Essay - Why Hold Cash?

[oddballstocks]

I may be dense, and I apologize in advance if this sounds like cold water, but isn't the conclusion trivially true?

 

"...this essay is not focused on remaining fully invested at all times, but instead advocates remaining fully invested when there are still compelling investments to be made."

 

If compelling investments can be made, then by definition they are better than cash, right?

 

I can't speak for Racemize, but the way I understood it, some people target a certain % of cash "just in case" some big huge fat pitch comes along, because they believe that having the cash to jump on these infrequent opportunities makes up for the drag that the cash creates the rest of the time. So they might have a hurdle of 15% and invest in whatever they can find that meets that, but they keep an extra 20% cash on hand waiting for "blood in the streets" scenarios, even if they could use that 20% to just buy more of what they have in the other 80% of their portfolio, or similar things.

 

Or a portion of their portfolio is illiquid and it's hard to sell illiquid stocks to buy the fat pitch.  I keep a portion of my portfolio in cash for this reason.  It fluctuates through the seasons but my goal is generally 5-15% if possible.  It's easier to buy a new stock with cash and sell something illiquid on my timing rather than be held hostage to the market on an illiquid position.

[treasurehunt]

Racemize,

 

A couple of questions about your study.

 

1) Did you assume that cash earns 0%? From the paper, it seems to me that you do, but it is not entirely clear. If so, I think it understates the returns from a portfolio that is partly in cash.

 

2) You mentioned that you are willing to share your calculations. I'd like to take a look at them. Could you let me know how to get access to the calculations?

[racemize]

Racemize,

 

A couple of questions about your study.

 

1) Did you assume that cash earns 0%? From the paper, it seems to me that you do, but it is not entirely clear. If so, I think it understates the returns from a portfolio that is partly in cash.

 

I assumed the cash earned 0% for two reasons:

1) Since the cash needed to be available to be deployed, I did not have it get invested in bonds, as I did not want to expose the study to interest rate risk; and

2) I was mostly doing the study for myself, and I don't invest cash in bonds when not invested to ensure its availability.  I also assume this is generally the case among most investors here, but perhaps I'm wrong on that.

 

2) You mentioned that you are willing to share your calculations. I'd like to take a look at them. Could you let me know how to get access to the calculations?

 

I'll PM you.

[treasurehunt]

I assumed the cash earned 0% for two reasons:

1) Since the cash needed to be available to be deployed, I did not have it get invested in bonds, as I did not want to expose the study to interest rate risk; and

2) I was mostly doing the study for myself, and I don't invest cash in bonds when not invested to ensure its availability.  I also assume this is generally the case among most investors here, but perhaps I'm wrong on that.

 

I think your two assumptions are reasonable, but even cash parked in a savings account typically provides some return. Or in other words, even the shortest-term treasury rate is usually not zero. Of course this rate has been zero for the past six years or so, but that is atypical. For instance, in 2006, the overnight rate ranged from 4.15% to 5.32%. (https://www.treasurydirect.gov/GA-FI/FedInvest/selectOvernightRateDate.htm)

[thepupil]

Why not use 3 mo. T-bills or money market rates?

[rukawa]

Excellent article!

[Guest longinvestor]

Hi All, I've finally finished writing and revising my essay on holding cash in a portfolio.  Several of you have asked about it over the last few months (which was flattering by the way), and I'm sorry it took me so long to get it out.  This year has been incredibly eventful for me, so I didn't get to devote the time needed to finish this until recently. 

 

In any event, I hope it is useful to board members.

 

https://www.dropbox.com/s/96hwafdp5egf460/2014-15%20Why%20Hold%20Cash.pdf?dl=0

 

Very good indeed. Weil researched and articulated. Congratulations.

 

You have made a clear case for staying fully invested for most people except active investors. Are Warren Buffet or Ted Weschler "active"? Or is "active" someone who is always looking to (believes they can) catch rock bottom?

 

On your comparison table of actual portfolios, PF #6 is obviously the time tested one, going back to 1993. It has done 22% annualized. As you point out, if that portfolio would have been best served holding zero cash, that is everything one needs to know. At least it does for me. Especially with permanent capital.

 

Thanks for sharing your hard work.

[Mephistopheles]

Racemize,

 

A couple of questions about your study.

 

1) Did you assume that cash earns 0%? From the paper, it seems to me that you do, but it is not entirely clear. If so, I think it understates the returns from a portfolio that is partly in cash.

 

I assumed the cash earned 0% for two reasons:

1) Since the cash needed to be available to be deployed, I did not have it get invested in bonds, as I did not want to expose the study to interest rate risk; and

2) I was mostly doing the study for myself, and I don't invest cash in bonds when not invested to ensure its availability.  I also assume this is generally the case among most investors here, but perhaps I'm wrong on that.

 

2) You mentioned that you are willing to share your calculations. I'd like to take a look at them. Could you let me know how to get access to the calculations?

 

I'll PM you.

 

Hi race, I just read your paper and think it's very well thought out and written. Would you mind PMing me your calculations as well?

 

Thanks for sharing!

[infinitee00]

Hi Race, I finally finished reading your essay and must compliment you on a very well written essay. I have been holding way too much cash for the last couple of years and maybe it's time for me to change my strategy. I am interested in your calculations too and was wondering if you can PM it to me as well. Thanks in advance.

[petec]

Racemise,

 

Many thanks for a well written and thought-provoking essay.  The key conclusion for me is that having a cash reserve does make sense in a low-cagr, high volatility environment, but makes no sense in a high cagr, low vol environment.  I have a nasty feeling that with global debt levels as high as they are, the former is what we will get for the next couple of decades, but it is a very difficult call to make. 

 

What is the difference between the S500 (7.88% pretax CAGR) and the 0% cash portfolio (14.56% CAGR) in your one-year, 100% volatility increase model?  Excuse me if this is a stupid question and just displays my mathematical ignorance, but I think of the CAGR as being the speed of progression from start to finish, and volatility as being the amplitude of the bumps along the way, so I don't see why  increasing the volatility increases the CAGR of a 0% cash portfolio, i.e. the S&P.

 

Pete

 

 

[giofranchi]

Pete,

whenever I find an investment that truly convinces me, I invest. Period. I don’t mind about a low-cagr, high volatility environment.

The problem is those opportunities I really like don’t come often. So, what to do while I am waiting?

Joel’s paper seems to suggest that it is better to wait invested in a low conviction idea (let’s say for instance a S&P500 ETF today) than to hold cash. And from a purely statistical point of view I might agree with him.

But I think this conclusion doesn’t take into consideration the psychological side of the matter: especially for those people who run very concentrated portfolios, I think it is extremely difficult to stay invested in low conviction ideas, waiting for the proverbial “right pitch”… Because the very idea of shunning low conviction ideas is a cornerstone of their investment process.

In other words I always look for “absolute” values, not “relative” ones. And, though statistically it might be the right thing to do, at least psychologically it is very tough to switch from an absolute value mentality to a relative value mentality.

Surely that’s the greatest difficulty I encounter in my asset allocation strategy.

 

Cheers,

 

Gio

 

[petec]

Pete,

whenever I find an investment that truly convinces me, I invest. Period. I don’t mind about a low-cagr, high volatility environment.for those people who run very concentrated portfolios, I think it is extremely difficult to stay invested in

The problem is those opportunities I really like don’t come often. So, what to do while I am waiting?

Joel’s paper seems to suggest that it is better to wait invested in a low conviction idea (let’s say for instance a S&P500 ETF today) than to hold cash. And from a purely statistical point of view I might agree with him.

But I think this conclusion doesn’t take into consideration the psychological side of the matter: especially low conviction ideas, waiting for the proverbial “right pitch”… Because the very idea of shunning low conviction ideas is a cornerstone of their investment process.

In other words I always look for “absolute” values, not “relative” ones. And, though statistically it might be the right thing to do, at least psychologically it is very tough to switch from an absolute value mentality to a relative value mentality.

Surely that’s the greatest difficulty I encounter in my asset allocation strategy.

 

Cheers,

 

Gio

 

I agree.  Ultimately I like the idea of having something I can invest if prices get better or I have a new idea.  And I'm willing to sacrifice some return, frankly, for that peace of mind because it makes me sleep better and make other decisions better.

 

But, my point is that actually Joel's models may not capture the best *theoretical* allocation for the current period.  If, in fact, we are going into a long period of volatile but overall sideways markets, then an allocation to cash along the lines of his 3-year portfolio might work very well.

 

To put it another way: these models all backtest against history.  If the future rates of return and volatility are different, then the results might also be different.  And given the starting levels of debt, I think the future might be different, for the couple of decades that matter to us all anyway.

 

Pete

[giofranchi]

But, my point is that actually Joel's models may not capture the best *theoretical* allocation for the current period.  If, in fact, we are going into a long period of volatile but overall sideways markets, then an allocation to cash along the lines of his 3-year portfolio might work very well.

 

To put it another way: these models all backtest against history.  If the future rates of return and volatility are different, then the results might also be different.  And given the starting levels of debt, I think the future might be different, for the couple of decades that matter to us all anyway.

 

Pete

 

It might be… But it seems we have become exceedingly efficient in engineering permanently high asset prices… I don’t know… We will see! ;)

 

Cheers,

 

Gio

 

[petec]

But, my point is that actually Joel's models may not capture the best *theoretical* allocation for the current period.  If, in fact, we are going into a long period of volatile but overall sideways markets, then an allocation to cash along the lines of his 3-year portfolio might work very well.

 

To put it another way: these models all backtest against history.  If the future rates of return and volatility are different, then the results might also be different.  And given the starting levels of debt, I think the future might be different, for the couple of decades that matter to us all anyway.

 

Pete

 

It might be… But it seems we have become exceedingly efficient in engineering permanently high asset prices… I don’t know… We will see! ;)

 

Cheers,

 

Gio

 

Are you suggesting that "stocks have reached what looks like a permanently high plateau"?    ;)

[racemize]

Hi all, thanks for reading and your questions/comments; I'm going to try to answer everything from my point of view below.  I've PM'd everyone links to the data that asked, I believe.

 

Many thanks for a well written and thought-provoking essay.  The key conclusion for me is that having a cash reserve does make sense in a low-cagr, high volatility environment, but makes no sense in a high cagr, low vol environment.  I have a nasty feeling that with global debt levels as high as they are, the former is what we will get for the next couple of decades, but it is a very difficult call to make. 

 

Hi Pete, thanks for your kind words.  I think what you are saying is probably right, but I didn't try the combinations you suggested.  Certainly, high CAGR, low vol, holding cash is very very expensive.  And from the data, I think high volatility makes cash much more important.  And since low CAGR implies low opportunity cost, it would seem to make sense that pairing high volatility with it would make holding cash a good idea.  I too share your feeling that prima facie, low CAGR high volatility makes sense going forward.  However, my personal view is solidly with Marks on forecasting--There's people who don't know and people who know they don't know; I'm solidly in the latter camp.  I also imagine people have had such thoughts at various points in the last century and have been proven wrong.  Of course, this time may be different!  The bull-run from the 80's to 2000's certainly would have taken people by surprise as an anomalous upside.  Anyway, I'm rambling.

 

What is the difference between the S500 (7.88% pretax CAGR) and the 0% cash portfolio (14.56% CAGR) in your one-year, 100% volatility increase model?  Excuse me if this is a stupid question and just displays my mathematical ignorance, but I think of the CAGR as being the speed of progression from start to finish, and volatility as being the amplitude of the bumps along the way, so I don't see why  increasing the volatility increases the CAGR of a 0% cash portfolio, i.e. the S&P.

 

I think you mean 9.15% pre-tax, 0 additional volatility and 14.56% pre-tax, 100% additional volatility.  I'm wondering if volatility is the right word here, after thinking about your question.  In any event, what I did for that one was amplify the returns each year, or basically use free leverage.  e.g., multiply the annual returns by a factor--for 100%, it was a factor of 2.  Thus, where the S&P 500 went up 20% and then down 30%, the model would use 40% and then -60% instead.  As you can imagine, there is an upper limit on this, because a downturn of 35% can only be amplified by 2.85 times before you lose all your money.  In any event, since it is magnified and the overall result is positive, it results in a higher CAGR.  I labeled this as increased volatility, since I was amplifying the ups and the downs.  That's also what I meant when I did the individual investor portfolios.

 

Pete,

whenever I find an investment that truly convinces me, I invest. Period. I don’t mind about a low-cagr, high volatility environment.

The problem is those opportunities I really like don’t come often. So, what to do while I am waiting?

Joel’s paper seems to suggest that it is better to wait invested in a low conviction idea (let’s say for instance a S&P500 ETF today) than to hold cash. And from a purely statistical point of view I might agree with him.

But I think this conclusion doesn’t take into consideration the psychological side of the matter: especially for those people who run very concentrated portfolios, I think it is extremely difficult to stay invested in low conviction ideas, waiting for the proverbial “right pitch”… Because the very idea of shunning low conviction ideas is a cornerstone of their investment process.

In other words I always look for “absolute” values, not “relative” ones. And, though statistically it might be the right thing to do, at least psychologically it is very tough to switch from an absolute value mentality to a relative value mentality.

Surely that’s the greatest difficulty I encounter in my asset allocation strategy.

 

To be clear, while your characterization of what I'm saying might be true and might be supported by the data, it wasn't the conclusion I was drawing or question I was trying to answer.  My question is one that both of us face and have reached different conclusions.  I'm going to describe it in both our situations, please correct me if I get yours wrong! 

 

In your case, I believe you hold around 5-7 ideas that you have high conviction in right now, and who's price you don't think is too high.  I also believe you have some amount of cash available, e.g., 20%ish?  So, the question I was trying to answer is, in your situation, if you still believe these stocks are cheap and meet your minimum, but are skittish about the macro environment, does it make sense to hold cash or to put the cash to work in these high conviction ideas?  When I started, I thought the answer would be that some amount of cash would be helpful, so that it would be available for downturns or when a new idea came along.  So, I tested to see if holding cash ever made sense for the general market, and couldn't come up with any good models that didn't result in underperformance.  Perhaps more importantly, I analyzed whether the idiosyncratic returns of actual investors would have been better off with or without cash.  The answer kept coming up 0% cash.  Thus, I'm not saying always be 100% invested (although that may be correct); I'm saying, if I still have a good idea, but am queasy about the market (as I am right now), should I invest in that good idea or not?  Or, in your position, should you allocate more money to FFH, BH, OAK if you have cash and have high conviction at current prices?  I believe the answer is yes. 

 

In my case, I have money coming in almost every quarter, and each time, I have had an available existing position that I could average my price down.  As a result, I've put the money to work and stopped worrying about what the market will do.  If I don't have a good idea for the money, or prices of my current positions are too high for me to be comfortable, I'll hold cash.

 

I agree.  Ultimately I like the idea of having something I can invest if prices get better or I have a new idea.  And I'm willing to sacrifice some return, frankly, for that peace of mind because it makes me sleep better and make other decisions better.

 

But, my point is that actually Joel's models may not capture the best *theoretical* allocation for the current period.  If, in fact, we are going into a long period of volatile but overall sideways markets, then an allocation to cash along the lines of his 3-year portfolio might work very well.

 

To put it another way: these models all backtest against history.  If the future rates of return and volatility are different, then the results might also be different.  And given the starting levels of debt, I think the future might be different, for the couple of decades that matter to us all anyway.

 

It absolutely does not capture the best allocation for the current period, but I don't view my ability to forecast the current period as good enough to rely upon, so I'm using history as a guide to see which whether holding cash has worked.  Ultimately, all the essay says is that timing the market is really hard, and you have to be really good to do it.  I do not believe I'm good enough to do it, so I don't.

 

[thepupil]

hey race, i was just curious if you ever updated your cash returns to reflect the yield of short term treasuries rather than 0? Did it change your findings in a material way?

[giofranchi]

Are you suggesting that "stocks have reached what looks like a permanently high plateau"?    ;)

 

Ahahah!!!!... Anyway, no!... I have just increased my investment in FFH meaningfully… Would I have done so, if I thought the stock market might be completely immune to high prices and high debts? Of course not! ;)

 

What I am saying is that, rather than holding cash, in this environment I'd prefer to own a business that will do fine enough, if nothing bad happens, and might turn out to be a spectacular investment, if a deflation scare actually occurs.

 

Of course such businesses are not many. I can think of Fairfax, of course, and maybe Oaktree (which might be able to increase AUM rapidly in a deflation scare). And that’s why I also hold some cash... But, if I could find another business with those same characteristics (namely, that could perform satisfactorily in a muddle through scenario, and could perform even better in a difficult environment), I would gladly part with my cash.

 

Cheers,

 

Gio

 

[racemize]

Or to use Klarman's lesson:

 

"8. Holding cash in the absence of opportunity makes sense."

[petec]

Once again racemize, thanks for the hard work, the clear writing, and taking the time to answer all the questions.  It's a very interesting piece of work and one that will inform my investing in the future.

 

I also agree that the future is unknowable and that people would have predicted dark times at various points in the past and been wrong.  I feel fairly comfortable with the statement that "when starting levels of debt are high growth will be slower and more volatile than when starting levels of debt are low, all else equal" but that's about it! 

 

Thanks again,

 

Pete

[racemize]

hey race, i was just curious if you ever updated your cash returns to reflect the yield of short term treasuries rather than 0? Did it change your findings in a material way?

 

I did not update it, as I was just focused on cash or not (I don't hold my money in treasuries if it isn't invested).  Also, since yields are absurdly low right now, it wouldn't really change things currently.  It would be a good exercise though.

[petec]

 

What I am saying is that, rather than holding cash, in this environment I'd prefer to own a business that will do fine enough, if nothing bad happens, and might turn out to be a spectacular investment, if a deflation scare actually occurs.

 

Agreed.  I also own Begbies Traynor, a British restructuring company that will do well if all our zombie firms go bankrupt and in the meantime trades at 12x and pays me a 5% dividend.  It's not bulletproof, but I'm content with the risk/reward.

[giofranchi]

In your case, I believe you hold around 5-7 ideas that you have high conviction in right now, and who's price you don't think is too high.  I also believe you have some amount of cash available, e.g., 20%ish?  So, the question I was trying to answer is, in your situation, if you still believe these stocks are cheap and meet your minimum, but are skittish about the macro environment, does it make sense to hold cash or to put the cash to work in these high conviction ideas?  When I started, I thought the answer would be that some amount of cash would be helpful, so that it would be available for downturns or when a new idea came along.  So, I tested to see if holding cash ever made sense for the general market, and couldn't come up with any good models that didn't result in underperformance.  Perhaps more importantly, I analyzed whether the idiosyncratic returns of actual investors would have been better off with or without cash.  The answer kept coming up 0% cash.  Thus, I'm not saying always be 100% invested (although that may be correct); I'm saying, if I still have a good idea, but am queasy about the market (as I am right now), should I invest in that good idea or not?  Or, in your position, should you allocate more money to FFH, BH, OAK if you have cash and have high conviction at current prices?  I believe the answer is yes. 

 

Joel,

Of course, you are right. But I don’t think your reasoning considers another psychological obstacle: to invest a very large percentage of your capital in a single business is hard. With only three large positions right now I think I have a portfolio more concentrated than most, and Fairfax today represents almost 43.5% of my portfolio. It is already by far the largest investment I have ever held. My cash reserve is around 18.5%… If I use it to buy more Fairfax, I would be making that single investment 62% of my portfolio… It might be the most rational thing to do… But, as much as I like Fairfax, I am not prepared for that yet! ;)

 

Cheers,

 

Gio

 

[giofranchi]

I also own Begbies Traynor, a British restructuring company that will do well if all our zombie firms go bankrupt and in the meantime trades at 12x and pays me a 5% dividend.  It's not bulletproof, but I'm content with the risk/reward.

 

Interesting! ;)

 

But what do you mean exactly by “restructuring company”?

 

Thank you!

 

Gio

 

[petec]

I also own Begbies Traynor, a British restructuring company that will do well if all our zombie firms go bankrupt and in the meantime trades at 12x and pays me a 5% dividend.  It's not bulletproof, but I'm content with the risk/reward.

 

Interesting! ;)

 

But what do you mean exactly by “restructuring company”?

 

Thank you!

 

Gio

 

Sorry - they basically close or restructure companies that are bankrupt, for a fee.  Ought to be countercyclical!  Business has been hard because low rates allows dead companies to live on.

[racemize]

In your case, I believe you hold around 5-7 ideas that you have high conviction in right now, and who's price you don't think is too high.  I also believe you have some amount of cash available, e.g., 20%ish?  So, the question I was trying to answer is, in your situation, if you still believe these stocks are cheap and meet your minimum, but are skittish about the macro environment, does it make sense to hold cash or to put the cash to work in these high conviction ideas?  When I started, I thought the answer would be that some amount of cash would be helpful, so that it would be available for downturns or when a new idea came along.  So, I tested to see if holding cash ever made sense for the general market, and couldn't come up with any good models that didn't result in underperformance.  Perhaps more importantly, I analyzed whether the idiosyncratic returns of actual investors would have been better off with or without cash.  The answer kept coming up 0% cash.  Thus, I'm not saying always be 100% invested (although that may be correct); I'm saying, if I still have a good idea, but am queasy about the market (as I am right now), should I invest in that good idea or not?  Or, in your position, should you allocate more money to FFH, BH, OAK if you have cash and have high conviction at current prices?  I believe the answer is yes. 

 

Joel,

Of course, you are right. But I don’t think your reasoning considers another psychological obstacle: to invest a very large percentage of your capital in a single business is hard. With only three large positions right now I think I have a portfolio more concentrated than most, and Fairfax today represents almost 43.5% of my portfolio. It is already by far the largest investment I have ever held. My cash reserve is around 18.5%… If I use it to buy more Fairfax, I would be making that single investment 62% of my portfolio… It might be the most rational thing to do… But, as much as I like Fairfax, I am not prepared for that yet! ;)

 

Cheers,

 

Gio

 

That makes sense--I thought you had more positions than three these days, so diversification is also a concern that has to be taken into account.