Cash why?

[gonetowindsurf]

This has probably been covered, but i couldn't find the information under the Cash heading.

What is the reason to have a 25% in an asset that does pretty much nothing?

Are there years where it is beneficial enough to warrant such a non-performing asset?

It appears that it ties up some funds that could perhaps increase performance in the other 3 assets? (whichever is in vogue).

Assuming one has an Emergency Fund of cash, and can draw on a HELOC if absolutely necessary, I wonder if it would be more prudent

(12 years away from a reduction in salary earnings)

to increase market share equally in the other 3 components?

I have watched how the three respond to each other on a daily basis - cash is just there?

Sorry if this has been re-hashed elsewhere - perhaps it should be a "mainstay" topic for the Cash topic.

Thanks for thoughts and wisdom.

[Pkg Man]

I initially struggle with this one as well, but came around to the idea. 

The cash piece was incorporated to deal with recessions, when pretty much everything else is doing poorly.  While cash right now is earning next to nothing, that is not usually the case.  Just before the recession EE-bonds were earning over three percent.  The return on cash has at times been the only component that had a positive return. 

Think of it as the stability component.  Having 25% in cash would have been very nice during the late summer of 2008.

[moda0306]

I , too, find cash to be way to much of a "sucker's play."  I keep whatever cash on hand I feel is good as a cushion in my checking account, and whatever it takes to have maybe a 3-6 month emergency fund. 

That's the nice thing about the PP... you can tweak it to give you your perfect exposure to risk.  I've never seen something that can be tweaked to give such great average returns with such low downside risk.

It's amazing to me this thing isn't marketed vigorously.

[craigr]

I love cash. It's a great place to park profits from assets during rebalancing. It also enables retirees to take living expenses out without having to disturb the other assets and generate taxable events. It is also a place where interest and dividends can be parked for the portfolio to lower bookkeeping tasks. During a very bad market it is a stable foundation that may be needed when the other assets are swinging wildly in value.

Finally, it's a great place to have dry powder for the periodic market swoons that create great buying opportunities in things like stocks. People may knock cash, but in 2008 and going into 2009 cash holders were able to swoop in and buy a lot of stocks at rock bottom prices not seen in a decade. Same thing happened in the 2000-2002 market crash.

Don't underestimate cash.

[Pkg Man]

Finally, it's a great place to have dry powder for the periodic market swoons that create great buying opportunities in things like stocks. People may knock cash, but in 2008 and going into 2009 cash holders were able to swoop in and buy a lot of stocks at rock bottom prices not seen in a decade. Same thing happened in the 2000-2002 market crash.

That's a great point.  Had I had extra cash lying around two years ago I would have done just that.  The PP "forces" one to have such cash available and then rebalance when the prices of other assets are low.

[moda0306]

When I look at the PP over the last 38 years with cash vs without, I think the increased return outweighs the risk.  Either Gold or LT treasuries, or both, go zonkers when stocks go down sharply.  Why would I hold cash for sharp stock downturns?

Ok, obviously you can park your dividends & interest in a small cash account, but to give cash 25% of a portfolio, in my portfolio anyway, is way too conservative.  Yes, of course when you sell and rebalance you are going to have some money in cash before you purchase another asset, but, once again, no reason it should be 25% of a portfolio.  Based on the risks/rewards of the moving pieces of the portfolio, cash is obviously the weakest link.  It has smoothed returns a bit over time, and helped the portfolio result in fewer negative years, but it's simply not worth it.

Take a look at the PP year-by-year returns over the last 38 years as well as the CAGR overall without cash.  Then look at it without one of the other assets.  It's obvious cash is the weakest link.  10% max of a portfolio.

My 2 cents.

[MeDebtFree]

When I look at the PP over the last 38 years with cash vs without, I think the increased return outweighs the risk.  Either Gold or LT treasuries, or both, go zonkers when stocks go down sharply.  Why would I hold cash for sharp stock downturns?

Ok, obviously you can park your dividends & interest in a small cash account, but to give cash 25% of a portfolio, in my portfolio anyway, is way too conservative.  Yes, of course when you sell and rebalance you are going to have some money in cash before you purchase another asset, but, once again, no reason it should be 25% of a portfolio.  Based on the risks/rewards of the moving pieces of the portfolio, cash is obviously the weakest link.  It has smoothed returns a bit over time, and helped the portfolio result in fewer negative years, but it's simply not worth it.

Take a look at the PP year-by-year returns over the last 38 years as well as the CAGR overall without cash.  Then look at it without one of the other assets.  It's obvious cash is the weakest link.  10% max of a portfolio.

My 2 cents.

I have done similar analysis and pondered the same thing.

What PP allocation do you propose for optimal performance (30,30,30,10)?

[moda0306]

My Debt Free,

You just opened a can of worms.  I've been analyzing the big 3 assets without cash (even though, realistically, cash would make up part of a total portfolio... I just know it hardly ever does better work at countering stock drops than bonds/gold.

I think it all has to do with risk appetite... what I first tried doing, was tried to figured out what the optimum allocation would be to maximize returns over time with those 3 assets, regardless of dips.  First of all, I knew it would be mostly stocks, then some blend of bonds/gold to be enough to even out the dips.  If you take it from 1972 (which gives a lot more advantage to gold than starting a couple years later), a 50% stock allocation, with evenly weighted bonds/gold seemed to give the optimum returns by November 2010.  When I started to see how much I should skew the portfolio to gold or bonds, I was surprised to see that it was performing better even being heavily skewed to gold.  I think it was basically the huge swing in the early/mid 70's where stocks dropped and gold exploded.  Gold has actually done better to counter stock drops in the last 38 years, so that was performing the best.

But I saw that as a "coming off the gold-standard" fluke, and decided to keep those two assets the same, no matter what.  So 50/25/25 was about the best return I could get, without overweighting bonds/gold relative to each other.  This was amazing to me, as it resulted in no calendar year (january 1 to dec. 31) loss of over 10%, and had fewer years of losses than a more stock-heavy portfolio (obviously) but returned better than stocks alone by a decent margin.  Obviously, if that's too risky for some, they can include more golds/bonds to even out the dips, but they will get less returns over time.

Then I came across this relative strength stuff, and while I'm nervous of using what I see as "technical indicators," it's interesting and very eye-opening to see how these assets have performed in large swells.  If you simply used the single best asset from the prior year, you'd have like a 12.7% CAGR, with a "worst-loss" (again, calendar year) of 22%.  I then did a little quasi-statistical analysis based on the idea that, with 3 assets, in a completely random world, there should be a 1 in three chance that the asset performed the best in 2005 as it did in 2004.  Well, this wasn't the case.  Some 44% or so of the time, the best and worst assets from the prior year were also in that order in the following year.  That should only be 33% if it's completely random.  Also, the order of the 3 assets was exactly the same in approximately 24% (if I remember right... spreadsheet's at home) of the years, which should only be 11.11% if completely random.  I did a mock portfolio of 75/20/5 relative strenth of stocks, bonds, and gold, and it proved even better long-term results than the single best relative strength asset, with only a 13% worst calender year loss, and much less overall volatility.

I have more playing around to do, but my whole theory is based on 3 very sound principals, well #3 may be more of a theory, but it bears out over the last 38 years.

1) Stocks have great gains built into their pricing, so they should drive any agressive growth portfolio.

- I know there's fraud, disaster, currency collapse, etc, but as Craig has pointed out, every day, the likelyhood of these things are re-priced into stocks by a huge and efficient market, as flawed as it may be.  LT bonds currently, all things staying relatively the same (I know that's never the case), will return 4.5% for the next 30 years.  Gold... not too sure how that's priced, but it's not a wealth-builder.

2) To offset the huge dips of stocks... both to smooth and further grow your portfolio beyond what stocks alone could... you need STRONGLY opposing assets. 

- Obviously this is built into the PP philosophy

- These assets need to 1) strongly bounce on any stock dips, and 2) return pretty well over time in their own right... not huge gains are needed, but it can't be a complete money pit until stocks fall.  Gold and LT bonds, together, have almost always strongly bounced on any dips and returned pretty well over time in their own right... though these are nominal, not inflation adjusted, returns.

3) These assets move in multi-year trends. 

- These assets, as indicators of macroeconomic forces, have a tendency to perform the same in year 2 as in year 1.  Not overwhelmingly so, but if you tweak your portfolio to capture this tendency you can reap greater rewards.

- These tendencies seem to happen more, on the negative end, to bonds & especially gold, then to stocks.

When I combine those 3 "ideas," I come up with something like if the order of performance for the year has stocks performing the best, then it's a 75/20/5 portfolio, if stocks came in 2nd in the prior year, then it's maybe a 40/50/10 stocks/1st place/3rd place.  If stocks come in 3rd, maybe 30/60/10 stocks/1st place/2nd place.  This would have to be done in a tax-deferred account, as I don't want to be paying the taxes on all that rebalancing.

I haven't tweaked it to this level yet to see the risk/reward, but I think, to some level, a smart portfolio should take all 3 of those factors into consideration.  Maybe a conservative portfolio would be 45/35/20, or maybe throw in cash and make it 40/30/20/10 relative strength.  I'm still thinking through all this, and obviously this probably belongs in the VP section of the board... but there you have it.

Sorry for the long post.

[Storm]

Cash is necessary to prepare for a prolonged recession or depression scenario.  That is one scenario that we have not really seen in our lifetimes, however, it is quite possible that we will see it.  In such a scenario, deflation would take hold, creating a deflationary feedback loop as high unemployment reduces consumption, causing price cuts, which in turn causes more job losses, and further reductions in consumption, causing more price cuts.

In such a scenario, 2 out of 3 asset classes would lose value.  Bonds and cash would carry the portfolio.  By cutting your assets to only a 33/33/33 split, or something similar, you are losing 17% of the upside potential created by the cash.

People say cash doesn't grow, and it's true, you can't really tell whether cash has increased it's inherent value or not, because the face value is the same, however, we all acknowledge that over time usually inflation causes cash to be worth less.  Likewise, in bad recessions, deflation causes cash to be worth more.

[moda0306]

Storm,

So maybe 33/33/33 isn't appropriate... maybe LT bonds should be 40% or more.  Point being, if deflationary trends would have persisted, LT bonds would have significantly outperformed cash.

On the flip side, many people like cash because it refinances every year into current interest rates, so when inflation is rising and so are interest rates, cash is at the very least providing good nominal returns, which LT bonds wont be since raising rates hurts them.  I'd still rather be holding Gold & LT treasuries, and suffer the 1981's here and there and have much better long-term return.

That said, I respect the cash portion for keeping the portfolio conservative.... I'm just not that conservative.

[MeDebtFree]

My Debt Free,

You just opened a can of worms.  ...

Worm can opening has always been a favorite past time in my family 

Thanks for your insight.  I enjoy hearing others' ideas and analyzing different facets of investing.  Clive too, of course, puts forth many interesting ideas.

I personally have not found anything yet (but my analysis is far from complete) compelling enough to make me stray too far from a plain vanilla PP as a core holding (my PP is a traditional 4x25).  Including the VP, I am a little stock heavy.  I run an 80/20 PP/VP.  My VP can be all cash at times but generally consists of individual growth stocks and various (relative strength based) ETFs.  I never add money to the VP and will move funds from the VP to the PP when lucky enough to have garnered some decent returns (say 30-40%).

I look forward to your future posts regarding your allocation analysis.

[moda0306]

Here's the thing.  I have no kids and I am a tax accountant (pretty stable work), so I have this invincible feeling that makes me want to tweak the PP, as beautiful as it is.  I'm sure if I had a more unstable career and a couple of mouths to feed I'd have a lot more tendancy to stick to it as-is.

[moda0306]

Clive,

I'm kind of new with some aspects of investing, and you seem like you have done a lot of analysis in other posts that is very interesting.  I am always looking for ways to either smooth returns or increase returns, obviously at as minimal expense to the other as possible.  There is one thing I'm confused about.

I'm not sure what you mean when you say 130% long and 30% short... sorry if this sounds dumb, but since when can I invest 160% of my wealth?  Jk, kinda.... I just don't understand long vs short, other than I know long seems to mean you think something's going up and you invest normally, and short is when you "rent-a-stock" and pay back the same number of shares, while in between selling the stock, hoping it will go down for a smaller buy-back.

I really don't know. 

It seemed odd to me that hedge funds had so many problems after the economic collapse of 2008... I thought/think to myself, "isn't hedging exactly what you WANT to be doing when times get bad?"  Do you have any insight into that?

[moda0306]

Another note,

I couldn't really improve my 70/20/5 Relative Strength returns with anything that favored stocks.  Sticking with relative strength, even if it means being 5% stocks, may just be the answer.

[Storm]

When he talks about 130% long, what he means is to invest some of your portfolio into the ultra-long treasury ETFs, which aim to provide either 2x or 3x exposure to LT bonds.

One of Harry Browne's big rules of investing is to never use leverage.  These leveraged ETFs are very risky, and I wouldn't touch them with a 10 foot pole, however, in your VP, maybe you could do something like this, by buying 2X LT treasury ETFs, junior miners in place of gold, and 2x leveraged S&P500 Index ETF, and hopefully amplify the returns of the PP.  It seems pretty risky though, overall.

[gonetowindsurf]

Craigr  you wrote "it's a great place to have dry powder for the periodic market swoons that create great buying opportunities in things like stocks. People may knock cash, but in 2008 and going into 2009 cash holders were able to swoop in and buy a lot of stocks at rock bottom prices not seen in a decade. Same thing happened in the 2000-2002 market crash."

Isn't this a form of marketing timing - something that we are trying ween away from? Hindsight is 100% . Plus in a rebalancing scenario we would have rebalanced when appropriate- in this case taking money out of treasuries and putting it into stocks - and takes the guess work out of the equation.

Still having difficulty with the cash component- if I have a 1M portfolio, $250,000 is a lot to be underperforming.

I appreciate all the well stated opinions - thanks.

[melveyr]

I am only 19 so holding cash seemed like a horrible idea to me because I'm usually told I should be investing in a risky portfolio. It's easy to thinking of cash is a do nothing asset but that is not entirely accurate. It's not as useful as the other assets because it has low volatility, but it still does have a low correlation coefficient.

If the Fed raised rates before the economy was ready I could make a strong argument that stocks, bonds, and gold would go down. However, cash would be yielding higher with each raise of interest rates, with no loss of principal because of the low duration. This combined with the easy rebalancing and liquidity is why I hold cash.

Oh, and I use the portfolio for money I will need in as little as 3-4 years so low draw-downs are very important.

[Jan Van]

Regarding those leveraged ETFs like DDM, one thing that still isn't too clear to me is how best to play them. The following comment is from Proshares:

[quote=Proshares ( http://www.proshares.com/funds/ddm.html )]Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. Investors should monitor their ProShares holdings consistent with their strategies, as frequently as daily.[/quote]

So what does that imply? Say, for instance, I want to play the bullish sentiment in the market. Should I just buy DDM as a semi-long term holding? And sell when I think it's had enough of a run? Or somehow market-time and go in and out? Have to figure that out...

[uncle Lou]

Removing the cash component of the permanent portfolio increased the 1981 loss from -3.9% to -11.5%.
  No thanks!

Stability with a decent smooth yearly return is the reason I invest in it.

If you remove the cash you have something but it is not THE Permanent Portfolio.

[craigr]

Craigr  you wrote "it's a great place to have dry powder for the periodic market swoons that create great buying opportunities in things like stocks. People may knock cash, but in 2008 and going into 2009 cash holders were able to swoop in and buy a lot of stocks at rock bottom prices not seen in a decade. Same thing happened in the 2000-2002 market crash."

Isn't this a form of marketing timing - something that we are trying ween away from? Hindsight is 100% . Plus in a rebalancing scenario we would have rebalanced when appropriate- in this case taking money out of treasuries and putting it into stocks - and takes the guess work out of the equation.

It's not market timing because these buys were done when rebalancing bands were hit. Having the cash in the portfolio gives stability which means an investor is more likely, psychologically, to rebalance when they should be. I am not advocating piling all one's cash into an underperforming asset in a market crash. But I do say that cash can be used along with the other three assets for very effective rebalancing operations.

Still having difficulty with the cash component- if I have a 1M portfolio, $250,000 is a lot to be underperforming.

I appreciate all the well stated opinions - thanks.

It's not underperforming. Look at it this way. The combined 25% LT bonds and 25% in cash gives an average fixed income duration of around 7 years. That is intermediate bond territory. What do most passive investing advocates recommend for bonds? Intermediate term.

What you get by splitting the fixed income is a barbell effect. You get cash to ride out market swoons and more flexibility to deal with extreme events from the LT bonds volatility.

I like cash. Running a business has instilled this in me as well. You need cash to run a business and ride out ups and downs just as we do for personal life circumstances. Cash is way underrated by investment gurus that insist people take 100% maximum risk with their money all the time. But if you look at the data and behavioral factors it is very clear that cash is a unique asset class that does provide benefits at certain times.

[craigr]

Leverage is a four letter word. It is not possible to use leverage safely for investing. IMO.

[julian]

I think many ppl who invvest in the PP are more concerned with NOT losing then making more which makes cash important. I would not accept a 10-15% calendar year loss vs 1981 of 3.6% just to earn extra. Losing in percentages sounds easy. Lose 15% on a million is $150,000. Not many people would like that & some might panic & sell. From Jan 1, 2008 to mid Nov 2008 the loss in a 25 PP was 10%. No need to make that 13.3%. Again, the percentage sounds small but any loss in dollars feels a lot worse.

[MediumTex]

When discussing the cash piece of the PP, I would make the same point that has been made about the other assets when viewed in isolation--the PP is a package.  It can be confusing and misleading when thinking about the PP as a whole to look at any individual asset, including the cash, without considering the role that asset plays in the overall portfolio.

The cash in the PP performs the specific functions of both dampening volatility and providing dry powder for rebalancing.

When looked at in isolation the cash in the PP may look like it's not doing anything.  When looked at as part of the PP package, though, it's performing a vital function.

[pplooker]

IMHO, there's two things about the "cash" slice that I think most people don't realize when they first read about the concept.

1.  The PP as discussed here often has a very liberal definition of "cash".  30 day treasuries to 3 year treasuries (SHY anybody) to I bonds and other things like SHV besides have been suggested or used as "cash" and that's just sticking to government guaranteed securities. 

Look at all the variety there, and I haven't even gotten into the fact that a lot of people use commercial alternatives, not necessarily out of a desire for better returns either (in fact most Treasury MM funds are closed to new investors).  Some people even use CDs!

I come from a background where anything that can be realized as cash within the relevant period (1 year for sake of argument) is cash, so that doesn’t particularly bother me to be so loose with the term.

2.  The PP is meant to be used for "all the money precious to you".  In other words, what you feel you need to "live".  Now keep that in mind here as I segue...

I would dare to speculate that most people keep between 15 and 35 percent (the usual "bands" of the PP) in "cash", given the liberal definition used in point 1, even if they aren't PP adherents.  A lot of people tend to mentally separate their money between "savings" and "investments".

Speaking from a US perspective as I'm not qualified to comment on how it works internationally, we have both great incentive to put wealth in tax advantage accounts, and a lot of very rigid rules that keep us or discourage us from moving money into and out of them so freely.

Combined that with the reality that, for discrete goals such as replacing a car, most people tend to save cash.  I do it myself as I'm more worried about meeting obligations than I am about maximum yield all the time.

Coming from this mindset, I too once balked at the idea of 25% of the portfolio as cash.  However I am in a unique position to see the inner workings of some very wealthy individuals, and I have realized, gradually, that they invariably have more than a tenth and less than a third of their assets in one of those liberally defined “cash”? instruments.

I admit I sometimes like to watch talking heads tell people whether or not it is okay to buy stupid things even though I make it a point to not make a habit of it.  One thing I notice in all these financial guru shows though is that when people call in, they always list their savings separately from their investments, usually listing tax advantaged, taxable, and savings in three categories.  But the reality is that it’s all one big portfolio but that’s not how Americans think.

If you overcome the idea of thinking of a “retirement account”? as its own thing and instead look at it as space in an overall portfolio, I think most people’s overall portfolios have more cash than they realize.

I daresay when you add it up, 25% of your assets being in cash is normal.  Being richer doesn’t seem to affect it either; the desire for liquidity/stability seems uniform across economic strata. 

This is purely my anecdotal experience and nothing more of course.

[KevinW]

Echoing what pplooker said, there is some confusion over the definitions of "portfolio" and "cash" which causes an apples-to-oranges comparison of the PP's cash allocation.

Harry Browne described the PP as a holistic approach for managing all wealth.  He put both volatile long-term investments, and emergency cash, under the umbrella of "portfolio."

Mainstream financial planning advice (e.g. Bogleheads or Dave Ramsey) is to first save an "emergency fund," something like 3-12 months' expenses, in cash.  After that, invest in a stock-heavy "portfolio."  The "emergency fund" and "portfolio" are treated as completely separate things, even though in practical terms they both represent invested, liquid wealth.

Under Browne's terminology, mainstream advice is to hold a portfolio of 100% to cash until an arbitrary threshold is reached, then start adding stocks and a small amount of bonds.  Someone starting this plan from scratch will have a majority of assets in cash for many years.  The fixed 25% PP allocation actually seems moderate by comparison.

As noted above, here "cash" means something like 1-3 year T-bills.  Other investing vernaculars would call that "short term bonds."  Approximately 25% of the Total Bond Market has a maturity <= 3 years.  So a 60/40 total market portfolio allocates 10% to what we'd call "cash."  A conservative 30/70 portfolio has about 18% in "cash."

Comparing apples to apples, I think most non-PP investors have at least 25% of their wealth in "cash," if not more.