Posted: 9-16-24 | Zach Terpstra
Having too much cash on hand is a common problem and many market participants are guilty of knowingly creating a drag on their portfolio performance. Given the semi-recent raising of rates by the federal reserve and the still-smarting bear market of 2022 which affected both bonds and stocks alike, cash became a psychological safe harbor for some of us to park our hard-earned dollars. Asking someone to deploy out of a money market which has been consistently yielding near five percent for the past year is akin to asking one to leave the party early. No one wants to be the first for fear of missing out on an unknown future. For others of us, we have a fear of that unknown future and cash is a surefire, steady thing. Yet history proves to us that this is often the prudent choice in the long run.
What is “Cash Management?”
Cash management refers to how one manages and optimizes the inflow and outflow of their cash. Consider your own annual spending. Most people tend to have daily spending needs, periodic needs which may occur on a predictable basis, and strategic needs which may occur infrequently but on a larger scale. An example of a daily need could be going to the grocery store, pumping gas, or going out to eat with a friend. The periodic needs refer to known expenses such as quarterly tax payments, debt repayment, or recurring charges you know will occur within a year. Lastly, the strategic needs may rear themselves only infrequently, when one finds “the perfect house,” at a great price for example. The chart below showcases these cash flow types and the recommended approach for each:
Important Cash Management Considerations
Thinking about our cash practically from a needs and utility standpoint allows us to effectively store and manage cash to be used as an actual investment rather than a passive protector. Put simply, for most of us there is a discrepancy between what we know to be true and our actions. This is called cognitive dissonance, and it is important to recognize when we are acting this way. We can recognize that the odds are extremely low that all our annual spending needs are likely to occur tomorrow, yet many folks find themselves sitting in the most liquid form of cash they can find. If we take this micro-liability matching approach to managing cash, the effects can be more stable in the long run than always designating our cash to be completely liquid with the least amount of risk.
Safety is cursed with the hidden cost of opportunity. History is prevalent with multiple instances of short-term yielding instruments such as money markets performing subpar relative to other public asset classes once the Federal Reserve begins to cut rates. Even before that, yields on certificates of deposits and bonds will begin to fall in anticipation of future rate cuts. JP. Morgan illustrates this in the chart below, capturing where markets stand today as the talk of rate cuts continues to make headlines.
A Blended Approach to Cash Management
Our yields from cash and cash equivalents tend to only be strong when the world is standing still, and markets are rarely static for long. Taking a blended approach to managing our cash and being willing to incur a marginal amount of risk can bode well for our long-term returns within any portfolio. Some fight this concept by segmenting cash away from their investable assets, such as holding outsized cash in bank accounts away from an investment portfolio. This is yet another fallacy that flies in the face of the bedrock of all modern investing, post-modern portfolio theory. The theory has been tested and shown that even the most conservative of all investors tend to incur less risk in the form of volatility and downside risk when making investment decisions within the context of all of their available assets, not simply liquid investments.
So, do you have a cash drag on your portfolio that is costing you performance and is working against you in the long run? A few minutes of thought and we can figure this out together. Ask yourself,
- “What is my annual spending, and how much do I need stored in cash to sleep at night?”
- “Are there periodic needs within my annual spending that I know I will not need tomorrow?”
- “Am I saving for a strategic goal which may not even occur this year?”
Once the above questions are answered honestly and truthfully, we have a little more creative freedom to be better diversified by allocating those three piles of cash separately from one another.