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When Cash Is King

William Bernstein

YIELDS ON SAFE investments—namely Treasurys, certificates of deposit, savings accounts and money market funds—are in the basement. Yes, Series I savings bonds currently offer an annualized 7.12%. But that rate is only guaranteed for six months, plus regular purchases are limited to $10,000 a year.

“Where can I go for yield?” goes the cry heard throughout the land. Nowhere, of course. As put by money manager Raymond DeVoe Jr., “More money has been lost reaching for yield than at the point of a gun.”

Still, I have a more optimistic take. My contention: The safe assets in your portfolio have the potential to be its highest returning components.

Let me explain. Decades of data show that the owners of mutual funds underperform, on a dollar-weighted basis, their conventionally calculated time-weighted returns by a percent or two per year. Why? They chase performance, buying high and selling low.

Ever wonder who’s taking the other side of their trades? I don’t know for sure—but I’ve often suspected, by process of elimination, that it’s corporate insiders and very wealthy private individuals. That brings me to three quotes, all from the 1930s.

The first was supplied to me by economic historian Richard Sylla, who forwarded to me a pretty good description of how this happens. The description comes from Matthew Josephson’s Depression-era classic, The Robber Barons, which was first published in 1934.

During a market panic, writes Josephson, “There are many casualties, cruel transfers of individual fortunes. Yet he who possesses even a modicum of unimpaired capital is as one who watches the sand run down in an hourglass, while fully aware that he may, at the given moment, turn the glass over and begin the process anew.”

The second quote comes from a young Ohio lawyer named Benjamin Roth. He observed in 1931 that, “A very conservative young married man with a large family to support tells me that during the past 10 years he succeeded in paying off the mortgage on his house. A few weeks ago, he placed a new mortgage on it for $5,000 and invested the proceeds in good stocks for long-term investment. I think in two or three years he will show a handsome profit. It is generally believed that good stocks and bonds can now be bought at very attractive prices. The difficulty is that no one has the cash to buy.” (Italics added.)

Our final quote is from the great Benjamin Graham, author of The Intelligent Investor. In 1932, he wrote in Forbes that, “Those with enterprise haven’t the money, and those with money haven’t the enterprise, to buy stocks when they are cheap.”  

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Graham’s phrasing is perhaps a little archaic. By “enterprise,” he meant cojones, which is perhaps also archaic, but more accurate. Summarizing all three, those with the most cash at a market bottom—Josephson’s “unimpaired capital”—are the ones taking stocks off the hands of the hapless masses.

In my mind’s eye, I can picture the modern incarnation of Josephson’s fat cat owner of unimpaired capital: someone with decades of investment experience who doesn’t necessarily possess the power to time the market—no one does—but who does know that the most spectacular returns are often earned in the first few days or weeks following a market bottom. She also has a large balanced portfolio, with a large amount of stocks that have benefited from high long-term returns, and also enough cash to sleep like a baby when things look the worst.

This point cannot be emphasized enough: If you have enough cash to pay your living expenses for many, many years, you’ll have no trouble holding onto your stocks for the long run and so reaping their rewards, and likely have some boodle left over to buy more during the inevitable fire-sales.

If the data on dollar-weighted vs. time-weighted returns are to be believed, our fat cat has most likely purchased her stocks in the form of mutual fund shares from panicked 401(k) and IRA owners, and she will likely sell them back to those same folks after the smoke clears and prices have risen. In the era of defined-contribution retirement plan investing, this is how the rich get richer.

The political economy of this upward redistribution of wealth is well beyond the scope of this essay. But for ordinary investors, the moral is clear: To prosper, one needs industrial quantities of patience, cash and courage—in that order.

Bill Bernstein is a recovering neurologist, author and co-founder of Efficient Frontier Advisors. He’s contributed to peer-reviewed finance journals and has written for national publications, including Money magazine and The Wall Street Journal. Bill has produced several finance books, including The Four Pillars of Investing, and also four volumes of history, the latest of which is The Delusions of Crowds. His life’s goal is to convey a suitcase full of books and a laptop to Provence for six months—and call it “work.”

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manager
manager
25 days ago

Research shows that a portfolio / index representative of the Large cap “value” universe has sustained a “7%” inflation adj annual withdrawal rate ( “sale of shares”, dividends reinvested ), accompanied by terminal portfolio growth, over seventy one rolling 20 year periods since 1933 https://tinyurl.com/y6key3v5 . And this income stream survived a World War, recessions, a myriad of geopolitical and economic environments, pandemic?, etc.
A modern investor is fortunate to have available well diversified, large cap value index funds ( such as the low expense Vanguard Value ( VTV ) mentioned, the DFA Large Cap Value, Fidelity Value Factor, etc. ), which may be used for this purpose – with the aggregate portfolio appreciation and dividend contributions of hundreds of companies allowing for a more flexible and tailored income stream – a pretty simple way to invest and harvest income with no forecasting involved.

Last edited 25 days ago by manager
parkslope
parkslope
28 days ago

I have immense respect for Bill Bernstein and Jonathan Clements. However, both have written positively about buying the dips, which is contrary to the evidence that you can’t time the market. Jonathan previously replied to my question about this called it a minor sin, but this seems like a rationalization rather than an evidence based answer.
Why Buying the Dip is a Terrible Investment Strategy
https://ofdollarsanddata.com/why-buying-the-dip-is-a-terrible-investment-strategy/

Jonathan Clements
Admin
Jonathan Clements
28 days ago
Reply to  parkslope

Market timing is about acting in anticipation of market moves. You’re making a market forecast. By contrast, buying the dip, along with rebalancing, is about responding to market moves that have already happened. There’s no forecasting involved.

David Rosenberg
David Rosenberg
22 days ago

Rebalancing is fine, but one never really knows if the rebalancing is happening at the end or the beginning of a market drop.

macropundit
macropundit
29 days ago

But when we speak of “cash” that will allow us not to sell stocks, isn’t that assuming one is retired? I’m a tradesman, and I always thought my stable job that provides a very essential service to society was what took the place of cash until I retire. I always thought of that as the perks of having a non-glamorous but essential job. So I saw life and disability insurance as key. Those in the tourism industry or some other non-essential category would have a different calculation I guess. If the economy went in the tank so bad that even essential work couldn’t be sustained I’m doubtful anything I could do to prepare including stockpiling cash would really help. Anyway, I always find myself scratching my head when people talk about the amazing benefits of cash. Seems to me there’s a number of assumptions behind that.

Gary Palmer
Gary Palmer
1 month ago

To have cash for purchases “at the bottom” means you have to put a percentage of your portfolio in cash, since everyone agrees that no one can time the market. Holding cash means your return will underperform the market, 100% of the time, during any long term period when the market average is rising. Seeking alpha is a fools errand. Hold cash, not for dry powder for purchases, but to avoid ever, ever, having to sell to raise cash in a down market, for say unplanned expenses or margin calls.
I’m reading A Random Walk again, and it all comes to rest on the one principal that everyone agrees on – you cannot predict the future – and yet everyone keeps trying.

Jonathan Clements
Admin
Jonathan Clements
1 month ago

Bill Bernstein asked me to post this comment:

Thanks for all the kind words!
Nick M stated that “Mutual fund owners are almost certainly adding dollars over time, so of course this shows up as underperforming the published time-weighted returns. This is simply a mathematical fact, and it has exactly nothing to do with chasing performance.”
This seems to be conventional wisdom in the fund industry, but the actual math actually has a slight bias in the other direction. I recommend this spreadsheet exercise: Invest $100 on 12/31/1925, and every month thereafter, and compute your end wealth on 10/31/2021. Depending on what database you use, you’ll get a final value of about $249.0M. The computed IRR–the dollar-weighted return–is 10.96%, versus 10.44% for the time-weighted return.
My point is not to market time to have cash at the bottom, which of course can’t be identified in real time, but mainly to have cash so you don’t wake up at 2AM in a sweat during a panic and sell your stocks.

Last edited 1 month ago by Jonathan Clements
Nick M
Nick M
25 days ago

If we go into PortfolioVisualizer.com and backtest an asset allocation containing only 1 fund, US Stock Market, with a $10,000 initial value, $1,000 added per month, and the six year period 2013-2018, it shows TWRR 11.68%, MWRR 8.63%.

Changing to a different market return series, the twenty years 2000-2019, it shows TWRR 6.30%, MWRR 9.69%. Again significantly different results between TWRR and MWRR, though now in the opposite direction.

My point is that TWRR for a given time period is often significantly different from MWRR for that same time period, for reasons that have nothing to do with behavior.

Last edited 23 days ago by Nick M
David Powell
David Powell
1 month ago

Welcome, Dr. Bernstein, to HD!

This timely piece reminds me of your wise and memorable introduction in Rational Expectations. That book is an essential element in any personal finance library. Patience, cash, and courage indeed.

Nick M
Nick M
1 month ago

A prior Humble Dollar article “Weighting Returns” explains exactly why “the owners of mutual funds underperform, on a dollar-weighted basis, their conventionally calculated time-weighted returns by a percent or two per year.” Per that article, “The total return number (of a fund) will be a so-called time-weighted return, meaning it’s the return you would have earned if you bought the fund at the beginning of the period, and thereafter never sold any shares or invested further dollars.”

Mutual fund owners are almost certainly adding dollars over time, so of course this shows up as underperforming the published time-weighted returns. This is simply a mathematical fact, and it has exactly nothing to do with chasing performance.

Last edited 1 month ago by Nick M
Stefano Grillo
Stefano Grillo
1 month ago

It seems to me that the author’s argument rests on the assumptions that there will be a market crash and that stock prices at that time will be significantly lower than today. However, this is a form of market timing (i.e. don’t buy more stocks now, wait till they are cheaper and you can get them at a bargain price…). Like all forms of market timing, it’s not clear that it will work.
My criteria for holding cash/bonds are 1. to meet expenses in the next 5-7 years and 2. avoiding a drawdown I would be unfortable with if the stock part of my portolio lost say 50%.
But holding cash with the idea of buying stocks ‘when there’s blood on the street’ might be a bad idea and one might end up paying an opportunity cost, since nobody knows if stocks will be significantly cheaper that today at a future date.

Last edited 1 month ago by Stefano Grillo
Jack Hannam
Jack Hannam
1 month ago

This nicely complements your recent essay on “stocks and their rightful owners”. Like you, I also am a retired neurologist, but one without your expertise in history or finance. While like everyone else, I miss the higher interest rates earned by cash investments not too long ago, I don’t let that distract me from the twin purposes of my relatively large cash position: to provide a liquid source of funds to meet my next ten years of living expenses, and beyond that, to be able to take advantage of stock market buying opportunities, whenever they may appear.

Subhajyoti Bandyopadhyay
Subhajyoti Bandyopadhyay
1 month ago

Bravo! I have never been able to articulate so clearly why I need more than “three to six months of living expenses” as cash. Sure, if I were homo rationalicus, that would have been enough. But I know I am not. Having the years of cushion allows me to never look at the “market news” and consequently not disturb my investments and keep on adding any extra income. Fat cat I am not, but I can truthfully say that I am a “sleep-well” cat (or at least, none of the reasons behind my lack of sleep has to do with money).

Philip Stein
Philip Stein
1 month ago

Some pundits maintain that “cash is trash.” They argue that a cash allocation doesn’t belong in a long-term investment portfolio because the opportunity cost of the reduced growth potential is too great.

But this may be true only if your cash allocation is static. If, as Dr. Bernstein points out, you maintain a cash position so you can purchase stocks at bargain prices at a market bottom, your future returns should more than overcome the opportunity cost of holding cash.

However, there seems to be one problem with buying at a market bottom — we never know exactly when that bottom is. Should we be dollar cost averaging throughout a bear market rather than wait for what we hope is the bottom?

David Powell
David Powell
1 month ago
Reply to  Philip Stein

Dollar cost averaging takes emotion out of the equation. Jeremy Grantham’s piece Reinvesting When Terrified suggests making a plan well before seeing that deep bear market opportunity (like March 2020). Since ideal timing is impossible, he recommends planning for several buys once you see prices in the range of good value for the type of investment you’re adding.

Ormode
Ormode
1 month ago

“…that it’s corporate insiders and very wealthy private individuals.”

You don’t have to be very wealthy to play, but you will become wealthy if you do play. Back in 2009-11, I bought MO for 15, VZ for 27, PFE for 16. Did the market think people were going to stop smoking, making phone calls, and taking medicine? No, any sensible person would have said that the world was not going to end, and that life would go on. You just had to have a little cash.

Leonard
Leonard
1 month ago

Great article! I needed to see this this morning, because I don’t own any Cryptocurrency, and I’m experiencing some Crypto FOMO. Probably wise to just sit on some cash stick with what I know.

Guest
Guest
1 month ago

And this is precisely why I believe those who say “cash is trash” really don’t know what they’re talking about. I’m perfectly happy with 60% stocks and 40% cash.

Last edited 1 month ago by Guest
Joey
Joey
1 month ago
Reply to  Guest

Curious, why 40% cash and not 40% bonds?

Guest
Guest
1 month ago
Reply to  Joey

The expectation of higher interest rates as the Fed has told us will happen fairly soon. So that means I expect bonds to lose value and that money market rates will move higher. I believe I’ll avoid losing money in bonds and make something, even a nominal amount, in the money market. We’ll see but even if I lose money after inflation on the money market, that doesn’t concern me.

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