How Much Cash Do You Need?

Investors may have been lulled into the false impression that stock markets only go one way – up. The past 5 years were dream years for U.S. stock investors, as they enjoyed returns of 15% per year, while Canadian investors earned good but less-impressive returns of 9% per year. Over the same 2012-17 period, Canadian bonds returned a relatively modest 3% per year.

Let’s look at 3 very different investors: June, Karen and Susan. June, a diversified global investor with an aggressive growth portfolio of 90% stocks, 10% bonds, earned about 10 per cent per year over the past five years. Karen’s conservative portfolio of 30% stocks and 70% bonds earned a much lower return of 6% annually. Susan’s portfolio, held entirely in “cash” – Guaranteed Investment Certificates (GICs), earned a paltry 2% per year over the same period.

It’s easy to see how Susan, and to a lesser extent, Karen, might look at these 5-year returns and tell themselves, “I’ve lost out by holding GICs and bonds, but I’ll make up for it by buying more stocks now.” This is exactly how investors can get burned!

Every investor should set her asset allocation – the shares of total assets held in cash, bonds, & stocks – based on their risk tolerance and time horizon. Stock-market investors must be willing to suffer a loss of about 20 per cent of their investment in any given year. Why would they take that risk? Over the longer term, say 10-20 years, a steep short-term loss will more than offset by longer-term gains.

 

The rule of thumb for whether you’re a saver rather than an investor is if you need the money within 5 years.

 

If Karen and Susan were holding the correct balances before, the rise in stocks would mean that Karen should now be holding fewer stocks to keep her asset allocation at her target. June wouldn’t change her asset allocation based on recent returns, since she is still at her target of 100% cash.

The rule of thumb for whether you are a “saver” rather than an “investor” is if you need the money within 5 years. Savers hold cash: savings accounts or GICs, whereas investors play the markets. Susan is planning on a home renovation, so she is not willing to lose any principal. Cash is king for Susan: Holding GICs is a good way to earn a guaranteed, albeit modest, return.

 

Holding cash is desirable to be able to pick up “bargains”

 

The other time when holding cash is desirable is to be able to pick up “bargains” in the market. This strategy is only in play for active investors – ones who want to either time the overall market, or select particular investments. Passive investors, in contrast, don’t wait for the best time to invest – they just make regular contributions to index funds and trust in the long-term upward trend in the stock and bond markets.

In our example, June is an active investor who picks dividend stocks and value stocks as long-term investments. From time to time, she sells some of her stocks and holds cash until she decides which stocks to purchase next. Although her goal is not to hold cash for very long, there may be several months when she has her money invested in a money-market fund (easily cashable) while researching ideas for stocks or waiting for a change in market direction.

As every economist will tell you, there is no such thing as a free lunch. What do you give up by holding cash or GICs? Clearly, investors give up expected returns in exchange for expected risk, but there is an additional risk associated with holding cash. This key risk is called inflation risk – the chance that your money will not grow fast enough to keep up with rising prices. In Canada, our inflation rate (the annual rise in consumer prices) is between 1-3%, and typically very close to 2%. If you are earning 2% returns on a GIC, you aren’t making any headway in real terms (after adjusting for inflation). In recent months, GIC rates have become a little more attractive, and now outpace inflation by a small margin.

How risky is June’s strategy of shopping for bargains with cash? If June uses cash only as a short-term strategy, she is not incurring undue risk. The risk to her strategy is, of course, that it is very difficult for an average investor to pick winning stocks…but that’s a story for another day.

 

“…investors holding out for the ideal buying opportunity sat on the sidelines during one of the best bull markets of the past century.”

 

Some investors hold cash for another reason. Let’s say they have determined that their asset allocation should be 60% stocks and 40% bonds and they have a lump sum ready to invest. Instead of putting their money in the market right away, they decide to hold off because they want to find the “perfect time” to invest. Every year over the spectacular 2012-17 period, market watchers and investors expected if not a correction, at least a setback in the U.S. stock market and were proved wrong five years in a row. Investors holding out for the ideal buying opportunity sat on the sidelines during one of the best bull markets of the past century.

The key message for investors is to get to your target asset allocation as quickly as you can. Your target asset allocation may include a significant share of cash if either: 1) You have a short time horizon until you need the money, or 2) You are uncomfortable with the risks involved with investing.

Remember this: The number one determinant of investor success is asset allocation.

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