Cash is for emergencies not portfolios

A scary repercussion of being cancelled and jobless is how fast the money runs out. Whatever counter measures you put in place — selling the car, no champagne before 3pm — regular outgoings soon swamp them.  

This is why financial advisers recommend keeping a certain proportion of assets in ready cash. You simply never know when you’ll be on stage at a conference telling a joke about Miami being underwater.

The rule of thumb is an amount equivalent to between three and six months of income. And indeed in the UK the average person has £17,000 in savings accounts, according to the latest Bank of England data — exactly half the mean annual income.

Yeah right! Averages are nonsense, with most of us either unwilling or unable to put anywhere near enough aside. But how should investors think about cash? What is the right amount in the context of a diversified portfolio such as a pension fund, where access to liquidity is not the point?

I’ve been asked these questions a lot this week due to the conflict in Israel. Unexpected events often have us dashing to cash. But there has been a rise in hoarding for a while. Higher interest rates have made deposits more attractive.

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Just this week Mohamed El-Erian told the FT Money Clinic podcast that he has reallocated some of his money from equities to “basically cash”. Meanwhile, hedge fund gazillionaire Ray Dalio now reckons his “cash is trash” mantra of yore is no longer true.

As ever, the rich already made the move before they disappeared to Ibiza or the Hamptons for the summer. A June survey by CNBC of US households with more than £1mn in investible assets found they had a quarter of their portfolios in cash.

That chimed with an average one-third allocation to cash or cash equivalents (such as money market funds or certificates of deposit) that a Capgemini survey of 3,000 wealth managers and clients revealed the same month.

I read these surveys at the time and could hardly believe the figures. Such high cash positions are well beyond what is needed to cover emergencies such as a new boat or buying Penelope her own flat near to art college.

Why have so much money out of the markets? All long-term asset studies are clear that cash is the worst-performing asset class over any medium to long-term time period you care to examine.

Laziness perhaps? Certainly my 12 per cent weighting is because I haven’t been bothered to reallocate some of the cash raised when I sold my US equities last month. I can pretend I’m timing the markets — but I’d be kidding myself.

Indeed, an April study by Allianz Life suggested that two-thirds of US investors know they have more money in cash than they should. Behavioural scientists will no doubt say this has to do with irrational biases against uncertainty or potential losses.

But holding a heap of cash can be the right investment call in certain circumstances (which can last for decades, as Japanese housewives understand well). And that is when the outlook for every other asset class is worse.

What is “worse” though? If it means a straight comparison of returns after adjusting for inflation, then it is hard to understand why cash is any more attractive today.

Here in the UK, for example, the best instant access savings accounts offer around 5 per cent interest. With inflation at 6 per cent, that is a real return of minus 1 per cent. Five years ago, deposit rates were 0.8 per cent with inflation at 1.8 per cent.

So an identical real return. Nor does the argument that cash is better than other asset classes stack up. Remaining in Britain for easy comparison, 10-year bond yields were 1.7 per cent at the end of 2018 — so a real yield of zero.

Today those same gilts have a 4.4 per cent yield, giving an income after inflation of minus 1.6 per cent. Now yield is not the same as total return. And we should be looking at expected returns and adjusting them for the risk being taken.

A mistake some people make is to assume that cash in their bank account is synonymous with “cash-like” investments such as money market funds

Regarding the former, if interest rates keep rising, bonds will do badly and vice versa. On the latter, bonds are more volatile than cash. Bonds also suffer from ratings risk, credit risk, interest rate risk, default risk and liquidity risk, among others.

You need a PhD to price these. But clearly some investors have reached the conclusion that an extra one percentage point of real return is not enough to compensate them for the extra risks. They would rather have the certainty of cash.

However this misses a crucial point when it comes to managing a portfolio. Sure, bonds rise and fall more than cash. But what also matters is how they move relative to your other holdings. Cash does nothing when equities fall, while bonds often rally — thereby lowering risk in aggregate.

Another mistake some people make is to assume that cash in their bank account is synonymous with “cash-like” investments such as money market funds. Sure, the latter have the word “money” in them. But they are not cash.

Most money market funds are full of short-dated fixed income instruments, issued by banks or governments or corporates. They are always high-quality, but these securities are exposed to the same risks with bond holdings.

With more than $1tn poured into global money market funds this year, I wonder how many investors believe they are risk free? But then again cash is not devoid of risk either, as any inflation-hit Argentine will tell you.

No wonder I receive more emails asking me to write about crypto and gold than any other topic. When I get one not written in ALL CAPS, I might just do it. For now, though, don’t expect to see any cash in my portfolio next week.

The author is a former portfolio manager. Email: stuart.kirk@ft.com; X: @stuartkirk__