The continuing market volatility provides a reminder for investors to not forget about the defensive side of their portfolios. So what part does holding cash play in this decision making and how much cash should investors keep invested in this defensive and boring but safe area of their investment portfolio?
The following is taken from a chapter of our book entitled - It's Time You Knew The Truth.
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The first decision to be made in building an investment portfolio is what percentage of assets should be exposed to growth assets and what to defensive assets. We will not go over this again in detail but provide a reminder of the basics.
Growth Assets
- Growth assets provide you with a higher expected return
- Growth assets have a greater degree of volatility and downside risk
Defensive assets include fixed interest and cash investments. We see fixed interest investments as being low risk, reasonably short term investments where the aim is to provide a return slightly higher than the return available from cash investments. We do not see this as an area of the portfolio that should be exposed to any great risks.
Perhaps the easiest description of the defensive assets in an investment portfolio is that they are the assets that should let you sleep comfortably at night. They are the assets that let you know that there is:
- enough cash immediately available to you to meet your cost of living plus a 'cash reserve' should an unexpected event arise that needs extra money
- enough funds in this section of your portfolio that, when added to a modest expectation of future income, could fund the next 5-10 years of your income needs
The role of defensive assets in a portfolio is to provide liquidity (ie cash available when you need it) and to reduce the overall volatility of the portfolio.
Choosing the Split: Defensive vs Growth
While there is a significant weight of research behind how the investment options within each investment class are chosen, the choices of asset allocation are driven by the needs and preferences of each individual investor. This is where the investment process gets personal.
There are three criteria that we consider at this stage including:
The timeframe of the portfolio
The liquidity (potential cash requirements) from the portfolio
The risk tolerance and experience of the investor
Let us look at each of these in turn.
The Timeframe of the Portfolio
Because of the volatility of growth assets, there should be great reluctance to use them in a portfolio where the investment timeframe is less than 5 years. This is because there is a chance that over that time the value of the portfolio could fall sharply, significantly reducing the end value of the portfolio. Short term investing should be heavily biased toward cash and high quality fixed interest investments, where there is no chance of volatility negatively impacting on the final portfolio balance.
In assessing the timeframe of a portfolio, keep in mind that even if you are at the point of retirement, for example, the investment portfolio could be in place for the next 20, 30 or 40 years. Even though you are starting to fund your lifestyle from your investment portfolio, there is still a strong argument to include growth assets to increase the expected returns from your portfolio, so that the portfolio will continue to perform well and be able to meet your longer term income requirements.
Liquidity - The Need for Cash
A portfolio may be required to provide cash for either regular payments over time, such as pension payments, or payments in an emergency, such as an unforeseen medical situation.
There is no exact level of cash that you should keep on hand. We wish that you could say 'that the correct and exact amount of cash that should be available in a portfolio is enough to cover the needs of 92.6 weeks expenditure'. However this level of prediction is just not possible.
Having enough cash on had to cover payments for at least the next 12 to 18 months makes good sense. For example, a person at retirement with a $500,000 portfolio might be taking $30,000 a year from their portfolio. Keeping $30,000 to $45,000 cash in the portfolio provides enough liquidity to meet future payments.
Consideration should also be given to how much income will be drawn in the next 5 years from the portfolio. Given that it is preferable not to invest in growth assets with a time horizon of less than 5 years, this amount of money should be invested in defensive investments. Referring back to the example of the person with $500,000 drawing $30,000 a year, having $150,000 invested in defensive assets will mean that there should be no concerns about making the $30,000 a year payments for the next 5 years. You will note that this is only $150,000 of the $500,000 portfolio, or 30%.
Over the 5 years, income payments will be received from the growth assets and these can be re-invested in defensive assets as the defensive assets are withdrawn from the portfolio. This is important as you cannot simply assume that in 5 years time you will get a positive investment return from growth assets. There have been 5 year periods where growth assets have performed poorly. The combination of having 5 years of living expenses set aside in defensive assets, plus receiving further income from the growth investments, should provide a reasonably base to fund payments from the portfolio beyond the initial 5 years.
Relying on growth assets to fund short term cash needs runs the risk that these assets may fall sharply in value, and you will then be forced to sell them at a time when their value is low.
Personal Risk Tolerance and Investment Experience
This third criterion relates to a personal preference as to how much volatility can be tolerated by you within your portfolio. Of course, you need to keep in mind that as you reduce the volatility of your portfolio, you also reduce your expected longer term return.
A good way to consider how you might cope with volatility is to look at the worse case scenario. Over the past 30 years the biggest market downturn has been the 1987 sharemarket crash. During this time growth assets fell in value by 30-35%.
The question that you can then ask yourself is, if there was another 35% market downturn, what magnitude fall in my portfolio could I handle? Of course, we would all prefer a 0% market downturn. However to achieve that we would have to have 0% of our investments in growth assets, meaning that our expected portfolio return would only be equal to or just above the cash return, around 6%.
The following table shows the trade off between asset allocation, the fall in portfolio value in the event of a 35% market downturn and the expected return of a portfolio.
|
Asset Alloc: |
Fall in Growth Assets |
Fall in Value of Portfolio |
Average Expected Return* |
|
0% Growth |
35% |
0% |
5% |
|
33% Growth |
35% |
12% |
7% |
|
66% Growth |
35% |
25% |
9% |
|
100% Growth |
35% |
35% |
11% |
*Average Expected Return: Growth Return 12%: Defensive Return 6%: Fees 1%:
*Does Not Consider Inflation or Taxes:
*Long Term Return - will be volatile in the short term:
*NB This is a simplistic Calculation
A common response seems to be that downside risk of about 20% in the event of a 1987 style market crash would be acceptable. That corresponds with an asset allocation that has about 60% of the investments held in growth assets, 40% in defensive.
Cash or Fixed Interest?
Having decided which proportion of your portfolio you want to be allocated to defensive assets, the next step is to allocate those funds between cash investments and fixed interest investments.
At this point we will say that this process is only valid if you subscribe to the view that fixed interest investments should be:
High credit quality
Relatively short duration investments (generally less than 4-6 years)
If you are trying to chase higher returns from your fixed interest investments, such as investing in 'promissory notes', 'debentures', 'mezzanine finance', or 'unsecured notes' then our approach to asset allocation is not appropriate.
It is best to build the approach to choosing the split between fixed interest and cash investments by acknowledging the three key differences between them
1/ Liquidity - cash can immediately be accessed. It will usually take some time (often only days) to redeem a fixed interest investment. In the case of some fixed interest investments such as bank term deposits they may only be redeemed on maturity, which could be a matter of months.
2/ Expected Return - there is a slightly higher expected return from holding fixed interest securities over cash.
3/ Volatility - fixed interest investments, which are not highly volatile, will still provide some volatility. Cash investments will have no capital volatility.
These three points lead us to build an understanding of the two, and how they vary subtlety. Their application within the defensive portfolio should be guided by these differences - cash being used for immediate cash needs, and fixed interest investments for longer term needs where the slightly higher return will benefit the investment portfolio. The volatility of fixed interest investments mean that they are not suitable to meet short term cash needs, on the off chance that the fixed interest investments have fallen in value and have to be redeemed at a low price.
As a rule of thumb keeping 18 months of cash requirements, or potential cash requirements, invested directly in cash investments makes sense. That way there is no risk that fixed interest investments will have to be redeemed during a period of volatility when they have fallen in value.
As a simple example, let us assume that a person had a $200,000 investment portfolio. They had decided that 30% of their portfolio, $60,000, should be invested in defensive assets.
They considered that the maximum that they would need to draw from their portfolio is $20,000 for a new car in about 12 months time. They also wanted to keep an extra $10,000 cash reserve in case they have some unforeseen expense. This would mean that keeping $30,000 of their $60,000 defensive investments in cash will cover both of these eventualities. The other $30,000 can then be invested in high quality fixed interest investments to target a slightly higher investment return.
Choosing Investments
Having decided to allocate portions of your portfolio to cash and high quality fixed interest investments the next question is which investments to use?
Preferred cash investments tend to be cash management trusts that provide some degree of functionality such as cheque books or B-Pay. This allows the cash account to also become somewhat of a 'centre' of the whole investment portfolio, collecting income, paying for new purchases, paying fees and providing income from the portfolio.
It is worth noting that there are now many 'e-accounts' that provide good cash returns provided the user is prepared to operate the bank account online.
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So how do we apply this for our clients?
Our focus is on building defensive asset allocations with enough cash to meet all short term cash requirements, with the remaining defensive investments in fixed interest investments.
Scott Francis has also presented a discussion of the use of cash in portfolios during a segment he presented on ABC radio last Saturday. His segment looked in more detail at the use of cash in investment portfolios and concluded that with increasing interest rates and financial institutions competing harder for your money, than for some time returns from this asset class will also be strong in at least the short term. Click on the following link to be taken to Scott's supporting article for this segment - Cash as an Investment Option - ABC material.
