash as serving two specific needs:
1: Source of diversification: During periods of weakness in markets, cash or cash-like assets (e.g. very high-quality, short-maturity bonds) have tended to consistently deliver positive returns.
2: Dry powder: Having cash readily available means an investor would have the ability to take advantage of buying opportunities during sharp market declines.
At first glance, these two factors may be a good explanation of why it makes sense to have a high cash holding.
However, these two descriptions miss one very important point - that holding cash for these two purposes can be expensive.
To illustrate this point, compare the last 10 years. Since June 30, 2009, a 100 percent allocation to global equities would have delivered an annualised return of about 10.8 percent. A 100 percent allocation to three-month cash, by comparison, would have delivered about 1.0 percent. This gap - the opportunity cost - is an example of what a high cash allocation can cost an investor in terms of missed returns.
For additional context, the US CPI inflation index over the same period grew at about 1.7 percent per annum, which means an investor actually lost purchasing power by allocating 100 percent in cash.
Of course, the response to this argument is that a 100 percent allocation to equities may very well have returned over 10 percent per annum but this involved experiencing a high level of volatility with which an investor may simply not be comfortable.
We agree - which is why achieving the right mix of asset classes that offers the best return versus risk trade-off that one is most comfortable with is so important. This mainly addresses the first purpose of cash (diversification).
The second purpose (as dry powder) is less straightforward. By definition, this is cash that is deployed into a riskier asset class, when the opportunity presents itself, in order to earn higher returns. This means the cost of holding cash while one waits for an opportunity to buy is directly relevant. Cash may very well serve this purpose well but only if it is also deployed in a disciplined manner. Otherwise, as an investor, one only assumes the cost but not the potential benefit of dry powder.
Against this backdrop, how do we judge whether we are holding too much cash?
As an approximate guide, our model allocations suggest anywhere from a zero percent to an 11 percent allocation to cash in an investment portfolio, depending on one’s risk profile. If one holds more cash than this range in one’s investment allocation, there is a high probability that the cash is not earning a sufficient risk-adjusted return. There are three things one can do to fix this.
Firstly, consider what share of the cash is meant to be a diversifier. For this bucket, note that simple ‘cash’ isn’t the only option. Other strategies, such as very high-quality and short-maturity bonds, can offer an investor higher returns than cash without sacrificing liquidity or taking more risk in a significant way.
For instance, developed market government bonds can be easily sold to raise cash and they have virtually negligible probability of a default, while the default rate on global investment grade corporate bonds in any calendar year since 1981 has ranged between zero percent and 0.4 percent (i.e. at most one out of every 250 such bonds have defaulted in any given year, with the rest paying back their principal amount when they mature).
Secondly, consider what share of this cash is meant to serve as dry powder. For this bucket, one can build a disciplined strategy around how and when to deploy the cash, and stick to the strategy.
Finally, an investor should consider seeking help in achieving one’s investment goals. The same Legg Mason survey cited above noted that ‘advised investors’ tended to have lower cash holdings and higher returns than ‘DIY investors’.
(The writer is Head of FICC Investment Strategy at Standard Chartered Private Bank)