Many investors tend to avoid holding cash. Most investors prefer to have their money generate higher returns, rather than sitting idle in a low return cash account or cashable term deposit. This desire to have money working for us is great, but it is acceptable and actually beneficial to have some cash sitting idle (or almost idle). The tendency of Do-It-Yourself (DIY) investors to use up all their cash within the investment portfolio is quite common. In contrast, highly successful investors such as Warren Buffett always have a significant percentage of their holdings in cash.
Holding a sizable portion of cash that is to be used for investing (whether held inside the actual portfolio or outside) has many long term benefits.
Note: This is also true and applies to small businesses as well. When I mention the word portfolio, it is not limited to a typical paper asset (stocks/bonds) portfolio. It can include real estate, a business, etc. Most general principles apply to all areas of investing.
Benefits Of Holding Cash (Flexibility & Opportunity) :
Holding cash has many benefits tied directly to investing activities, mainly in flexibility and capitalizing on opportunities :
• Without being too restricted by capital, you are able to take advantage of a wider range of investment opportunities.
• Ensures adequate capital for planned opportunities (business expansion, market opportunities during financial crisis).
• Ensures adequate capital for unplanned opportunities (when unexpected news brings a stock price down, real estate deal, business opportunity, etc).
• Being able to act the moment that you have determined an investment is worth investing in (after research & analysis) which allows you to take advantage of favorable prices as well. The more undervalued the asset the better the return when it reaches its fair intrinsic value (generally speaking). Short term price volatility may present favorable prices that may not last very long (short window of opportunity).
• You can make investment moves that would have a large impact on your portfolio or business. Whether for restructuring purposes, or taking advantage of a very good opportunity, the larger the percentage of cash the bigger the impact. Note that you could also make a move that has a large negative impact as well. Large moves must be always be made with a sound, thorough, and logical decision making process.
How Much Cash Should You Hold?
There is no set rule, and everyone has their preferences for various reasons and for different investments.
For example, in real estate, an adequate amount would be holding enough cash to make a down payment. Considerations would be the price range of the property that is likely to be purchased. This cash amount should be outside of the amount that is normally set aside for emergency maintenance, etc.
In stock investing, an adequate amount may be enough cash to purchase at least two small positions in an investment. Considerations would be any associated fees or the monetary value of a position. Going further with the stock example, the trading fees may be $9.00. If the investor finds it acceptable that 0.5% of a transaction can go towards trading fees, then the position size would be $1800. Then two small positions would be $3600. If we look at it from the monetary size of a position, and an investor finds that each position should be no smaller than $5000. Then two positions would be $10,000 worth in cash.
Holding Cash For Beginners Is Especially Important :
For beginners, holding cash is even more important. I always recommend that beginners to be patient and hold cash (savings account) or short term cashable guaranteed investments (term deposits, GICS) while they learn. This is despite the fact that such savings & investments have a very low return. However, people often recommend that they should jump in immediately, and purchase specific “safe” investments with all of their money that is to be used for investing. They recommend not to let their money sit idle while they are learning. The most common investment usually recommended by DIY investors is a low cost index fund or ETF (of the S&P500 or TSX/S&P500 composite). Their reasoning is that such an investment is considered “safe” because the indices are a bargain and relatively lower than their pre-financial crisis peak. They also believe the market will continue to go up in the short term so risk of investment loss is almost non-existent.
This is nonsense! As Warren Buffett always reminds us, “no one knows what direction the markets will take in the short term”. Lets assume a beginner purchased shares on April 1, 2010, of an index fund / ETF that tracks the S&P500 index (such as the iShares S&P 500 Index Fund).
The price on April 1, 2010 was $13.63. Lets assume that after 4 months, the beginner finished reading Benjamin Graham’s Intelligent Investor, and wanted to purchase shares in a high quality undervalued company. On September 1, 2010, the share price of the iShares S&P 500 Index Fund was $12.43. The market price had dropped -8.8%. If the beginner sold their shares, they would have lost money and end up with significantly less to invest with. Imagine if the beginner had done this just prior to the crash, selling would have essentially wiped out their investment money. Both Benjamin Graham and Warren Buffett continually remind investors that “risk comes from not knowing what you are doing”.
It is important for beginners to hold cash and be patient until after having finished reading/learning more:
• Once you put your money in, you essentially commit. If you do decide to go with ETF/index while you learn, be prepared to commit because you never know what direction the market will take in the short term like in our example. It could have easily gone up as well though.
• Once you learn more, you will probably wish you had not made the same investment moves that you would do based on your knowledge today. Even though fund and stock prices are relatively low right now, there will be opportunities that you wouldn’t otherwise see until you have accumulated more knowledge.
• Your plan will most likely be different as well, which will impact how you allocate capital. It depends on the individual investor’s plan.
• Different tools/investments are used under different conditions. Some investments may not be appropriate until later into the plan for a variety of reasons (capital, experience, knowledge, situational, etc.).
• Having mapped out your plan, you will also know your time horizon. Knowing your time horizon helps to direct your capital towards specific investments that would be suitable. Ignoring your time horizon would increase the risk of investment loss, especially for equity based investments.
How To Maintain Your Cash Balance :
The next question would be how to keep your cash balance at a certain level once you’ve used it? Investors should get into the habit of replenishing it or adding to it, on a regular basis. Even if you haven’t drawn down on any of your cash, it is still a worth while idea.
• Set aside money for investing on a regular basis (per week, month, quarter, 6 months, paycheque, etc).
• Place extra lump sums of money into the balance:
– – bonus
– – cash rebates
– – tax refund
– – tax credit
• Put a certain amount of profit from investments sold, back into the cash pile.
• Direct dividends, interest payments, etc, into the cash balance.
How I Do It :
I hold roughly 15% in cash that is intended for investing in non-guaranteed investments (whether they be stocks, bonds, real estate, etc). This amount is outside of, and excludes, my guaranteed investment portfolio (maintained separately). I hold the cash in a savings account and within Canadian & US money market funds. I use all of the above (and on regular basis by paycheque) when replenishing my cash.
General Recommendation :
Leave money in a low interest money market fund or savings account until you find a great investment (sound, low risk, high return) at a great price (highly undervalued, high margin of safety) that is worthy of your investment dollars.
Doing so is beneficial, because you aren’t losing money with a guaranteed short term investment (or savings account). You end up earning a tiny return in the area of 0.5%, while waiting for an investment opportunity, that may give you 100% return without unnecessary risk. That is better than putting it something that will only net you a small (1-10% for example) or possibly a negative return, that restricts you from capitalizing on a great investment when you find one. Patience is a key virtue. It sounds like your money is idle, but what it does is ensures that your money is only invested in the best investments.
Holding a useful portion percentage of your money in cash is a part of successful investing, which ultimately leads to higher returns over the long term.
Please read: The Successful Investing Series Introduction.
Real investment tips that work. This series is intended to help people become a more successful investor, increase returns, and sustain them over the long term.
Thanks & Happy Investing! – © 2011