Last month, I met two HNW (high net worth) individuals who were holding an unusually large portion of cash in their portfolios for two very different reasons.
The first was an elderly patriarch of a family real-estate business. He had started building his cash allocation several years ago, exiting his equity investments in the wake of the 2008 financial crisis. Yet, several years after the downturn, he still had little confidence in most every asset class.
The second was in his mid-50s. He had sold his services business in the oil patch about three years ago. He had used some of the proceeds to achieve some personal financial goals, but almost three years after the sale, most of the proceeds were still in cash, largely because he was unclear about what he should do with it. Everything seemed very volatile; cash appeared to be the best choice.
Now, these individuals both had valid reasons for holding cash. But what wasn’t valid was the length of time they had been holding it. To be blunt, both of them were stuck in a kind of “cash paralysis.” They had gotten used to the certainty of cash without thinking about the cost of that certainty over time.
I find this is a common trap. There are a lot of investors raising cash right now, and considering the recent market selloff, that’s probably a good move. But it’s important to keep in mind the long-term implications of holding cash. Too many people ignore inflation, taxes and historically low interest rates – all of which can make cash extraordinarily unappealing over the long term.
As a professional adviser (and investor), I’ve always known cash offers the least attractive returns of the asset classes. But I was shocked to see how unattractive it actually was. In fact, according to some recent research from BlackRock and Morningstar, between 1926 and 2012, cash has averaged a -0.8% annual return after taxes and inflation. By comparison, bonds have averaged 0.6%, while equities have averaged 4.5%.
Now, don’t get me wrong – there are legitimate reasons to hold cash:
•You have expenses/commitments coming up in the short term. Say you want to buy a house or pay for a child’s (or grandchild’s) tuition or take a trip around the world. When the expenses are certain, your source of funds needs to be certain as well. Cash fits the bill here.
•You’re protecting your downside and/or researching other opportunities. Maybe you’ve determined the market as a whole is too expensive. Or, perhaps you’re waiting for a selloff to bottom out before you go bargain hunting. Or you need more time to complete your research or due diligence. This kind of short-term tactical hedge is tailor-made for cash.
•You’ve had a liquidity event, and you’re taking a “time out.” Perhaps you sold your business or your commercial property. Or maybe you received a large inheritance or settlement. Cash is a perfectly legitimate “parking place” while determining your next move.
•You have a business/ investment that requires an ongoing source of cash. People who own rental property know this problem: there’s always something to repair or improve, expenses to pay, etc. Warren Buffett has this problem too. Most of his investments generate attractive returns, but some (railroads; power generation) require a lot of cash in order to do it.
Raising cash to protect yourself in a selloff is usually a good idea. Same goes for raising cash to take advantage of future opportunities. But take care that you don’t suffer “cash paralysis.” Cash is best viewed as a short-term tactical hedge – for times like these. But it can’t really be considered a viable long-term portfolio allocation. It’s simply too expensive. •
