Is holding cash a good idea?

Over long enough time periods, the stock market has always performed well. There are plenty of bumps and bruises along the way, but the overall trend has always been up and to the right. In fact, the worst total return in history over a 20-year period was +54%. The worst 30-year return was +854%. We’ve all seen images like the one below that show this never-ending march up.

2000px-DJIA_historical_graph_to_jul11_(log).svg.png

Even when markets are high, as many people believe them to be now, the future expected returns from the stock market are still positive. I think this is an important distinction because I’ve talked to many people who think that because the market is high a crash must be inevitable and thus future returns will be negative. If the market is in fact too high right now (which we won’t know for another 5-10 years when we can look back), that means that future returns will be lower than historical averages—but not negative. Though I don’t put much value in people’s opinions who try to estimate future stock market returns, almost all of the estimates I’ve seen are in the low to mid-single digits—call it 4%. 4% isn’t great, but it’s a hell of a lot better than earning 0% in cash.

If the above is true and the stock market always has a positive expected value, shouldn’t we always be 100% invested? The usual reasons given from investors (myself included) to hold cash are:

  1. Cash is optionality. If the market tanks, holding cash allows us to be nimble and quickly take advantage of cheap stocks.
  2. There is nothing cheap to invest in (definitely been here before, like, right now for example).
  3. Behavioral / psychological reasons (peace of mind, etc).

The third one is very personal to each person’s situation and mindset, but I’m not sure the first two hold up to scrutiny. If the broad market is a bet that wins more often than not and it’s a bet we can always make, then anytime we want to own cash, shouldn’t we just own a broad stock market index fund like SPY instead (SPY is an index fund that tracks the S&P 500)? On the first point from above, SPY might as well have the same optionality as cash because I can buy and sell it instantly (SPY’s average daily volume the past three months is over $20 billion dollars). On the second point, even if there are no good individual stocks to invest in, a broad stock market index fund that has a positive expected value is better than cash at 0%.

Whether conscious or subconscious, I feel like a lot of investors (again, myself included) actually hold cash as a way to time the market (even though none of us claim to do it, maybe some cognitive dissonance here) or because we manage other people’s money and are embarrassed to invest in an index fund (which makes sense, paying someone to invest in an index fund does sound pretty stupid). But market timing and/or pressure from outside investors aren’t great reasons. I believe very, very few people can time the stock market consistently and thus the rest of us should probably just be 100% invested and benefit from the market’s inevitable march upwards over the long-term.

If an investor averages a 10% cash position per year (which is low for a lot of investors) and the stock market returns 8% per year over the long-term, that investor is costing themselves 0.8% per year by not putting their cash into a broad market index fund. If the starting account value was $100,000 and 10% was in cash, that’d be $10,000 in cash to start. If the $10,000 is always invested in broad market index funds earning 8% on average, that $10,000 would grow to over $43,000 by year 20. If put in cash, that $10,000 would grow to exactly $10,000 by year 20. Ok, you’d probably get a little interest on the cash. If the cash was able to somehow earn 1% per year, it would grow to just over $12,000 by year 20. $43,000 vs $12,000 is a big difference! Missing out on 0.8% per year doesn’t sound like a big deal, but it can add up to a lot of money.

I asked several money managers I talk to about their views on holding cash and got some quality input. I thought Fred Liu did a great job of describing the trade-off mathematically:

“The other way to think about it is yes, you’re giving up say 8% a year, with the trade-off that a recession / bear-market should bring it down (call it) 40%.  With the assumption you can call a bottom (a big assumption), you’re basically assuming a bear market will come in the next 4.5 years, if you’re holding cash today.  But note at the core, this is a market timing call.”

My take away is that for it to be mathematically correct to hold a meaningful cash position, one has to believe the market is going to have frequent and/or very deep downturns. The above also generously assumes the person invests their cash position near the market bottom, which we know isn’t usually the case. A lot of investors would actually have a bigger cash position at the bottom because the 40% drop they just experienced scared the shit out of them. I think an attitude of always being 100% invested can protect a lot of investors from these kinds of behaviors and cognitive biases that can hurt their long-term results.

Of the money managers I talked to about this, every single one cited some sort of behavioral or psychological reason for wanting to hold cash. Samir Patel brought up an interesting point that I hadn’t considered myself:

“In theory you always want to swap the apparent 17% IRR for the apparent 21.6% IRR, but in practice I find that it’s usually hard to value things that precisely or anticipate when that value will be realized.  As such, I find it hard to rob Peter to pay Paul – it’s easier for me to manage the portfolio when the decision to buy/sell one stock is mostly discrete from another (assuming no overlapping exposure, i.e., if I own FOGO, I don’t also want to buy a bunch of some other restaurant.).”

I think that makes a lot of sense. I’ve gone through that process many times where I’m 100% invested and want to add a new position. Then, I have to figure out what holdings to trim or sell completely to make room for that new position. That decision making process may very well be improved if those buy and sell decisions are completely discrete and not influenced by each other.

Two other investors I talked to about this brought up holding Berkshire Hathaway as a placeholder for cash, but they also mentioned that selling Berkshire may be difficult to replace with another company (that isn’t run by arguably the best investor of all-time). Thus, Berkshire in theory sounds like a good placeholder for cash, but it could easily turn into a normal position. My hunch is that owning SPY would not have that same psychological commitment, but maybe not. SPY is still a distinct position you have to sell to make room for something new. And if your SPY position it down, it may be difficult to sell thanks to how averse humans are to taking losses (loss aversion).

As I’ve been thinking about this concept the past few weeks, I went back and looked at some of my own purchases from the past year and three stood out. First, the big addition I made to my Franklin Covey (FC) position in mid-2017 that took my sizing from the low teens to the high-20s was when I had a big cash position. I wonder if I would have made that same addition if I was 100% invested and buying more Franklin Covey required me to sell other positions. I sure hope I would have if all I had to do was sell SPY, but I don’t know.

The other two purchases that stood out were almost identical—Calloway’s Nursery (CLWY) put out great earnings after market close, so I put in buy orders immediately (because I had cash sitting around) and was able to get a small number of shares at the market open. I’ve made similar small additions to positions several times over the past couple years, but it’s only possible in micro-caps (where new information isn’t immediately reflected in the stock price) and when cash is sitting in the account. If I had all my “cash” invested in SPY, by the time I sold SPY and tried to buy CLWY at the market open I may not have gotten my shares—who knows. So if you invest in micro-caps, I think this is a very legitimate reason to have a small amount of cash sitting around (3-10% maybe?), but those opportunities are never available in larger companies.

Despite what the above sounds like, always being 100% invested isn’t yet an investment philosophy of mine (though I think the logic is sound so far). I’ve held plenty of cash over the years, but whether or not that’s a smart thing to do is something I’ve been challenging myself on recently. “Cash is optionality” is one of those market truisms that almost everyone believes, but I’m not convinced it’s right in the long-term. I think “liquidity is optionality” is closer to the truth—and a lot of things other than cash are extremely liquid. My current thinking is: if the market always has a positive expected value, there’s no reason to ever hold a meaningful amount of cash (vs a broad, liquid index fund).

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

As of this writing, Wiedower Capital owns shares in CLWY, FC, and FOGO. This is subject to change.

12 thoughts on “Is holding cash a good idea?

  1. I think Seth Klarman is very good on this topic:
    http://www.elevationcapital.co.nz/the-painful-decision-to-hold-cash/

    While you could buy an index fund rather than holding cash, when a more attractive opportunity arises (hopefully in the short to medium term), your index fund value will have fluctuated. The movement may or may not be positive, but just because it’s likely to be positive over long periods doesn’t mean it won’t have fallen significantly over the short to medium term period.

    Crucially, the opportunity you are waiting for doesn’t have to be that generally stocks are cheap, just that there is something attractive to buy… it could just be one stock! Therefore, personally I wouldn’t view holding the cash as trying to time the entire market, but simply as waiting for an attractive opportunity.

    I live in the UK, the FTSE 100 index (admittedly not looking at total return here), was around the same level in 2000 and 2016. Within that period there were many ups and downs, it wouldn’t seem a very safe place to park cash, when looking for better opportunities … by the time you’d found one the amount of cash you had to invest may have changed dramatically!

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    • Thanks for posting that Seth Klarman note, I hadn’t seen it before. Even though he’s taking the opposite viewpoint, I think he’s actually proving my point. “Move only when you have an advantage. It’s very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.” If you believe a stock market is going to go up over the long-term, then the odds are always in your favor. Whether something falls or not in the short-term really doesn’t matter. If the long-term expected value of some bet is positive, then making that bet over the long-term will make money.

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      • Thanks for the reply.

        If you believe a stock market will go up over the long term, and are satisfied with the return you would expect from that market, then it can follow to buy the index and hold for the long term. However, holding “cash” in an index fund while waiting to deploy it somewhere more attractive is not investing in that index for the long term. You may want to sell within a few months, or a few years, where the result could easily be very unsatisfactory.

        Further you will only hold the index every so often (when other opportunities aren’t available), meaning your return will likely not follow the long term averages. You may even find you only buy the index when markets are generally highly valued (if that’s when other opportunities are lacking), if so you couldn’t expect to get average long term returns from those purchases.

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    • You know the answer to that. The only economy I claim to have much knowledge of is the US. Funnily enough the Wikipedia page for the Nikkei notes “The Nikkei average has deviated sharply from the textbook model of stock averages, which grow at a steady exponential rate.” Exception that proves the rule? I don’t know.

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  2. Why not bonds instead of cash? Or is this in the context of an equity portfolio with a mandate to either hold stocks or cash?

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  3. Interesting ideas. But let me ask you this: Is there any way you could have written this post in 2009? In other words we forget crisis situations when they are far away in memory.

    Also I think being in cash is just the default. It is exactly not deciding, but being neutral.
    Thinking this further, if you decide to do sth, then why not put your money in your best idea even more, or your second best idea. After all you probably don’t plan to invest in SPY for the long run. But thereby you just increase your odds to get into it at the wrong time (when you have no better idea) and get out at the wrong time (when you have better ideas). That’s exactly why almost nobody gets the paper returns of SPY.
    It is still an investment and ask any financial adviser, he will tell you not to invest for the short term.
    In my opinion you should buy only for the long run and if you expect high returns.

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    • I was expecting the 2009 question to be the first comment on this post 🙂 I don’t know. The market being high is definitely a part of it, but another part is me maturing as an investor and starting to challenge more investing axioms. When I started out playing poker I learned a bunch of axioms (like never fold AK preflop) that I later realized are great rules for beginners to follow, but aren’t actually optimal. I’m not saying holding cash is a beginner investing move—just making the point that I’ve learned before that challenging things we take for granted can have good results.

      To your point about 2009 though, most investors underperform markets over the long-term. One of the big reasons is because the average investor buys high and sells low. Thus, for a lot of people the above post would be even more meaningful in 2009 than it is now because they get scared and have a huge cash position right when the future expected returns are highest (after a big drop). For those types of investors I think requiring yourself to always be 100% invested would help long-term results.

      I know I’m simplifying things, but if the market always has a positive expected value then it doesn’t really matter whether the market is at 2009 or 2018 levels because the bet will win over the long run.

      To your second paragraph, that was potentially going to be a follow up post so good call 🙂 I think if you are in agreement with my post, the logical next step is be more willing to stay 100% invested in stocks and not even have a broad stock market index position. Even if my “worst” positions are fairly valued and I think they can maybe grow 8-13% per year, that’s better expected value than the market and it avoids taxes that would come from selling a position and buying SPY. There’s more risk in an individual stock vs a broad index fund so that’s another factor. I haven’t fully fleshed out my thoughts on this aspect, but I’ve been thinking about it lately as well.

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      • Great, looking forward to this next post!
        One more thought: I think especially for funds like yours in contrast to individual investors, it is better to increase your best positions than to buy the market. Your job is basically to not be the market, because you can do better. Your investors give you money to work with it. Most have probably enough cash and market exposure already. That doesn’t mean holding no cash at all is the best idea, because cash is 100% safe. So you take the timing out. Even bonds can fluctuate, but for dry powder you need it to be stable at the time you want to use it. So I guess a little bit of cash is useful, but other than that, follow your best ideas.

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  4. A couple thoughts:

    I agree it might very well be easier to sell SPY than something you own with a more emotional attachment. However, my thinking is your portfolio doesn’t track SPY that closely so you might find holding SPY during a time when the big names go down more than small caps, a little frustrating for you.

    In a margin account, you can always buy first and sell something else later in the same day and not incur an interest charge. This negates the need to carry cash just to be able to buy before selling.

    I do not subscribe to the 20% cash club, but it is nice to be able to open up a 2-3% position at any time with available cash. I always wonder if those dry powder guys ever get to 100% invested.

    My best sells are almost always when I sold to buy something better. If I am selling just to buy cash and improve my “strategic options”, that previous investment I just sold probably wasn’t a good one 🙂

    Lastly, I’ve given a lot of thought to this over the years and don’t think there is an all purpose answer. Its very context specific. If you like your portfolio, just ride it out. However, if you find yourself asking this question frequently, I’d bet there might just be some weak holdings in your portfolio that that you wouldn’t want to own in bad times and should just sell them down now.

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