My F&M

Investment Q&A

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Why Hold Cash?

Cash (i.e. money market funds) earns essentially nothing today, so it’s reasonable to wonder “Why hold so much cash?”  We hold cash for risk control and flexibility.  Yes, holding cash above the amount needed to accommodate cash flows does have an expected long-term opportunity cost, and that cost is higher when short-term rates are lower.  But the benefit of additional flexibility is also greater when prospects for market volatility are higher, and we think that potential benefit more than compensates for the expected cost.

We believe market risks have risen as yields have dropped.  Valuations are more stretched, profit margins are unsustainably high, and monetary policy remains unusually expansionary, increasing the likelihood of an “asset bubble”.  So we’re positioning portfolios defensively, and one part of that is to hold a little more cash than absolutely necessary.  In a market correction, cash both maintains its value and provides flexibility to purchase assets temporarily “on sale”.  And in a bull market, a modest amount of cash (e.g., 4-6%) results in only a modest performance drag.  We consider cash an important part of temporarily defensive portfolios.

That may lead to another question: “If you expect a bear market, why not hold more cash?”  While we all know a bear market is coming sometime, we have no idea when it will begin.  Yes, we assess that risks are higher than normal now, but that’s been the case for a few years and may persist for many more.  Given heightened risks but uncertain timing, the prudent course is holding a little more cash than bare minimum but not so much as to significantly raise opportunity costs while the bull market continues.

Why Hold Bonds?

We have been noting for some time that interest rates are historically low and, perhaps, artificially so.  Given that coupon income is modest, and the possibility that rates may increase in the future (causing bond prices to decline), it’s reasonable to ask:  why hold bonds at all?

One reason is income.  While bond income is lower than usual, it is still far higher than the zero return from cash.  For example, a 5-year US treasury, which yields less than any other type of  5-year bond, yields 1.31%, and a 7-year treasury yields 1.95%.  Our clients’ bond portfolios generate far more income than this would suggest, because we build our bond portfolios using many different types of bonds, virtually all of which yield substantially more than treasuries.  Our ability to evaluate the credit risk of these bonds allows us to increase income while minimizing the risk from higher interest rates by keeping average maturities in the 4 to 7 year range.

The most important reason for having bonds in portfolios is the role they play in risk management.  While intermediate maturity bonds have downside risk if interest rates rise, that risk is dramatically less than for stocks.  Furthermore, bonds frequently move in the opposite direction from stocks, which make them even more valuable as part of a diversified portfolio.  For example, the intermediate bond index rose 6% in 2008 when stocks plunged and rose 10% in 2002 when stocks fell 22%.

Why Hold Market Risk Hedges?

Given the strong market returns this year, you may be asking why invest in market risk hedges.  Before we address the “why” let’s take a moment to describe the “what”.   Market risk hedges are mutual funds that often use a short component (selling a stock not currently owned in anticipation that it can be bought back later at a lower price) or an option strategy to protect against stock market drops. 

Market risk hedges, by virtue of these defensive strategies, provide a buffer during market declines.  While all market risk hedges won’t go up in a market decline, they should do much better than stocks, and by behaving differently than stocks, enhance your portfolio’s diversification, which lowers risk.  We only have to look back to 2008, when the S&P 500 declined 37%, to see that market risk hedges dampened the effect of stock market losses on portfolios.  The nature of these strategies means that they will be weak performers when stocks are strong, but they should produce positive rates of return over market cycles in addition to adding stability when markets are weak.