Hindsight is a powerful tool to add clarity to past decisions. Hindsight can also prepare us for similar situations in the future.
Given the current state of our markets and the economy, we don’t know if we’re in the clear just yet. Even though we don’t know what the future holds, we can use what we know now to formulate future decisions.
A Higher Weighting in Cash?
Over the past few months, the most echoed statement I’ve heard from clients in the accumulation and distribution phases of their investing lives is, “I wish I had more cash to invest.” But keeping money in cash can create a cash drag on performance.
Cash drag refers to holding a portion of your investment portfolio in cash rather than investing those dollars in the market. By holding cash, every dollar not invested has the potential to reduce your future returns in a up market.
You have two options. Stay fully invested and experience no cash drag or maintain some cash and understand there may be some cash drag. There are positives and negatives to both options.
In a fully invested scenario, every dollar will see the return of its underlying holding. In an up market, this could be beneficial. In a down market, you may wish you owned a non-correlated asset, cash.
In a scenario in which you maintain cash in the portfolio, in an up market, you may miss out on a higher upside. In a down market, you’ll have options such as additional capital to deploy, a safety cushion, and a non-correlated asset. The cash will cover income needs so you won’t need to liquidate a position that is down.
The Effects of Holding Cash
How can a higher weighting in cash effect long-term investment performance? For a better understanding, I compared a $1 million portfolio invested three ways over different time periods.
Trailing Five Year Returns
Portfolio 2’s beta or indicator of risk over the trailing five years was .632. It underperformed the S&P 500 by .7 percent a year while taking 36.8 percent less risk. Portfolio 3’s beta was .593. It underperformed the S&P 500 by 1.11 percent a year while taking 40.7 percent less risk.
While the S&P 500 isn’t the best benchmark to compare portfolios 2 & 3 from a performance standpoint, the data allows you to see the returns and risk compared to a benchmark. All things considered, the cash drag in portfolio 3 didn’t materially affect performance when compared to portfolios 1 or 2.
1/1/2010 – 12/31/2019 10-Year Returns
Portfolio 2’s beta over this 10-year period was .630. It underperformed the S&P 500 by 2.4 percent a year while taking 36.7 percent less risk. Portfolio 3’s beta was .585. It underperformed by 3.14 percent a year while taking 41.5 percent less risk than the S&P 500.
The S&P 500’s performance over this 10-year time period was exceptional. The index’s annualized return over the last 70 years was 7.47 percent. You start to see a greater cash drag in this 10-year window. The spread on returns in comparison to the trailing five years went from .48 percent a year to .74 percent a year.
1/1/2000 – 12/31/2019 20-Year Returns
Here’s where the data gets interesting. Portfolios 2 and 3 outperformed the S&P 500 over this 20-year time period. The cash drag on portfolio 3 compared to portfolio 2 was less than the 10-year and trailing 5-year annualized returns. In the 20-year period, the cash drag reduced performance between portfolio 2 and 3 by .17 percent on an annualized basis compared to .57 and .31 on the 10- and 5-year numbers, respectively.
The beta on portfolio 3 was identical to the 10-year return, and just slightly higher at .643 for portfolio 2.
Keeping a higher weighting of cash in a portfolio can provide you with flexibility. But the added flexibility may come at a cost. Hindsight shows that in the last 5- and 10-year time periods, staying fully invested was best from a return’s perspective. But if you go back 20 years, not only did you outperform the S&P 500, but you also held 10 percent of your money in cash which was a definite win. However, like most investment decisions, these will be specific to each investor. You should talk with your advisor to determine which option is best for your specific goals.