Thursday, January 8, 2015

Cash Is King?

For investors, determining the cash percentage of their overall investment portfolios is always a tough question.

We should be able to agree that any cash that you have on hand is (1) either necessary to cover ongoing expenses (monthly bills, gas, etc.), or (2) represents cash awaiting investment. I do not think that “nice to have” qualifies as a valid reason for hoarding and/or managing your cash!

It may be useful to first address how much one would need in ‘savings’ to cover monthly expenses. This is critical, especially in the event of unforeseen situations like illness or a job loss. Most people would likely agree that one should hold enough liquid cash to comfortably cover 6-12 month’s worth of living expenses, thereby creating a near-term safety net.

Any cash on hand in excess to the safety-net amount above, which would also be subject to individual circumstances, should be viewed as cash awaiting investment.

Now, here is the tricky part. You may have an investment portfolio made up of various financial instruments, like cash, equity/stocks, bonds, mutual funds, etc. The question always begs… what percentage of my investments should be in cash?

Advisors will offer many different opinions. A good answer may even be, “It depends.”

A professional wealth manager will typically be able to review your investment portfolio, determine your risk profile, ask about your desired rate of return on investment (also subject to individual circumstances), and more.

Typically, you may arrive at a ‘cash awaiting investment’ percentage of around 10-20% of your total investment portfolio value.

If you hold too much cash, you will miss out on gains when the market is bullish (or going up) because the cash value would be static. And, if you hold too little cash, the balance of your portfolio would be subject to larger losses in market downturns, albeit that the reverse would be true in market upswings (lots of cash; smaller equity gains).

See… it is not that simple a question!

But, math can provide the answer to all of mankind’s questions, so here are some examples:

Investor No. 1: Assume $100,000 portfolio
90% basket of Dow equities + 10% cash
Opening positions:      $90,000 + $10,000 = $100,000
Dow goes up 1%:       $90,900 + $10,000 = $100,900
Dow goes down 1%:  $89,100 + $10,000 = $99,100

Investor No. 2: Assume $100,000 portfolio
50% basket of Dow Equities + 50% cash
Opening positions:      $50,000 + $50,000 = $100,000
Dow up 1%:                $50,500 + $50,000 = $100,500
Dow down 1%:           $49,500 + $50,000 = $99,500

In the example above, investor no. 1 achieved nearly double the gain achieved by no. 2 when the market went up by 1%. And the reverse is true for a downturn of 1%. This is why knowing your risk tolerance is critical.

The human element of emotion is not covered in this post. The market will go up, and the market will go down. Unskilled investors buy high, and sell low. Skilled investors do the opposite, either by managing their investment emotion, or by using tools like stop limits, trailing stop orders, etc.

What if the market declined by 5% and Investor No. 1 lost $4,500 in a day or two? Does the shock and disappointment of losing so much of his/her investment in such a short period of time spook No. 1 enough to hit the sell button and get out? That would be a terrible investment “strategy,” likely to cause investors great personal financial loss.

Over the long term the market goes up. This is not rocket science, but a combination of inflation causing prices of finished goods and services to go up over time, increased corporate sales revenue, globalization (more consumers in more markets), and more.

By way of an example, if you were to invest in Boeing ($BA), you would expect the stock price to go up over time as the corporation gains efficiency through automation; increases sales revenue by selling airplanes for more money, to more customers; cuts costs by outsourcing non-core services; eliminates waste by becoming more ‘lean’, or agile in procurement, inventory control; etc.

As a result of the aforesaid and inflationary pressure in general, the stock price will edge up over time, and - if the corporation continues to be managed professionally - so will your dividends.

By way of a practical example, Boeing's stock price gain over five years is about 114% and over ten years, about 162%. That means $10,000 invested in Boeing in 2005 would be worth over $16,000 today. And if your mother had bought some Boeing stock in 1978 for about $2/share, her gain over this period would equal about 7,500%.

Now we're talking!

And, had it not been for the financial market downturn of 08/09 when Boeing’s stock crashed from about $100/share to about $30/share, the 162% 10-year gain example above, would likely have been much greater.

Over the last century, the Dow has returned about 7% annually. If you also reinvest your quarterly dividends, you can average about a 10% annual return on investment. Such a rate of return would allow you to double the value of your investment portfolio every 7-10 years.

Happy investing!