Finding value in money

Strategic asset allocation, whether explicitly modelled or more implicitly as a result of thinking through asset class preferences, generally focuses on investments such as equities, bonds, property, and perhaps alternatives.

Frequently, though, we either overlook cash or think of it as a residual allocation, and even more so with interest rates at near-zero levels. The problem with this approach is that it ignores the fact that cash itself has a value – not just in monetary terms, but in terms of liquidity. Just as, in theory, asset classes with low liquidity (for example, private equity) should offer an illiquidity premium – that is, compensation for their lack of liquidity – cash has a low return but does offer (theoretically) perfect liquidity.

Why does this matter? Most of us do not know the time horizon for our investments. In fact, if we do, a sophisticated roll-down strategy using quantitative modelling of asset class combinations that change over time to de-risk the portfolio as we move closer to the “maturity” date makes sense. But this is another article in itself. Most of us save for a “rainy day” (which, as I have argued before, is why diversification across multiple asset classes is important in managing volatility). A lot of rainy days, though, are quite small, and might only require a relatively small proportion of our savings. So is there a problem? It depends when that rainy day falls.

In times of market crisis (unfortunately very topical at the moment) risk asset prices are generally depressed. While an investor with a high exposure to gilts at the moment could sell with easy liquidity and at a good price, those with Greek debt or equities more generally could potentially be doing so at a capital loss (depending on when they invested) and certainly any sale now would not be at attractive levels when viewed in a long-term perspective. For an investor in a mutual fund, they can console themselves with the fact that any redemption is straightforward and liquidity concerns are likely to be low (although remember that some funds can have either swing pricing or an anti-dilution levy to offset the costs of trading), but for an investor with a direct portfolio of stocks, a forced sale can mean exiting at prices well below the theoretical “market price”, particularly in smaller capitalisation names.

In either case, however, any sale is sub-optimal, and is compounded by the fact that, in times of crisis, an investor is likely to find any attempt to fund rainy day expenditure through debt to be either very expensive or impossible – and so selling investments is inevitable at times. Which brings us back to the importance of cash – just because an asset is not itself value-creating should not rule out its inclusion. Cash is value-preserving – both in the sense that it does not (in nominal terms, at least), fall in value, but also because it has the potential to prevent the need to sell assets at depressed valuations. How much cash an investor should hold requires client-specific tailoring as well as knowledge of their entire financial situation and not just “invested assets”, but this does not mean it should be ignored.