I just read Paul Limâ€™s book: Investing Demystified and I can say Iâ€™ve got the biggest understanding of cash and investing from it. I thought I should share an excerpt from it with you which discussed the topic Demystifying Cash.
We all know why we need cash in our lives and why we need to raise more of it to fund our financial futures. But why does an investor, as opposed to a saver, expressly need cash in his or her portfolio?
While many people regard cash and bonds as interchangeable assets perhaps because both offer a degree of ballast for an equity portfolio-they are actually quite different instruments. Bonds are an income and diversification tool that investors use to stabilize their growth-oriented portfolios while simultaneously generating income that exceeds the rate of inflation.
This is a fancy way of saying that bonds are designed to grow your pot of money. Even conservative shorter-term bonds, ultra-short-term issues, which purchase debt that matures in a year or less, have different characteristics than bank certificates of deposit or savings accounts. That’s because, even on the margins, short-term bonds put some of your money at risk in order to eke out slightly higher yields than traditional savings instruments can offer.
Saving vs. Investing
Perhaps the biggest distinction between bonds and cash is that you invest in bonds but save in cash. This is a critical point. Cash is designed first and foremost to protect your money. Cash accounts, for instance, are not designed to beat inflation over the long term. And they won’t. Going back to the Ibbotson numbers, the average long-term rate of return for cash is about 3 percent, which is precisely what the long-term rate of inflation is. So on a net basis, you are not likely to advance one iota in a cash account in real terms.
To be sure, this doesn’t mean that the interest you earn in a savings account is irrelevant. Far from it. But the point of maximizing your interest in a cash account is to keep up with inflation in order to protect your principal, not to leave inflation in the dust. To do that, you’ll need longer-term and riskier instruments, such as stocks and bonds.
Moreover, though cash represents one of the three pillars of a portfolio, along with stocks and bonds, the purpose of holding cash is not to beat those other two asset classes in the short term-though in fact in some years you may. Investors who moved money into cash in 2000, 2001, or 2002 probably felt victorious because their accounts, which were yielding perhaps 1 or 2 percent, still wound up doing better than stocks. But that’s not the reason one goes to cash.
How Investors Use Cash
In theory, cash should be the final asset that investors shift their money into as they near a financial goal. It all works as part of a continuum.
For example, if you are 20 years from retirement, you’ve probably put most of your money in stocks, for reasons of capital appreciation. But to avoid suffering major losses in a bear market as you get within five to 10 years of that goal (it can often take around five years to fully recover from such downturns) you will want to shift into bonds, to keep the money growing but with much more stability. You wouldn’t want to shift all of your money into bonds at this point, only the portion you will absolutely need to spend in around five years.
Then, as you get within one or two years of needing to spend that pot of money, you’d probably want to shift at least portions of it into cash (again, only that chunk that you will absolutely need to tap in two years or less) to preserve it for immediate spending purposes.
The allure of cash is that it’s designed to offer de facto or de jure principal protection. Cash accounts offer a floor for people who want to make absolutely certain that a particular pot of money will remain fully intact and available for other purposes.
You’ll recall that in any given year the odds are about one in four of losing money in the stock market. And while many investors might assume that bonds can protect one’s portfolio in the short run, remember that in certain years bonds have lost value. The risk you run by putting your savings into those assets is that you will need to spend the money in the same year that they suffer losses.
Cash, on the other hand, is designed principally to protect your money. This is why your emergency stash or rainy day fund belongs in cash. Some types of cash accounts explicitly guarantee 100 percent principal protection. And while others don’t contractually guarantee that much, they deliver those assurances in practice.
In addition to preserving your gains, cash is also a convenient place for investors to move money temporarily when they can’t find decent opportunities in other markets, such as stocks, bonds, or even real estate.
Mutual fund managers, for example, often sit on anywhere from 5 to 10 percent-or even more-in cash when they run out of good ideas (Figure 7-1). When times look especially lean in the stock and bonds markets, some managers will put as much as one-quarter or even a third of their assets in cash while they investigate their options.
While putting money into cash might slow a stock fund down in the long run-because stocks tend to generate higher returns than cash instruments in the short run, the low single-digit returns that cash provides are better than making a foolhardy decision in equities and losing money. So instead of forcing the issue by putting money into second-tier ideas, professionals would rather put some money in cash-or as they say, “move it to the sidelines””until better ideas surface. This explains a phrase on Wall Street during times of market instability: “Cash is King!”
Why not go into bonds instead? For starters, cash is an ultimately liquid investment, where you can go into and out of these accounts with little or no restraint, penalty, or commissions. Every time you buy or sell a bond, on the other hand, you’re likely to pay transaction costs, taxes, and commissions. For these reasons, investors regard cash accounts as ideal short-term parking places for their money.
Funding Source for New Ideas
In addition to being a good defensive parking place, cash can also help investors take advantage of opportunities in other assets.
If you were to invest 100 percent of your money in stocks and bonds, it would be difficult to jump on new, better ideas as they make themselves known. After all, you as a fully invested person would have to sell stocks and bonds currently in your portfolio-which could take time if you wanted to obtain the best prices-to fund those new investment ideas. Moreover, if you were forced to sell other stocks or bonds that have appreciated in value to fund new ideas, you would have to take the time to make tax-related decisions as you sell.
But if you left a small portion of your assets in cash-say, 5 or 10 percent you would always have access to a funding source for new investments, which would allow you to jump on them in a moment’s notice. As a result, cash could be an ideal place to leave a fraction of your money to deploy elsewhere in the near future.