The debate of how much cash one should hold is one that will always rage on. Members of 5i Research will be aware that we are not big fans of large cash positions in a portfolio and this can be seen in our model portfolios, which rarely hold over 5% in cash. Typical arguments in favour of cash balances are along the lines of having some form of liquidity to enter attractive opportunities if or when they appear. Typical arguments against cash are that it is a drag on portfolio returns (cash pays you nothing) and that it is akin to trying to time the markets which statistics show time and again that this is very difficult if not impossible to do successfully on any repeatable basis. Regardless, today we do not want to discuss the more conventional arguments but take a look at less talked about reasons why we think low cash balances are important.

Limits number of positions

We think this is a big one that gets overlooked. It is too often that we see in both professionally managed and retail portfolios, holdings that amount to over 80 individual securities. With 80 holdings and some funds thrown into the mix, an investor quickly creates a portfolio that is tough to manage and monitor while providing what is likely very close to market returns. This is often a result of too much cash being available to an investor. If you hold a 10% or 25% cash balance, it is not difficult to add a 1% position here and 1% position there. Unfortunately this gets out of control very quickly and the portfolio ends up with too many names. If the cash is unavailable, it becomes difficult to start adding numerous names to a portfolio. 

Scarce cash resources keep an investor honest

An investor that has a low cash balance usually only has enough resources to make one or two purchases, depending on position sizes. This means that those investments need to be the best ones that they feel are available, opposed to chasing the latest hot stock or picking up a bad company that is simply cheap after a bad news event. Where the rubber hits the road in our view is after those one or two positions are added, an investor now needs to decide what to sell. This is where an investor is forced to be honest. They are required to look at the portfolio holdings and determine if the current stocks are offering the best opportunities relative to the investors needs. If there are better names out there, a stock needs to be dropped from a portfolio (or at least trimmed). If there are no better opportunities, the investor is given solace in knowing that they hold a close to optimal portfolio. This essentially forces the investor to think twice about buying and selling. It is easy to get caught up in a hot stock or theme. Being required to actually sell a stock that one likes (in order to add another), while potentially incurring taxes and transaction costs really makes one ensure that they are making an appropriate decision and may give one pause before rushing into a story stock.

There just aren’t that many ‘great’ ideas out there

While we believe an investor is well served by 20 to 30 stocks in a portfolio, most investors seem to hold something in the range of 30 to 60 securities, with what biases closer to the 60 holdings range. This is OK, as more stocks do not really hurt a portfolio, but the benefits of diversification are greatly diminished. In most cases, an investor would not believe that they are holding ~60 of the best opportunities for their specific needs. We think most investors would be hard pressed to point to 30 securities in a portfolio and be confident in saying that these are some of the best investable names that are available. While no investor expects 100% of their names to work out, the point is that few investors (professional or otherwise) are able to find 60 companies that are ‘great’, high conviction names. Holding these sub-optimal investments is fine for the sake of diversification, but surely one can be found for removal to allow for the addition of another. If investors have too much cash, they never need to do this and end up holding a large, sub-optimal portfolio.

Not getting paid to hold cash

While this could apply to the fact that no returns are generated on a cash balance, we are actually referring more to professionally managed portfolios here. When considering the points above along with the opportunity cost of idle cash and, as noted earlier, the difficulty in getting ‘go to cash’ decisions correct (remember ‘sell everything’?!); we think the argument against professional managers holding large cash balances is a strong one. The manager is being paid to invest for the end beneficiary and not hold cash for them. Investors are capable of holding cash themselves while not paying a fee on it. We do note that we are not referring to a large cash positions over a month or two due to portfolio changes being made, rather consistent positions at and above 10% of the total fund.  An additional issue, albeit less material with the current rate environment, is that cash balances often generate interest which is taxed at higher rates than capital gains, creating a bit of a tax drag relative to other options. 

So there you have it, a few less mainstream reasons as to why we are not big fans of cash. If or when a large downturn occurs, those who have held large cash balances since 2008 will look like ‘geniuses’ but then will need to call the bottom to decide when they can deploy funds making their job all the more difficult. 

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