Cash holdings are often criticized for reducing performance in uptrending markets, but an increasing number of investment banks, including The Goldman Sachs Group Inc. (NYSE: GS) are recommending investors increase the liquidity within portfolios due to economic uncertainties ranging from China to the Brexit vote. The are three main reasons for cash positions in investor portfolios.

Liquidity and Opportunity

Warren Buffett has long been a proponent of holding cash and has alluded to maintaining a minimum of $20 billion in the portfolio of Berkshire Hathaway Inc. (NYSE: BRK.A). By the end of 2015, however, the holding company’s cash stood at $72 billion. One of the key advantages of holding cash, particularly for aggressive investors, is liquidity allows for opportunistic purchases when company valuations decline to attractive levels. An example of the advantage of liquidity is Buffett’s purchase of 1.6 million shares of Wells Fargo & Company (NYSE: WFC) at an average of $8 per share in 2009. As of June 29, 2016, Wells Fargo was priced at $46 per share.

The liquidity provided by holding cash also presents the opportunity to make purchases using a dollar-cost averaging plan. For example, an investor who sees Apple Inc. (NASDAQ: AAPL) as being valued at an attractive level might dollar cost average into the shares using 25% of the amount allocated to the stock for an initial purchase. The key benefit of dollar-cost averaging is more shares are bought when prices are low, while higher prices result in purchases of lower share amounts, which reduces the average cost per share. Subsequent purchases can either be made on a regular schedule, on price declines or based on company developments.     

Reduced Portfolio Volatility  

             

Holding cash in a portfolio may reduce returns as markets appreciate, but its stable value can serve as an anchor within a portfolio to limit losses during declines. For example, a 20% market decline in a fully invested portfolio results in a loss of 20%. By reducing market exposure to 80% with a 20% cash position, the same market loss results in a portfolio loss of 16%. The right amount of cash held in a portfolio differs depending on investment objectives and risk tolerance, but a cushion of cash may also provide peace of mind, which can reduce the chances of panic-based selling when markets get volatile. Access to cash in the portfolio during a downturn may also preclude the need the sell stocks or bonds in the event of an emergency or unplanned expense.

 

An Aging Bull Market

The second-longest bull market in history is showing signs of slowing down, including four consecutive quarters of declining earnings in the S&P 500 and a rapid contraction of profit margins, as of Q1 2016. At the same time, the price-to-earnings ratio (P/E) of the S&P 500 is 24.22, almost 50% than its historical average, as of June 24, 2016. As opposed to the dotcom bubble in 2000 when the valuations of tech stocks were significantly higher than the broad market, defensive sectors such as utilities and consumer staples are trading with valuations significantly higher than historical averages as well.

Citing these factors for its neutral stance on equities in May 2016, Goldman Sachs recommended a cautious approach to equities, including raising cash levels in portfolios. For example, investors who usually maintain 10% cash holdings might consider increasing cash positions to 15 to 20% by proportionally reducing equity exposure, either by trimming current holdings or allocating a percentage of proceeds from stocks sold over time to cash.   

Key Takeaways

  • Holding cash as a portfolio position provides benefits for aggressive traders as well as investors with less tolerance for risk. Aggressive traders can take advantage of portfolio liquidity for opportunistic purchases, while others can opt to reduce risk using dollar cost averaging strategies.
  • Cash holdings can make periods of high volatility more tolerable by providing an anchor to reduce the swings in the value of portfolios. Cash also provides a solution for investors seeking to rotate out of equities after a prolonged bull market due to high P/Es across the market, the correlation of commodities to equities and the risk of buying bonds at or near their all-time highs.