Let me come out and say it: I'm not a big fan of holding a lot of cash as a part of a "normal" portfolio allocation.
The reason is simple: the returns on cash currently are dismal. In fact, the returns on most cashable GICs, money market funds, and similar investments is currently anywhere between 0.5 per cent and 1.5 per cent if you're lucky, less than the rate of inflation. So you're actually losing money right out of the gate, after inflation and taxes.
Over the long term, the opportunity costs of holding cash are absolutely enormous. From 1926-2012 cash averaged a 0.5 per cent return after inflation (a U.S. figure, but the number would be similar here in Canada).
However, cash as a short-term tactical holding–well, that's an entirely different matter. In times of market extremes, holding cash makes a lot of sense. And with the U.S. market posting a return of 32 per cent (with dividends) this year, I'd like to suggest raising some cash might be a good move right now, at least with the U.S. portion of your portfolio.
I realize I don't have a crystal ball. It's not possible for anyone to tell whether the stock market will rise or fall in the next week, month, or quarter. But I think every investor needs to take a look at what might be called the "balance of probabilities," and try and make an educated guess about the likelihood of a temporary pullback or correction. No, you won't be right 100 per cent of the time. But I firmly believe this kind of thinking is a necessary part of being a prudent, "safety-first" investor.
Many of the asset managers I've spoken to recently (portfolio and hedge fund managers, private equity people, etc.) have very recently increased their cash positions. Not necessarily to their all-time highs, mind you, but still a significant and noteworthy shift.
Many of the high-net-worth (HNW) individuals I've spoken to very recently have done the same, upping cash in their portfolios by perhaps 5-10 per cent over the past several weeks, cutting back on speculative positions, and getting very selective and cautious about allocating money to new positions.
I wouldn't characterize any of this as a "panic move" – very few people I've talked to believe we're headed for a market disaster (although there remains some healthy skepticism about economic growth). It's more of a tactical manoeuvre: a reaction to what these investors see as relatively rich valuations south of the border. Equities in the U.S. are getting a little too expensive, and a lot of these people would rather wait than buy now. They see this as time for caution rather than "all-in" bets.
Why would now be a time to trim some winners, take profits, and increase cash? Well, I can think of two tactical reasons:
1. Taking advantage of opportunities
Holding cash gives you flexibility no other asset class offers. During downturns and market corrections, cash can be a very precious commodity–particularly if you have it, and few other people do. Having cash on hand allows you to back up the truck on cheap investments when they start selling at a discount. Such a move can work out very, very well over the long term.
Case in point: Warren Buffett. At the height of the 2008 financial crisis, Buffett was a lender of last resort. At that time, he put $25-billion to work lending to and investing in companies such as Mars/Wrigley, GE, Goldman Sachs, and others between 2008 and 2011. So far, those investments have reaped almost $10-billion in profits for Berkshire investors. Simply put, those profits would not have been possible if Buffett had not had the cash on hand, ready and waiting at the time.
2. Maintaining portfolio quality
This is just as important, but it's something you don't hear about as much. Holding cash helps ensure you don't get suckered into making sub-par investments. That is, investments that don't exactly meet your quality criteria, but you make them anyway, because there's nothing else available.
Over the years, I've seen many investors (including many HNW individuals) fall into this trap. They think they have to put money to work even in more expensive investments, because they have to work with the hand the market deals them. Such thinking often leads to destruction of capital down the road. In reality, you don't have to invest in everything. Wait for what Warren Buffett calls "fat pitches." Until that happens, there's nothing wrong with holding some cash.
I want to be absolutely clear here: I am not saying the U.S. stock market is necessarily in "bubble" territory. And I'm certainly not saying that of the Canadian market either, which we believe is currently perhaps 20-25 per cent undervalued vis a vis the U.S.) Nor am I saying the sky is about to fall for the economy.
What I am saying, however, is that the U.S. stock market has had an impressive run over the past year, (or since March 2009, for that matter) and now may be the time to take profits, trim your more aggressive or speculative positions, and build up a short term cash position (note the emphasis on short term). I, for one, believe there will be better buying opportunities ahead in 2014 and some healthy corrections. It's time to get ready.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada (www.tiger21.com/canada). He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. (www.stennerinvestmentpartners.com) (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.