Six years into one of the better bull markets of the modern era, investors are still holding onto a lot of cash. According to a survey last year by State Street’s Center for Applied Research, globally retail investors are holding 40% of their assets in cash. Is this a good idea? The answer may be no.
Cash is one of the three major asset classes and it serves several legitimate purposes in a portfolio: it dampens volatility and provides liquidity. The cost is that cash typically produces much lower returns than stocks or bonds. Once you adjust for both inflation and taxes, average returns have been negative (See chart below).
Given that U.S. short-term interest rates are stuck at zero, and are likely to remain unusually low for some time even if the Federal Reserve starts to raise rates later this year, return for cash this year is almost certain to be negative. The only potential exception would be if the U.S. enters a deflationary environment.
Help cushion volatility with bonds
It’s true that the volatility of cash is low, but there are other ways to potentially bring down volatility in a portfolio: adding bonds is one option.
Consider this simple example with a three-instrument portfolio comprised of a S&P 500 ETF, a long-term bond ETF and a cash-proxy ETF.1 Based on daily returns since 2010, the annualized volatility on the cash proxy (a short-term bond ETF) is effectively zero, compared to 16% and 15% for the stock and bond ETFs. A quick glance at these numbers seems to suggest that the best way to dampen portfolio volatility is to hold a lot of cash, but this conclusion ignores the important diversification benefits of bonds.
For the past five years or more, bonds have had a strongly negative correlation with stocks; in this environment, adding bonds to a stock-heavy portfolio now is highly diversifying. Unless you have an unusually low risk tolerance, an outsized cash allocation is rarely optimal.
No right amount
While there is no such thing as “the right amount” when it comes to cash or any other asset class, investors need to consider both their return objectives and risk tolerance when making allocation decisions that are right for them. For a portfolio with a multi-decade horizon and high return objectives, cash positions could be relatively small; cash has been adding little to expected returns and investors should be able to manage the volatility with a long investment horizon. The shorter the time horizon, the more cash you should consider holding. Barring a very short horizon—say two years or less—a 30%-40% cash position would likely result in a negative after-inflation return.
On the other hand, a large temporary cash position makes sense for market timers, who believe they have the skills to move in and out of asset classes and profit from such actions. But as the State Street numbers suggest, for many investors it is easier to get out of the market than to get back in.
1Based on IVV, TLT and SHY, using daily returns beginning in 2010.
Source: BlackRock; Morningstar