Why Hold Cash?

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Hi All, I've been giving Pabrai's cash allocation model some thought for a while, and I'd like to get thoughts from the forum members, both on Pabrai's method and holding cash in general.

First, I assume that everyone has some minimum hurdle rate for an investment, e.g., 10, 15, 20%, whatever.  I assume that if an investment does not match the hurdle, it won't be made, so there are times that cash will occur simply because an investment cannot be found.  This is not the situation I'm trying to focus on.  Instead, what I'm trying to consider is whether or not cash should be held at times even though an investment opportunity exists that exceeds the hurdle rate.

For example, after 2008, Pabrai has indicated that he thinks about cash allocation in the following manner:

1st 75% cash - 2x in 2-3 years

next 10% cash - 3x in 2-3 years

next 5% cash - 4x in 2-3 years

next 5% cash - 5x in 2-3 years

last 5% cash - >5x in 2-3 years

Initially, I thought this was very rational and a good way to proceed.  However, I wanted to model this type of behavior in a spreadsheet to see how high the opportunity cost is.

For example, I initially modeled S&P returns and assumed an investor would invest fully only after big down turns (e.g., 2003, 2008), which happen every 5 years or so.  The results were under-performance for all cash levels.

Then, I modeled 15% returns with cash allocation where the cash would be used every 5 years for extraordinary returns.  The results were essentially that you had to put the cash into something that was 5x better than your "normal" rate of return (which makes sense, since the event happens every 5 years, in that model).

Thus, after looking at these models, I'm drawn to the conclusion that keeping cash when you still have opportunities exceeding your hurdle rate is simply not a good idea.

I think there are many who disagree with this.  I would like to hear any thoughts people have on this idea in general; particularly if you disagree.  If you do disagree, could you also indicate the assumptions you are making, so that it might be shown in a simple model?

Thanks!

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Great post. I think I remember discussing this with you before-- I agree with your conclusion for the same reasons.

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You are correct if you have long-term patient capital.  I don't know if Monish's comments were in the context of a fund where he has to be concerned with redemptions.  The other factor being fully invested is the volatility of a portfolio versus one with cash.  If was in context of a fund, I think it makes sense if it is long-term patient capital not required for a long period of time then your approach is more appropriate.  The opportunity cost is indeed high if say the long-term expected return on equities is 10% and you think with your approach you can beat that.

Packer

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I am with you on this one. The two reasons I can see for holding substantial amount of cash are (a) you are managing OTM or have other reasons to expect substantial withdrawals and (b) the number of existing investment opportunities is such that the concentration would exceed your risk tolerance.

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I don't understand why he would put more money in something that has 5x potential than in something with 2x potential in the same timeframe

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The logic makes sense to me--but there's a middle ground too (which I think I saw elsewhere on the board)... hold "cash like" downside protected, asset cheap investments instead of cash, that have some probability of a high (>30-40%) return on an uncertain timeline. For example  in accounts I manage I often hold these types of things (mutual bank conversions, OTC growers at double digit earnings/fcf yields, etc., even merger arb.)...the type of stuff that can re-rate at some point but is highly unlikely to be permanently impaired. Granted you don't have ALL the liquidity benefits of cash...

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In his most recent video at BC it seemed that his rational is that holding cash offers downside protection and then the ability to capitalize on those downsides when they occur. He was badly burned in the financial crisis and probably now has a higher preference for protection over performance.

If I were as wealthy as he is that would be my preference as well. For now I think I'll do as racemize suggests and invest up to my hurdle rate.

Now I'm curious - what are your hurdle rates?

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Joel,

I think anyone should read and study Mr. Russell Sage’s methods and how he made use of his “cash reserve”. Don’t forget that we are always talking about the future while investing… And the future is never certain!

1) The fact an investment meets “your hurdle rate” is and will always be a supposition you make about a business you don’t manage… And even if the fate of that business were in your own hands, you may never be sure about its future… I am absolutely not sure about what will become of the businesses I manage personally!

2) I think events that create great opportunities are inherently unpredictable. Other people are not able to predict them, otherwise they simply wouldn’t occur, would they? Why are we supposed to best other people in predicting them? I don’t need to predict. Because I know I will always have the cash to take advantage of them.

3) Besides Mr. Sage, I know of no other great financial mind of the past, who didn’t always have ample cash reserves, Mr. Buffett included:

Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.
AL2012

If we are not to learn from those great and very successful minds of the past, how are we supposed to navigate the perilous waters of investing?

This being said, I admit it is much easier to raise cash, when you cannot find any investment that matches or exceeds “your hurdle rate”! ;)

Gio

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I also like to have some cash around, even if it hurts my short term performance.

The cash helps you to stay detached and opportunistic.

If you're fully invested, you partly loose that optionality, because you have to be right. Things have to play out as you expected, any other scenario will disappoint you.

If I have some cash around, whatever happens is all right.

If things go as expected, I earn some money, if not, I have the flexibility to adjust.

It makes me think about the "Rich Man, Poor Man" analogy from Richard Russell. There's a lot of thruth in it : "In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN'T NEED THE MARKETS. I can't begin to tell you what a difference that makes, both in one's mental attitude and in the way one actually handles one's money."

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I also like to have some cash around, even if it hurts my short term performance.

The cash helps you to stay detached and opportunistic.

If you're fully invested, you partly loose that optionality, because you have to be right. Things have to play out as you expected, any other scenario will disappoint you.

If I have some cash around, whatever happens is all right.

If things go as expected, I earn some money, if not, I have the flexibility to adjust.

It makes me think about the "Rich Man, Poor Man" analogy from Richard Russell. There's a lot of thruth in it : "In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN'T NEED THE MARKETS. I can't begin to tell you what a difference that makes, both in one's mental attitude and in the way one actually handles one's money."

+1 Good post!

Gio

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The argument against cash is the opportunity cost; but it is very much a short-term, & PM view, & supposes that your predictions are perfect. If you are paying for OPM, & getting paid for AUM; to maximize your income - you need all the assets invested, at all times.

If the opportunity cost is so bad, you should always be heavily margined; so long as you can invest the cash at above your hurdle rate. The result is a systemic leveraged prediction error, & much of the reason why buy & hold returns are so volatile.

According to the investment literature, volatility should be managed primarily through options/futures. The optimal portfolio is narrow scope, highly leveraged, a big user of options/futures, & rebalancing frequently (ie: an ETF). Notice though … that the optimal portfolio is also the highest fee generating portfolio? – more trading commissions, margin spread, & often wider bid/ask quotes. And it could not exist if folks could not be convinced that holding cash is bad.

The argument for cash is the opportunity gain; but it is very much a long-term, & neophyte investor view. Virtually all neophytes lose money investing, lose it in large amounts, & never recover it. They would have a material opportunity gain - if they simply stopped investing, & used the cash to pay down mortgages, go to school, or even just go for a beer. But everyone is the next WEB …

Different strategies will call for varying amounts of cash, & how much cash you keep on hand will change with circumstance. As most people have been managing a bank account for most of their lives, most are pretty good at assessing how much they need - & in what form.

If your advisor ‘loves you’, you are probably too close to the ETF portfolio - & making that advisor very rich while you bear all the risk. The advisor is a salesman, so if you are not hearing resistance … who is the patsy? And if your advisor is so good - why does he/she still have to talk to retail clients – n years after being in the business? … should they not have become rich already?

You have to be able to sleep at night, & cash is your pillow. Hard (T-Bill/Gold) or soft (loan agreements, liquid markets) depends on how you like to hold your liquidity.

SD

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In his most recent video at BC it seemed that his rational is that holding cash offers downside protection and then the ability to capitalize on those downsides when they occur. He was badly burned in the financial crisis and probably now has a higher preference for protection over performance.

If I were as wealthy as he is that would be my preference as well. For now I think I'll do as racemize suggests and invest up to my hurdle rate.

Now I'm curious - what are your hurdle rates?

That's his reasoning, but all the models I've set up show long-term underperformance for holding the cash.  Or, in other words, because the cash is held in order to take advantage of the rare higher opportunities, you end up with lower performance.  The only way it works out is if the rare opportunities either 1: happen relatively frequently or 2: have enough upside to offset the lack of performance of the cash.

e.g., if the event only happens every 5 years, the new investment has to be 5x greater than the normal rate of return.  This hurdle seems extremely hard to overcome.

If it is to simply reduce volatility, then I'd rather it be stated in an intellectually honest way, e.g., indicating that it sacrifices long term performance for lower volatility.

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I also like to have some cash around, even if it hurts my short term performance.

The cash helps you to stay detached and opportunistic.

If you're fully invested, you partly loose that optionality, because you have to be right. Things have to play out as you expected, any other scenario will disappoint you.

If I have some cash around, whatever happens is all right.

If things go as expected, I earn some money, if not, I have the flexibility to adjust.

It makes me think about the "Rich Man, Poor Man" analogy from Richard Russell. There's a lot of thruth in it : "In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN'T NEED THE MARKETS. I can't begin to tell you what a difference that makes, both in one's mental attitude and in the way one actually handles one's money."

Well, what I'm saying is it hurts all performance (not just short term).  I'd rather handle the volatility than have lower long-term gains.

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Gio, I knew you'd be on this thread!  Responses below:

Joel,

I think anyone should read and study Mr. Russell Sage’s methods and how he made use of his “cash reserve”. Don’t forget that we are always talking about the future while investing… And the future is never certain!

Do you have some references for this that I could read?  e.g., something outlining his strategy?  I'd like to compare it against being fully invested, if possible.  So far, I haven't found any model that indicates holding cash increases performance, unless you are a timing genius.  To be clear, I started out thinking 5-10% cash was probably a good idea, but couldn't make the numbers work out in any realistic scenarios.

1) The fact an investment meets “your hurdle rate” is and will always be a supposition you make about a business you don’t manage… And even if the fate of that business were in your own hands, you may never be sure about its future… I am absolutely not sure about what will become of the businesses I manage personally!

Well certainly, but that's true for everything in the portfolio.  My point is, if you have a process that works at a certain rate, and know that you have such opportunities around, it appears that it is best to invest and not hold cash for some other reason (e.g., demanding a higher hurdle for the last bit of cash).

2) I think events that create great opportunities are inherently unpredictable. Other people are not able to predict them, otherwise they simply wouldn’t occur, would they? Why are we supposed to best other people in predicting them? I don’t need to predict. Because I know I will always have the cash to take advantage of them.

Actually, this is exactly my point.  If they aren't predictable, then holding cash is an opportunity cost that goes up almost all the time.  Unless holding that cash pays off for the events when they happen, it is not worth doing.  I have not found any evidence/model that allows the cash to overcome this opportunity cost.  In fact, if there is a time or rule set where you can tell me it is good to hold 5% cash, then it will also say you should have held 100%.  Either holding cash helps or it hurts over the long term--I haven't found any evidence that it helps long-term performance.  Please let me know if there is any evidence!  I'm looking for it.

3) Besides Mr. Sage, I know of no other great financial mind of the past, who didn’t always have ample cash reserves, Mr. Buffett included:

Charlie and I believe in operating with many redundant layers of liquidity, and we avoid any sort of obligation that could drain our cash in a material way. That reduces our returns in 99 years out of 100. But we will survive in the 100th while many others fail. And we will sleep well in all 100.
AL2012

If we are not to learn from those great and very successful minds of the past, how are we supposed to navigate the perilous waters of investing?

Well, this is with regard to a business--a business should have cash reserves, but that is besides the point.  I'm referring to the portion of money that is designated for investments, so that would be outside of cash reserves for persons or for businesses.  For that investable money, the question is whether to hold cash, so I do not think the above quote applies.

Moreover, I believe that someone asked Buffett how he would be invested if he had a smaller amount of capital in 1999, and he said 100% stocks.  That's a hard thing to search for, but I'm pretty confident on the quote.  I might be able to find it.

This being said, I admit it is much easier to raise cash, when you cannot find any investment that matches or exceeds “your hurdle rate”! ;)

Gio

Absolutely, and in those times cash should be raised!

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Hi All, I've been giving Pabrai's cash allocation model some thought for a while, and I'd like to get thoughts from the forum members, both on Pabrai's method and holding cash in general.

First, I assume that everyone has some minimum hurdle rate for an investment, e.g., 10, 15, 20%, whatever.  I assume that if an investment does not match the hurdle, it won't be made, so there are times that cash will occur simply because an investment cannot be found.  This is not the situation I'm trying to focus on.  Instead, what I'm trying to consider is whether or not cash should be held at times even though an investment opportunity exists that exceeds the hurdle rate.

For example, after 2008, Pabrai has indicated that he thinks about cash allocation in the following manner:

1st 75% cash - 2x in 2-3 years

next 10% cash - 3x in 2-3 years

next 5% cash - 4x in 2-3 years

next 5% cash - 5x in 2-3 years

last 5% cash - >5x in 2-3 years

Initially, I thought this was very rational and a good way to proceed.  However, I wanted to model this type of behavior in a spreadsheet to see how high the opportunity cost is.

For example, I initially modeled S&P returns and assumed an investor would invest fully only after big down turns (e.g., 2003, 2008), which happen every 5 years or so.  The results were under-performance for all cash levels.

Then, I modeled 15% returns with cash allocation where the cash would be used every 5 years for extraordinary returns.  The results were essentially that you had to put the cash into something that was 5x better than your "normal" rate of return (which makes sense, since the event happens every 5 years, in that model).

Thus, after looking at these models, I'm drawn to the conclusion that keeping cash when you still have opportunities exceeding your hurdle rate is simply not a good idea.

I think there are many who disagree with this.  I would like to hear any thoughts people have on this idea in general; particularly if you disagree.  If you do disagree, could you also indicate the assumptions you are making, so that it might be shown in a simple model?

Thanks!

Although, I do not clearly understand your model, I think you are making a few assumptions here that maybe you should think about a little more:

1. An investment will meet the required rate of return

2. The return will be experienced constantly (i.e. a smooth 15% a year)

Let me know if and how you considered these.

Probably a few more that I will think of later.

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Although, I do not clearly understand your model, I think you are making a few assumptions here that maybe you should think about a little more:

1. An investment will meet the required rate of return

2. The return will be experienced constantly (i.e. a smooth 15% a year)

Let me know if and how you considered these.

Probably a few more that I will think of later.

Well, it is to approximate the behavior of the set of rules.  So, basically, I'm trying to assume that his rules always work perfectly and then determine if it makes sense to follow them, versus say just using the initial hurdle rate (his is 2-3x in 2-3 years).  So far, I haven't been able to make a test that shows it is rational to hold cash according to his rules unless the event happens frequently enough and/or the returns are a multiple corresponding to the frequency of the event.  Looking back over market returns, I do not think that happens.

In reality, neither 1 nor 2 happen, but this is just to test whether the rules are rational.  In a "real world" experiment, I would assume it would be even more in favor of not holding cash, since the returns are unpredictable, and probably less than 7x in 2-3 years.

Please point out any issues though, or any other way to model returns/strategies where holding cash makes sense.  I'm happy to try to generate the numbers to see if it works, as this is a question that I'm trying to answer for my own investments.

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You could also be 100% invested and hedge a portion of what you invest with at-the-money puts.  You'll do better this way as long as you beat the hurdle rate of the annualized cost of the puts.  You won't suffer too much anyhow if the market goes straight down -- it would have been better to be in cash in that case... however I think during the rest of the years you will (I believe) make up for it.

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You could also be 100% invested and hedge a portion of what you invest with at-the-money puts.  You'll do better this way as long as you beat the hurdle rate of the annualized cost of the puts.  You won't suffer too much anyhow if the market goes straight down -- it would have been better to be in cash in that case... however I think during the rest of the years you will (I believe) make up for it.

This is worth some more thought on my part; however, I've never actually used puts before.  Would you mind giving an example that you think would be in the ball park of what you are saying, so I could play around with it?

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You could also be 100% invested and hedge a portion of what you invest with at-the-money puts.  You'll do better this way as long as you beat the hurdle rate of the annualized cost of the puts.  You won't suffer too much anyhow if the market goes straight down -- it would have been better to be in cash in that case... however I think during the rest of the years you will (I believe) make up for it.

This is worth some more thought on my part; however, I've never actually used puts before.  Would you mind giving an example that you think would be in the ball park of what you are saying, so I could play around with it?

I'm about as Australian as you can get without having actually been born there.

So the concept of negative gearing is in my blood  ::) ::) ::)

That might explain everything if you take the totality of all my trades.

Let's say you put your last 20% of liquidity into BAC stock and you want that 20% to be available on a moment's notice.  You purchase \$15 strike puts that can be exercised (worst case) in a panic to ensure that you do in fact have \$15 worth of cash to pay your monthly bills (or meet redemptions if you are a fund manager).

The puts cost you an annualized rate.  So that's the hurdle rate on what would otherwise have just been a cash position.

There will be times when you wind up with less can than otherwise (due to the puts costing you money).  But the rest of the time when you are beating that hurdle rate, it should make up for it.

Anyhow, in my personal life I don't hold any cash at all.  I just have a large chunk hedged with puts for liquidity guarantee.  I would rather lose it to the options market than the tax man anyhow.  The puts don't cost as much as they appear in a taxable account -- the IRS shares my losses on them.

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1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform.

2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation.

Vinod

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One of the best asset allocation ideas I have seen is to have 3 years living expenses in ST bonds as a safety valve to use if markets decline if they go up take income from your stocks.  This will keep the cash component to a realistic level compared to expenses and allow you to fully invest without fear of having to sell to pay for expenses.  Christopher Browne of Tweedy Browne has done this historically with his clients.  As an alternative you could buy puts of the same amount which can be exercised in a downturn.

Packer

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1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform.

2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation.

Vinod

I just tried re-doing this where the year before the market as a whole goes down.  e.g.:

Year 1: 15%

Year 2: 15%

Year 3: 15%

Year 4: -15%

Year 5: 15%

where in years 1-4 in x% cash, year 5: 100% allocated.

This makes the idea work a bit better.  If you assume this occurs every 5 years, with the above returns, your extra cash only has to make 45% the fifth year to match the returns.  At 6 years: 67%, at 7 years: 78%.

That starts to be similar to Pabrai's rules, assuming he can pull off those big returns on the down years.

However, note that the % cash does not matter.  If the rule holds, then you should just be 100% in cash in years 1-4 and then 100% in at the high returns on year 5.  Thus, I haven't seen anything where having a low percentage of cash is better than a high percentage, it either breaks the threshold or it doesn't.

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1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform.

2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation.

Vinod

I just tried re-doing this where the year before the market as a whole goes down.  e.g.:

Year 1: 15%

Year 2: 15%

Year 3: 15%

Year 4: -15%

Year 5: 15%

where in years 1-4 in x% cash, year 5: 100% allocated.

This makes the idea work a bit better.  If you assume this occurs every 5 years, with the above returns, your extra cash only has to make 45% the fifth year to match the returns.  At 6 years: 67%, at 7 years: 78%.

That starts to be similar to Pabrai's rules, assuming he can pull off those big returns on the down years.

However, note that the % cash does not matter.  If the rule holds, then you should just be 100% in cash in years 1-4 and then 100% in at the high returns on year 5.  Thus, I haven't seen anything where having a low percentage of cash is better than a high percentage, it either breaks the threshold or it doesn't.

During GD, the stock market went down 89% for the stock market as a whole and 86% for large cap. I am thinking if you have losses in this range just having cash should make up for all the drag. Any scenario where you have market going up long term would I think make a cash allocation a drag. What about periods when the market is volatile but maybe it just stays at that level at the end of a 10-15 year period.

Vinod

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One of the best asset allocation ideas I have seen is to have 3 years living expenses in ST bonds as a safety valve to use if markets decline if they go up take income from your stocks.  This will keep the cash component to a realistic level compared to expenses and allow you to fully invest without fear of having to sell to pay for expenses.  Christopher Browne of Tweedy Browne has done this historically with his clients.  As an alternative you could buy puts of the same amount which can be exercised in a downturn.

Packer

Very smart.

As per Eric, I have been 100% invested for 15 years.  Perhaps there were times when I shouldn't have been, but it worked out.

The problem I have with holding cash for something other than the 3 yrs. packer suggest is:

Under what situation would you invest it?  We all know people who didn't invest in 2009 because things were going to get cheaper.

When I have excess cash I start to move down the quality curve.  This will start becoming a problem if the markets begin to overheat.  I have been slowly liquidating to pay down household debt, essentially the mortgage.

Presumably as the broader economy improves interest rates will rise, making cash to medium term treasuries a better deal.

Finally Vinod, in the Gd, if you held many stocks they still,paid their dividends.

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Anyhow, in my personal life I don't hold any cash at all.  I just have a large chunk hedged with puts for liquidity guarantee.  I would rather lose it to the options market than the tax man anyhow.  The puts don't cost as much as they appear in a taxable account -- the IRS shares my losses on them.

This is the equivalent of just buying calls (synthetic calls).  Interesting that you consider the tax angle. I suppose that doing the synthetic call is in fact more tax efficeint?  you keep taking the tax losses and can hold the shares and not pay those taxes indefinitely?  Is that the strategy?

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