The real reason you should hold cash

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#1
The real reason you should hold cash
PUBLISHED: 8 HOURS 56 MINUTES AGO | UPDATE: 4 HOURS 39 MINUTES AGO

The real reason you should hold cash
Warren Buffett is a big believer in holding cash for the options it can provide.  Photo: Reuters
STEVE JOHNSON
Despite calling cash the ‘worst investment you can have’, Berkshire Hathaway’s Warren Buffett has sat on billions of dollars worth of non-interest bearing bank deposits. Meanwhile, Baupost’s Seth Klarman recently called cash ‘the ultimate contrarian investment’.

These cash hoarders are joined by many a man on the street. The average cash weighting in Australia’s self managed super funds is 28 per cent.

Some think sharemarkets are expensive. Others think all asset classes have been pumped up by low interest rates and unprecedented monetary stimulus. But can we really enhance our returns by going to cash when the market is expensive and buying back in only when it is fair value or cheap?

That’s a question Tobias Carlisle, US investor and author of the blog Greenbackd, put to the test in a statistical study of the past 88 years of US market returns. Carlisle used the Shiller PE as a proxy for the relative valuation of the market and tested what it would do to your returns were you to sell and hold cash when it flashed expensive.

His conclusion? You would have been better remaining fully invested the whole way through:

“The Shiller PE is not a particularly useful timing mechanism. This is because valuation is not good at timing the market (Nothing works. Timing the market is a fool’s or genius’s game).”

Obviously, had you sold your whole portfolio on October 2008 and bought it back on the lows of March 2009, at 55 per cent cheaper, you’d be rich (and probably famous) today.

But Carlisle’s analysis ties in with my own anecdotal experience. There are always a few people who are going to look like geniuses in hindsight but most do themselves a disservice holding large amounts of cash.

Those that sell out at the top in­evitably get back in too early or fail to reinvest at all. Most of those who happened to get fully invested at market lows in 2009 shifted to cash way too early and missed out on the substantial gains of the past few years.

On average, you are better off riding out the unpredictable waves fully invested than trying to time the market.

So we should be fully invested all of the time, then? No. In our Australian Fund the average cash balance has been 15 per cent since we started almost five years ago. And it has ranged from close to zero to more than 20 per cent. But that has nothing to do with trying to time the market.

It has everything to do with trying to emulate Buffett and Klarman.

Firstly, individual bargains occur more frequently than market-wide bargains, so our lazy cash comes on and off the bench much more frequently than Carlisle’s piece might suggest.

Over the past 12 years, I’ve seen three times where the opportunities where broad (2003, 2009 and 2011). Over that same time, though, I’ve found dozens of individual bargains to buy, many of them outside those three periods. As Klarman puts it: “One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.”

The current market is a perfect example. Despite the index trading at five-year highs, there are pockets of the market offering extreme value. Cash is the enabler that allows us to move quickly when these opportunities arise.

Secondly, and most importantly, holding cash gives us optionality. Alice Schroeder, author of the definitive Buffett biography, The Snowball, says this is one of the most important things she learned: “the optionality of cash”.

“[Buffett] thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”

Extreme bargains don’t usually arise because of varying opinions on the value of a share. They arise when the market is fearful and when someone must sell, irrespective of price.

At the depths of the financial crisis, Buffett’s Berkshire invested tens of billions of dollars in General Electric, Bank of America and Goldman Sachs on incredibly favourable terms.

The companies issued him preference shares, paying interest of 10 per cent or more, and attached warrants that allowed him to participate in share price appreciation.

These companies needed money, and Buffett was the only one who could provide it because he spent years sitting patiently on cash waiting to use it.

And this is the true value of cash. I don’t hold cash because I think it’s going to give me a return. I don’t hold cash because I think the market is expensive and is going to crash. I hold cash because it gives me an option. The option to be the one who can act when everyone around me is panicking.

Steve Johnson is chief investment officer of Forager Funds Management.
The Australian Financial Review
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#2
^^ Die if it is mult-year bull market and only got cash.
"... but quitting while you're ahead is not the same as quitting." - Quote from the movie American Gangster
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#3
I don't disagree with the author, but its my opinion that this only applies if your have a couple of billion AUM and your universe of stocks is much smaller than the average retail investor.

Buffett has stated on many occasions that if he managed <$10 million, he would be investing in a different way than how he does now.

I've enclosed one of the videos here:


Regards,
theasiareport.com
http://theasiareport.com - Reflections From Finding Value In Asia
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#4
I agree with the author in general, but I find it hard to distinguish these few points he said:

He don’t hold cash because:

1. He thinks it’s going to give him a return
2. He thinks the market is expensive and is going to crash
3. He thinks holding cash gives him an option to act when everyone is panicking

Isn’t these points related? I mean, what causes panic? When market crashes (point 2). And when market crashes, those who holds cash will have an option (point 3) to buy cheap and expect a return (point 1).

Anyone can help me to distinguish these three points?
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#5
Buffett is never in a net cash position probably in his whole investment life. Overall, he always has more debt than cash, just like most ordinary people in the world. They have higher mortgage than their cash holdings. You only hold cash because you don't have the time to spend it yet and it does not mean, you can hold on your cash in any circumstance.
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#6
That's really true. Using Berkshire as a vehicle, he has a lot invested through "float" i.e. leverage, albeit on favorable terms to him.

Cash positions gives him the assurance he needs that claims can be paid out if needed. Also, the cash pile is also partly a result of the cash generation capability of his companies.

Regards,
theasiareport.com
(30-07-2014, 10:08 AM)freedom Wrote: Buffett is never in a net cash position probably in his whole investment life. Overall, he always has more debt than cash, just like most ordinary people in the world. They have higher mortgage than their cash holdings. You only hold cash because you don't have the time to spend it yet and it does not mean, you can hold on your cash in any circumstance.
http://theasiareport.com - Reflections From Finding Value In Asia
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#7
This is my understanding of the article.

He holds cash as part of the the portfolio throughout the year because it gives him options if and when a opportunity arises.

For your points :

1. He thinks it’s going to give him a return - He is not holding cash because he thinks holding cash itself will give a good return.

2. He thinks the market is expensive and is going to crash. - He is not increasing his cash portion in the portfolio because he predicts a crash.

3. He thinks holding cash gives him an option to act when everyone is panicking - I read this differently. He holds cash as part of his portfolio and if a crash happens, he can profit from it by investing broadly across the market, but at the same time if a crash does not happen, he will deploy the cash selectively when an opportunity arises for certain stocks but not across the market.

If he did not have the cash as part of the portfolio, he would not be able to invest in both instances when the opportunity arises. Having the cash gives him the option to invest compared to no option at all.




(30-07-2014, 09:58 AM)Ben Wrote: I agree with the author in general, but I find it hard to distinguish these few points he said:

He don’t hold cash because:

1. He thinks it’s going to give him a return
2. He thinks the market is expensive and is going to crash
3. He thinks holding cash gives him an option to act when everyone is panicking

Isn’t these points related? I mean, what causes panic? When market crashes (point 2). And when market crashes, those who holds cash will have an option (point 3) to buy cheap and expect a return (point 1).

Anyone can help me to distinguish these three points?
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#8
(30-07-2014, 11:00 AM)flinger Wrote: This is my understanding of the article.

He holds cash as part of the the portfolio throughout the year because it gives him options if and when a opportunity arises.

For your points :

1. He thinks it’s going to give him a return - He is not holding cash because he thinks holding cash itself will give a good return.

2. He thinks the market is expensive and is going to crash. - He is not increasing his cash portion in the portfolio because he predicts a crash.

3. He thinks holding cash gives him an option to act when everyone is panicking - I read this differently. He holds cash as part of his portfolio and if a crash happens, he can profit from it by investing broadly across the market, but at the same time if a crash does not happen, he will deploy the cash selectively when an opportunity arises for certain stocks but not across the market.

If he did not have the cash as part of the portfolio, he would not be able to invest in both instances when the opportunity arises. Having the cash gives him the option to invest compared to no option at all.




(30-07-2014, 09:58 AM)Ben Wrote: I agree with the author in general, but I find it hard to distinguish these few points he said:

He don’t hold cash because:

1. He thinks it’s going to give him a return
2. He thinks the market is expensive and is going to crash
3. He thinks holding cash gives him an option to act when everyone is panicking

Isn’t these points related? I mean, what causes panic? When market crashes (point 2). And when market crashes, those who holds cash will have an option (point 3) to buy cheap and expect a return (point 1).

Anyone can help me to distinguish these three points?

I think the author is just referring to the real option value of cash, ie, see Alice Schroder's description of it as a call option with no expiration and strike price, and not really whether he thinks the market is overoptimistic, or whether cash itself has a good return.

Real options suggest that all options, discounted today, maintain a certain value, such as the opportunity to wait it out vs going in now; or the option to change or modify vs being locked in. In this case, the opportunities cash hoarding provide are quite clear.

Concept is quite textbook in corporate finance, think you can wiki it for more.
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#9
The insurance component (Geico) of Bershire generates lots of cash flow.

So, WB is able to have a huge cash hoard to reinvest in other companies.

I am trying to use this investment model. Smile
My Dividend Investing Blog
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#10
How? Unless u own an insurance company.
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