How can cash be king with interest rates hovering around zero?
Shouldn’t this headline read, “Forget About Cash, Its Return Stinks”?
Cash has a solid place in your portfolio, even with interest rates near zero.
How to profit from cash. Modern portfolio theory recommends keeping a certain percent of one’s assets in fixed investments. These fixed investments include, bonds, but also cash and cash equivalents.
This is because holding cash will normally give you a small interest payment along with stability as stocks and bond values teeter-totter. But is it still a good idea to hold cash when there is virtually no interest paid on cash? Yes.
1. Asset prices are valued high today. The stock market has a price tag and it’s called the price/earnings ratio or P/E ratio. Simply put, the P/E ratio takes the combined price of all of the stocks and divides it by the combined earnings. The resulting percent is the market’s price tag. You may also calculate the P/E ratio on individual stocks.
On Oct. 6, the Shiller P/E Ratio (a special P/E ratio that uses the average of the past 10 years price and earnings data) for the Standard & Poor's 500 index was 26.04. In order to accurately interpret the P/E ratio, you need to compare it with its historical averages. The mean Shiller P/E ratio is 16.55. When compared with the average 16.55 Shiller P/E ratio, today’s ratio is 36.44 percent higher than its historical average. This ratio supports the claim that stocks are overvalued today.
At some point stock prices will return to their historical average. To preserve your net worth, it’s a good idea to hold some cash now, in order to cushion the fall when the inevitable market drop arrives. Cash will cushion your losses.
2. Holding cash gives you psychological peace of mind. If you’ve invested for at least 10 years, you have been through a stock market decline. It hurts. It’s painful to watch your portfolio value decline. It’s even worse if you have to sell assets after a decline, because you need the money.
The psychological medicine of holding cash can't be underestimated. Imagine how you would feel, even if you don’t need any of the money in your investment portfolio for a long time, if you saw the S&P 500 index drop 20 percent or 30 percent, and you didn't have any cash in your portfolio.
This type of experience causes fear to take over, and investors to feel like they must “do something." And usually, doing something involves selling stocks at the bottom.
A cash cushion may both reduce the desire to sell, as well as reduce the overall losses to your investment portfolio.
3. Cash is a physical cushion. If you need money, for anything, having cash is a comfort. Expenses occur. When your roof needs replacing, it’s a comfort to know you can pay cash to replace it. When your investment portfolio drops, you can ride it out, without feeling pressured to sell at an inopportune time.
Most financial professionals (myself included) recommend having six to nine months cash in an emergency fund.
Do you have homeowners and auto insurance? Of course you do. Well, holding a nice cash cushion is the same type of preventative measure. There are periods where unexpected expenses crop up. Maybe your dad, who lives across the country, gets sick, and you need an extra chunk of change to fly out to see him. Continuing with that scenario, what if you need to take a few weeks off from work? The extra cash will definitely come in handy.
4. Cash gives you, the investor, flexibility. How wonderful would it have been to have a pile of cash to invest in 2009? On March 6, 2009, the SPDR S&P 500 Trust ETF hit a low of $68.92, after dropping from a high of $148.33 on Aug. 24, 2007.
Imagine if you had backed up the truck and bought shares in SPDR S&P 500 Trust ETF at the low of $68.92 and held them until today. On Oct. 6, 2014, the SPDR S&P 5000 Trust ETF is selling for $196.30. That’s a 184 percent return.
And that’s why cash is king. When financial assets are selling at bargain prices, you are ready to “buy low."
The pros weigh in on holding cash. According to Morgan Housel in an article in The Wall Street Journal, “Hate Earning No Interest? Here’s Why Cash Isn’t Trash," there is a real return to maintaining cash in your portfolio, although it may be difficult to quantify.
Michael Kitces, director of planning research and partner at Pinnacle, mentioned that the trade-off for holding cash is that you lose a small amount to inflation in exchange for the possibility of a larger future return.
Mikhail Simutin, University of Toronto assistant finance professor, released research in 2013, in his paper "Cash Holdings and Mutual Fund Performance," that found those actively managed funds which hold a greater amount of cash than is necessary to meet shareholder withdrawal demands, perform better than peer funds holding less cash (all other factors being equal).
Finally, Yacktman of Yachtman Focus and Berkowitz of Fairholme Funds have kept approximately 20 percent of their fund’s holdings in cash. These managers outperformed their benchmarks by a few percent on average during the last two decades.
A healthy dose of cash can stabilize a current portfolio and benefit the investor in the future.
The cash tradeoff: The downside of holding cash. When you hold cash today, your money is not going to grow. At today’s zero interest rates, your cash won’t compound very quickly. Even though inflation is low, you may lose a small amount of purchasing power to inflation by holding cash.
Finally, like any strategy, more isn’t necessarily better. These experts aren’t recommending selling everything and running for the hills. In investing, as in life, take a moderate approach. In today’s low interest rate environment, don’t forget about the benefits of cash.
By: Barbara Friedberg
SOURCE: Money US News
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