‘A dollar today is worth more than a dollar tomorrow.’ This adage used to describe a common desire of many investors to secure their wealth rather than grow it is a good explanation for why we see so much cash in investors’ portfolios at the moment.
Despite the return of a modest appetite for riskier investments in recent months, investors still seem very much attached to cold hard cash. This is despite historically low interest rates. The need for security, a cultural bias as well as mistrust of many investment products that exist are all valid reasons why investors hold on to cash. But how much cash should one hold to prevent it from becoming a destroyer, rather than a preserver of wealth?
Holding excess cash can result in a sub-optimal investment portfolio and lower the portfolio returns. Opportunity costs from lost alternative investment opportunities and the effect of inflation on the yield of the cash held are examples of how cash can turn into a wealth destroyer if it is not managed correctly.
To determine the optimum cash allocation investors should view cash as they would any other investment and apply a systematic approach to the investment process. In this low interest rate environment investors may seek extra yield pick up through the inclusion of alternative liquidity solutions (ALS). ALS are often structured money market products which behave much like cash, often providing the investor with daily liquidity and capital and accrued interest protection but giving much higher returns than typical call and fixed term deposit products. However, even in the world of cash there is no such thing as a free lunch and in return for these enhanced returns the investor will have to bear some additional risks not typically associated with regular cash deposits.
It is important to understand some of the psychological motivations that drive investors to hold excessive cash. Cash provides perceived safety and security. Compared to innovative products, cash enjoys a reputation as being simple and has the key benefit of daily liquidity. The easy to understand nature of fixed term and call deposits gives cash a competitive advantage over more complex investments. As a result investors feel more comfortable with cash and tend to neglect other often more suitable products.
Cash is also closely linked to some of our most basic needs. Abraham Maslow’s hierarchy of needs places the need for safety after our physiological needs in terms of importance. In today’s society cash provides investors with a sense of security against the many uncertainties that we face. However, this sense of security is often misplaced especially when considering the wealth damaging effects of inflation.
With the knowledge that an investor will always hold cash, how should they determine the appropriate allocation of cash within the overall portfolio? By applying a systematic process to understand why cash is being held, and if the levels of cash being held are warranted, it is possible to determine an optimal cash portfolio allocation.
Cash allocation analysis
There are three major reasons for holding cash that can be looked at in the context of a cash allocation analysis. (see table)
# Consumption Cash (transaction motive): This is cash that is needed for financing future cash consumption, for example, to pay bills and consumption which goes beyond your monthly income. The higher an investor’s income, the more they consume, meaning that consumption cash typically increases with personal wealth. When considering the amount of consumption cash needed an investor should ask themselves whether or not they will be purchasing fixed assets in the near future or if they have any big-ticket expenses coming up such as tax bills, etc.
# Iron Reserve (Precautionary Cash): Iron reserve cash is cash that is held to provide security against unforeseen events. This is cash that is needed to sleep well. Even though this cash may remain untouched for many years it can be seen as a constant source of liquidity, providing a comforting element to an investor’s financial holdings.
# Asset Portfolio (Speculative): Cash should also be held as liquidity for future investments in stocks and bonds. This cash is normally of a speculative nature. As a rule of thumb, about 5 per cent of the value of your investment portfolio should be held as cash to service the needs of the investment portfolio.
An investor seeking to determine their optimum cash allocation should then look at each of the buckets above and consider the following questions:
# What are my annual consumption expenses and what should be set aside to cover this (eg. two times annual living expenses).
# What is my risk attitude and how important is it for me to have cash set aside to sleep well at night (ie. how much risk and return do I want).
# What does my investment portfolio look like, how much cash should I set aside to service this?
Once cash has been allocated into these three buckets, any cash that is left over can be considered excess liquidity which should be invested into a higher yielding diversified investment portfolio. To assist with this process UBS Wealth Management has built a research-based framework to help investors make better investment decisions. The framework takes into consideration the investor’s needs as well as the current portfolio allocation and provides fact-based research about appropriate products.
Alternative liquidity solutions
It is clear that a systematic cash analysis is essential to define an investor’s actual cash needs. By performing such an analysis it is possible to identify excess liquidity for reinvestment into other products, and it is possible to identify cash needed for near term consumption as well as cash needed to sleep well at night. As cash in both the consumption and the iron reserve bucket does not necessarily get used straightaway (particularly true for iron reserve cash) this cash runs the risk that inflation might lessen its worth (eg. 0.5 per cent earned on a fixed deposit versus 2-3 per cent long term inflation)
Given the low interest rate environment and the superior returns that can be achieved from some of the ALS products that are available today, leaving cash in fixed deposit products is not the best option.
An ALS is typically structured in note or certificate form and behaves much like cash in that it can provide the investor with daily liquidity and typically provide capital and accrued interest protection. The benefit is that the returns are often superior to traditional deposits.
It is, however, only with some additional risks that some of these ALS products are able to offer returns that are higher than basic money market instruments. As ALS are not considered deposits they do not enjoy the deposit protection schemes that many governments around the world have implemented post financial crisis. They also require the investor to take on the credit risk of the issuer of the product, meaning he is fully exposed to the potential default of the issuer.
Some of the more complicated ALS products do not provide daily liquidity. Investors should consider this liquidity risk and be prepared for the fact that there may not be an active secondary market or they may be charged a fee for early redemption. Finally, some of the more complicated products may also face market volatility risk as the daily value is marked to market.
Such products are therefore not for everyone, but if investors understand the risks they can be an attractive addition to a cash portfolio.
The recent market volatility has created a flight to safe haven assets such as cash. However, with interest rates at historically low levels, excessive cash holding might perhaps be doing more damage to your wealth than good. Undertaking regular reviews of your cash needs and carefully identifying the parts of your portfolio which can benefit from investing in products such as ALS is key to avoiding the undesirable effects of too much cash – value erosion through inflation, and investment opportunity costs. More importantly, identifying excess liquidity which can then be put to work in a well-diversified portfolio can help to raise your overall return and should be considered a key activity in the successful management of your investment portfolio.
EMMANUEL BUCAILLE – Managing Director and Head of Products at UBS Wealth Management Singapore
Source: Business Times, 1 Dec 2009
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