Most financial advisers will say that holding cash in their investment portfolio for long periods of time is not a wise idea. Over time, research has shown that long-term returns improve as funds are spread to diverse pools of assets. In the long run, market timing attempts haven’t worked very well for the average person historically. However, most investors have cash. Rich valuations, a desire for liquidity, and a fear of volatility are all reasons investors sometimes want dry powder. They are waiting for the saying “fat pitch”.
In a sense, surplus cash (more than cash reserved for short-term costs or debt) can be seen as an option to take advantage of more attractive future investment opportunities. Is there a way to evaluate this option like other financial options are evaluated?
Unlike options that are traded daily on financial markets, there is no Black-Scholes equation that determines the “fair” price of holding cash. Still, look at the various inputs entered into a standard pricing model, such as time, volatility, risk-free interest rate levels, current prices, and optional strikes, to make some form of qualitative judgment of the value offered. Can be formed. By tactical cash allocation.
Time is on your side
Most option traders are constantly fighting watches. All financial options have an expiration date, after which the premium will be lost if the value of the underlying asset does not exceed the strike price. Cash holders, on the other hand, can sit in their liquidity as long as they wish. There is no expiration date.
Still, cash is usually raised with a specific time period in mind. “Raise additional cash at the end of the year” or “I think there will be a fix in the market within the next three months” will set an implicit expiration date for the option, but not an explicit expiration date. You won’t lose your premium if your money doesn’t work, and you can extend the period whenever you don’t get the results you expect. Opportunity cost is the only factor. Options that never expire are certainly worth a lot.
The higher the volatility, the higher the value of the option
In addition to time periods, tactical allocation of cash to other assets often has specific reasons. Investors may want to temporarily withdraw from the market in the hope that they will return to the market after a 10% adjustment. In essence, by doing this, investors are a long put option and outperform the positives to protect against the negatives. If the market falls by 10%, investors will buy back shares at a lower price. That put option is worth it. The higher the implied volatility, the higher the value of the option, and the lower the implied volatility, the lower the value.
If the volatility is high enough in the above situations, there may be more attractive alternatives. For example, an investor can choose to sell put options and receive a premium instead of holding cash. If your implied volatility is very low, holding cash may be a better choice. The higher the volatility, the more likely the market will move to the “strike price” or target.
Recall the depth of the COVID crisis in March 2020. Option premiums have skyrocketed, thanks to the surge in implied volatility. The cash position was so flexible that it was worth a fortune. Therefore, current and expected levels of volatility must play a role in determining to retain additional liquidity.
Low interest rates do not make cash allocation attractive
Let’s face it: Today’s cash balances are of little value from a financial point of view. Yes, they offer options, but they certainly don’t provide income. Bank deposits and money market funds provide virtually no returns as nominal interest rates remain close to 0%. With an interest rate of 5%, the decision to hold cash is a little easier. Keeping cash is more expensive when interest rates are low.
There are more things to consider than the nominal interest rate. Inflation-adjusted interest rates, or real interest rates, are even more important. Inflation is expected to exceed 4.5% next year, so the actual cost of holding a cash position is minus 4.5% instead of 0%. Purchasing power is lost every day, every month, every year. This is why so many investors are entering the stock market these days. The alternative is a negative real return. The certainty of today’s inflation-adjusted negative cash rate of return should be weighed against the opportunity cost of exiting the market. The negative real interest rate environment reduces the selectivity of tactical cash positions and is one of the main reasons investors feel the need to continue investing.
Relative evaluation plays a role
Some argue that the opportunity cost of getting out of the market is declining. Most asset prices are high, so it’s very attractive to “knee down” and wait for a fix. Assume that the prospective return expectations include reversion to the mean of the valuations that many models make. In that case, the perceived “richness” or “cheapness” of the market must play a role in deciding whether to raise cash in the portfolio.
If the long-term past P / E multiple of the S & P500 is 20x, then withdrawing from the market and raising cash at a multiple of 30 is more intuitive than if the P / E multiple is 10x. Makes sense. Again, market timing is difficult, especially when using metrics such as price-earnings ratio. However, in this fictitious example, including relative valuation as input to the analysis makes sense in determining the value of cash options in the portfolio. The higher the perceived valuation, the lower the expected return in the future and the higher the cash selectivity.
The level of surplus cash should depend on the investment environment
Most investors have at least some surplus cash in their portfolios for a variety of reasons. Yes, there is an option to have ready-to-deploy liquidity, but waiting for such an opportunity is also a cost. You cannot measure the value of each directly, but you can see the actual cost of additional cash in your portfolio by treating cash as an option and looking at it as if other financial options were valued. Expectations for higher volatility, nominal and real interest rate levels, and current valuations compared to the past are all relevant.