Tuesday, July 3, 2018

"Hold On To Cash For Crash" Theory

Cash has always traditionally been pegged against the real adjusted inflation rate of return and has been touted as a poor class of asset class over the long run. The idea that cash will always return below the long run average return of inflation means you will lose out in the race of compounding the longer you held them.

But still cash does have their own usefulness.

For one, everyone who's holding on to cash in their portfolio are doing some sort of hedging one way or another, especially against asset classes such as stocks which has direct relation to the market condition of the economy.

But that's the irony.

Theoretically speaking, if the world is full of companies or investors who's holding stashes of cash trying to deploy capital during dark times, then prices wouldn't go down.

For retail investors like you and me however, it is a different story.

Most retail investors who are holding on to warchest and subscribe to the cash for crash theory will face multiple decision when it comes to deploying them.

The three musketeers decision of Market Timing, Margin of Safety and Cashflow come into question for someone who's holding on to the cash for crash theory.



Market Timing

First, you are technically playing market timing.

The fact that you are waiting for a full blown economic cycle means you'd have to have patience in holding them for longer period of time while accepting the much lower return for your cash during these periods.

Because of the much lower returns you've lose out on these years, you have to make it up during a market recession by seeking a much higher stellar return to make it up for all the past years. This means you won't go for mediocre returns of 8% to 10% on a company you've identified but rather companies that can give you 30% to 40% sort of returns.

The whole idea of holding cash in the first place is that option call that you have.

The longer you hold them, the more expensive they've become.

Margin of Safety

Folks who subscribe to the cash for crash theory also often remembers the number one rule in investing and that is not to lose your capital.

During market recession, market tends to behave more irrationally and that usually leads to mispricing on asset classes or companies.

It is during these times that investors can seek to invest in companies that is trading much below their expected intrinsic value.

Even if some of the computation for the intrinsic value are off, there's still some margin of safety to play with and the probability of losing your capital is much lower. 

Hence, in essence, you are protecting your capital.

Cashflow

I once read a financial book that says:

"Cashflow is King, Cash is Queen"

Alright, you probably get the idea.

Cash is technically a stagnant asset class while Cashflow provides that moving parts that leads to increased cash.

Both are equally important in their very own aspects and they complement one another in pushing each to get higher.

During a bull market, cashflow can help to compound your wealth faster by having them reinvested in the growth of the company while cash play a role during recession to slow things down.

Think of them like a husband and a wife.

Final Thoughts

There's no right or wrong to determine how much you should be holding on to cash as part of your overall portfolio strategy.

I can mathematically cast out statistics using historical data to prove that either one strategy can be better than that another but that will all only be on hindsight.

In present and future form, they are only as good if they help to produce the kind of results you are expecting. If not, holding cash for a crash is just a theory that won't be crystallized in your returns.

Thanks for reading.

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7 comments:

  1. Fully invested or cash for crash --- both also can do well in the long run. Main thing is the psychology & being prepared.

    All too often in the real world, those fully invested end up selling out near the bottoms of bear markets or crashes.

    While those holding cash end up being too scared to invest in the midst of recessions, especially when they see heavy retrenchments happening. They'll wait until the coast is clear, and by then the stock indexes are up 50% already.

    ReplyDelete
    Replies
    1. Hi Anonymous

      Well said you summed it all up.

      Regardless of whatever strategy one is adopting if the execution failed then the whole plan doesnt materialize.

      A good plan needs a good execution as well.

      Delete
  2. Hi B,

    I was recently reading a book reading by Howard Marks (fund manager). His interpretation of margin of safety is to set aside a sufficient cash buffer to capitalise on high undervalued securities in times of market turbulence.

    Compared to professional funds that have to be fully invested in order to attempt to beat the others (relative performance)(Fidelity Peter Lynch) , retail investors can simply focus on absolute performance and focus on their individual performance over the long run regardless of market cycles / performance.

    It is ultimately a personal choice. For those with limited capital, a cash hoard can serve also for emergency purposes. The opportunity cost of cash can be painful in the short run but they can always be reinvested to cash equivalents (ssb, treasury bonds etc)

    ReplyDelete
    Replies
    1. *Seth A. Klarman* - Margin of safety

      Delete
    2. Hi INTJ

      Actually for an individual, if we track our portfolio the same way using nav method, it’ll be a lot harder to quantify our expectations of returns. That is why I seldom kept much cash in my portfolio and thats because I probably cannot execute it as well as I wanted.

      Delete
  3. But paradoxically , Berkshire Hathaway is holding its largest cash hoard ever .

    ReplyDelete
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