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Today I want to continue our discussion of diversification started in my most recent column. In that article, it was established, or at least posited, that a properly-diversified portfolio almost always contains some cash along with fixed income securities and equities; and that cash usually gets the smallest allocation among the three asset classes, between 5% and 10% of total portfolio assets.
We also noted the irony in that, while cash is the asset class on which it is hardest to earn a superior return, it is also the asset class to which most investors pay by far the least attention when making and reviewing their investment decisions. Finally, we looked at what might be the most and less optimal containers in which to hold cash.
We got all that accomplished and yet, it seems, we missed covering the most basic issues: a definition of cash, and an explanation of its role in a portfolio.
The need to actually define cash became evident in a couple of the comments received on that previous article. One reader proudly claimed to have a large proportion of his overall portfolio (40%!) in cash, invested in XSBs (TSX:XSB) and XBBs (TSX:XBB).
To those not in the know, those are two bond exchange-traded funds, which are containers for bonds, not cash. When cash is invested in bonds, it is no longer cash; it becomes part of your fixed-income allocation. Based on the above reader’s description of his overall portfolio, he holds zero percent in real cash.
Another reader asked what the role of cash is, and why any allocation at all to cash would make sense when the returns are so low. Specifically, the question was, “What is the purpose of having cash in your portfolio? Given that almost all investments can be turned into cash in 24 hours, and most people have lines of credit, I see no reason to have cash lying around not earning anything. Unless the market is too risky to invest in.”
Well, I certainly have my work cut out for me. First to define cash in a portfolio sense, and second to describe its role in that portfolio.
On the first point, cash is currency and coin in circulation, and could be denominated totally in Canadian dollars, or a variety of currencies. In a portfolio, that cash could be held in a number of different ways: simply as cash in a brokerage account, or in that brokerage account in the form of a Tax-Free Savings Account, a term deposit, a treasury bill, bankers’ acceptances, GICs or term deposits. Cash invested in any other security, such as stocks or bonds, even if its is just ‘parked’ there temporarily, does not qualify as cash; it qualifies as equity or fixed-income.
As for why you would hold cash when most investments can be turned into cash rather quickly, I prefer not to quibble with the accuracy of that assumption. Instead I will say that this question assumes that cash plays only one role in a portfolio: to provide liquidity, presumably as a result of an unexpected event such as an emergency.
The real reason cash should be held in a portfolio is two-fold. One is to fund emergencies, as noted above, as well as to fund more-expected expenditures such as portfolio management fees, taxes and safekeeping fees. Cash is also the destination for matured bonds, as well as dividend, distribution payments and interest until that cash is redeployed into the market. That’s one reason to hold cash; after all, you don’t want to have to pay a commission and disrupt a nice stock position just to pay your portfolio management fees, margin interest costs or your annual RRSP fees.
The second role of cash in a portfolio has nothing to do with convenience, and everything to do with proper diversification. Cash has a different correlation with stocks and with bonds than bonds do with stocks and, of course, vice versa. As such, cash contributes to bringing down the risk-reward ratio. More on that next issue, but for now, rest assured that cash plays a bigger role than just providing liquidity.
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