Sunday, July 5, 2015

Diversification and Portfolio Performance – The Cash Effect

In bear markets, you may feel quite the investor if you own enough cash and are in a position to buy shares of quality companies at dirt cheap prices.  But, your overall portfolio performance may still be only mediocre because you may have been anticipating this bear market for the last 6 years.  In fact, many retail investors have never returned to the stock market since 2008. Others may have held 30 or 40% cash and whatever the profits of a rare stock investment may have been, those investors probably never owned enough stock for these profits to have made a significant impact on the overall portfolio performance.

For the last two years, I have been advocating to hold up to 20% cash in your portfolio, in addition to real estate, gold, stocks and a bit in short term fixed income instruments. But there is a cost associated with so much cash and yes we’re now nearly 7 years in this bull market, but if you look at investor sentiment; investment gurus or just at this year’s tepid market performance you could conclude that a real market peak and subsequent crash is not in the cards for at least another year or two. Hmmm, that makes holding cash very expensive!
I rolled out the unavoidable spreadsheet software (i.e. Excel). A few posts ago we calculated what kind of returns you may consider realistic in a reasonably well diversified portfolio during the last five years. Now, I updated this spreadsheet to vary the cash levels in 5% increments in order to learn how cash affects overall portfolio performance.  Below are a table and a graph that shows the results.

In the first column of the table, the cash level is enumerated from 5 to 45%.  Real estate and gold are kept constant at 50% and 3% respectively thus totaling 53%.  The remainder of the portfolio is held in stocks and fixed income (bonds). But rather than using the customary 60/40 ratio, I prefer for today’s markets 82% stocks and 18% fixed income (mostly in the form of short term corporate debt and one year GICs).  With the cash level going up, the money available for stocks and bonds goes of course down while the stock/bond ratio remains constant.
Annual average return on stocks is set at 7%; cash is returning zilch; fix income returns a measly 1%; return on gold is 3% and on real estate return is 8% (somewhat like in the recent posting on diversification). You can see that with cash increasing your return on the total portfolio drops dramatically. With 5% cash the annual return is 6.2% but with 20% cash it is barely 5.3% - still better than a GIC or 5 year government bond though. If you stayed nearly entirely out of stocks then with 45% cash your return is only 3.8%. Below, the same story is shown graphically – there is a straight-line relation between your cash level and return.


Considering my personal investment goals combined with the current market conditions, I return to 10% cash.  Although a 5.9%  return is not stellar, it should still represent some portfolio growth. Maybe I’ll enhance that performance with some call and put option writing but that is an whole other topic all together.

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