The debate on holding cash (Dry Powder) will always rage on. The reason is due to cash being a low-yield investment compared to other options such as bonds and stocks. I have very different views about holding cash that is largely shaped by my experiences and my overall financial objective.

TABLE OF CONTENTS:

A brief intro into cash as an asset class.

What I write below is not suggesting you follow my path. However, to provoke you to think about holding cash from a different perspective. To hold cash or deploy it is an important consideration when shaping your Investment Philosophy. It will be based on your beliefs about markets, your time horizon, your risk profile, and your financial goals.

The argument to be fully deployed is typically pumped from financially incentivised organisations to encourage investors to invest. Why? Because they have products to sell. It’s not always the case but often it is followed by headlines such as, “Only the fearful hold cash”, “Cash is the worst investment to hold”, and my favourite, “Inflation is eating your cash away to zero”. Following each fear-sparking headline is a graph like the one below. Showing how holding cash has underperformed stocks and what investors have missed out on.

I’m not debating the underlying principles of inflation and its effect on cash, but these headlines certainly evoke action as they play on investors’ emotions. It brings emotions to the surface that make investors feel as though they are missing out.

Many investors are hoarding cash. Some are drawn towards the safety of cash, and others lack the confidence to intelligently deploy it. Sometimes investors are trying to time the markets and sit out until corrections occur. There are many reasons why investors choose to go to “Dry Powder”.

Cash is an important asset class that comes in and out of favour of market cycles and individual investor preference.

What is the typical argument against holding cash?

There are some drawbacks to having a lot of cash sitting in the bank. The main argument is about inflation and the time value of money. Inflation is the rise of costs and goods over time and that eats into the purchasing power of money. Cash steadily loses value if it is earning zero or low rates of return. If inflation is 5% and your cash is earning 2% then in theory you are losing 3% of your cash in purchasing power every year.

The purchasing power of idle money evaporates over time. The idea behind deploying cash is to generate higher returns on capital to combat the effects of inflation. For example, if you earned a 10% return on your capital by investing in the S&P 500 and inflation was still at 5% then you have a real rate of return of 5% (still have to consider tax but it is a basic example).

The other consideration is opportunity cost. Not necessarily about beating inflation but money earning low rates of return perhaps in fixed-interest accounts or low-yielding bonds has an opportunity cost associated with it. The opportunity is it could be deployed to earn a higher rate of return from stocks, property or other asset classes.

What are the arguments for holding cash?

One of the most valuable assets to have during a time of uncertainty is cash. In down markets, investors who are holding cash can deploy it into undervalued assets when other cash-tight investors must liquidate. In environments where interest rates are rising and investors can get 5%+ from the banks or higher-yielding bonds, then why would investors absorb more risk?

Holding cash can play a core role in a defensive portfolio. Not only earning reasonable returns but with the ability to deploy it when the right opportunity comes along. In this environment “Cash is King”.

How do I view holding cash?

For me, cash is an important part of my philosophy. Outside of Inflation fears, rates of return and opportunity costs, it is about lifestyle and independence to focus on what I am doing.

As an active stock picker who invests for a living, cash is a very important part of my overall strategy. Holding a lot of cash allows me to be very focused on other areas of my life that produce far greater returns than being fully deployed.

This blog is called The Stoic Investors so of course you can expect there to be a philosophical perspective involved!

Holding cash gives me freedom. If I were deployed more, I would be concerned about other areas of my life, how will I fund my lifestyle and look after my family. I have enough cash to sustain what I am doing for a very long time. This allows me to be patient, invest in the highest conviction ideas, and invest in myself, and areas that produce more cash flow and returns.

It gives me comfort, and peace to stay the course sometimes on opportunities that will take years to pull off, especially in small-caps. Being self-employed means I must think years out.

I’ve held cash for years earning nothing and then one or two opportunities came up and I went all in and made 2-3x my capital back, working out to 40-50% CAGR. Investors need income or cash holdings to ensure they don’t disrupt the power of compounding because they need money for other areas of life. Letting winners run is key.

Most active full-time investors who are self-employed also share this philosophy and remain cashed up.

How much cash should investors hold?

I am not encouraging investors to sit on cash for decades, but to think about the decisions behind why they choose to hold cash or not. Every investor has different views, timelines, objectives, risk tolerance and experience levels.

If you are holding cash out of fear, then that can become a problem. Allowing emotions to get in the way of rational investing decisions can lead to a loss. If you are uncertain how to deploy it, maybe there is an education and knowledge gap. Usually, I see investors holding a lot of cash because they have no plan, they are not sure where to begin. They can always dollar cost average, diversify and start small to build up their confidence over time.

I’ve also seen investors deploy cash unintelligently into sub-par opportunities out of fear that they are losing purchasing power. Rather than wait for the right opportunities that can bring market-beating returns they are impatient.

This is my biggest concern about the misconceptions about holding cash.

How much cash you should hold should be based around the following:

• An investors financial goals and objectives.
• The time horizon you have to invest.
• Your risk appetite and psychological make-up.
• Lifestyle demands, living costs, employed/self-employed.
• Knowledge and experience in investing in general.
• Your level of wealth, why take more risk when you don’t need to.

Sometimes investors have to be fully vested to get the desired returns. Other investors who have strong income can also allocate more to investments over holding cash. Everyone has different needs and demands.

Ask yourself how you feel about holding cash and a time frame where you feel is too long to hold it.

In Summary…

My ideologies are deeply rooted in waiting for the right opportunities, not sitting on my hands expecting things to come along or because I am indecisive. I am presented with opportunities every week as a stock investor. I can choose to say yes or no. As I know I have a long runway ahead to not make irrational decisions I’m always looking for the best risk to reward pay-offs that are stacked in my favour.

Don’t look at cash solely as a defensive asset or portfolio strategy. What can it do to your life in general? Perhaps it gives you the freedom to invest, to work on the things you want to, and to ensure you can have patience in selecting the best. When the time is right to deploy cash, do it intelligently not out of fear. I’ve heard all sorts of arguments for and against holding cash from a range of wealthy independent investors. All are bullish on their choices…one thing they all have in common is they are successful either way.

They know why they make their decisions, not out of fear or because of the erosion of capital. Your views about cash and returns will shape a big part of your philosophy and long-term investing strategy.