Cash as an asset is very comfortable for many people to own. It is an asset you can actually touch, feel and hold. Prudent financial and investment planning suggest that you should hold some cash, especially for emergency purposes. Often, 3 to 6 months and sometimes more depending on your personal situation is a good rule of thumb. There are some situations where holding more cash might be prudent. One example that comes to mind are people that have specific known medical conditions that require cash to cover the expenses of healthcare that insurance does not cover. Having cash often helps provide a sense of safety and a feeling of being able to sleep better at night. That is completely understandable!
I have found that the job of a professional advisor is to listen to a client’s needs and craft a plan that has the greatest chance of achieving those needs. I tell my clients that my job is not to tell you what makes you feel good but to advise you on what needs to be done to achieve those goals. That said let’s take a look at Cash as an asset and how potentially the good feeling of having lots of cash, “Cash Is King” may not be the best and potentially could be increasing your risk.
In order to understand that cash may not be king we must understand the effects of inflation on our buying power, and current and historical interest rates on cash. We will use CPI (Consumer Price Index) as the proxy for inflation and the 30 day treasury bill rate for the interest rate on cash, as is customary.
First: inflation as measured by CPI can be defined as a sustained increase in the general price we pay for goods and services over a period of time. We all know that the price of a loaf of bread has gone up since we first started eating it in our childhood. So we understand that things get more expensive over time. If we put money in our mattress when we were 3 years old to buy 10 loafs of bread at the price we would have paid for it then and took it out several years later we would likely not be able to buy as much bread. That can be what holding cash can do if no interest or rate of return is achieved on it.
Second: cash as an asset class is typically not stored in mattresses. More commonly it is stored in bank accounts and brokerage accounts. Rates of interest on cash have varied widely over the past 20 years and for quite some time have averaged 0% in most cases.
Let’s now assume that for a period of 5 years inflation averaged 2.5% and cash averaged 0% interest. Our simplistic real rate of return on that cash is not 0% it is negative 2.5%. Hence we have been losing money during that time and not even potentially realizing it because, well, we still have the same amount of dollars on hand so “I did not lose any of them.” That is factually correct that you have not lost any of the dollars you can count but you have lost on the amount of goods you can turn those dollars into.
Starting off in a position where you are in a negative return scenario right out of the box is a hard perspective for investors to grasp but that is exactly what has been happening for the majority of the last 5 years. Looks to me like holding cash is risky and potentially more risky than many know. This is at the core of why Financial Professionals after understanding a person’s current situation, future goals, feelings and family dynamics, as well as one’s understanding of risk and tolerance for it may need to recommend less cash as a percentage of portfolio holdings than someone may find comforting. We as professionals need to strike the best balance we possibly can in order to achieve those goals. Even if the goals are not exactly achievable, it is our duty to provide a plan that can make the money invested last as long as possible, to achieve as much of the goal as possible. Ultimately, however, investors comfort levels are important and should they decide that holding cash still feels best in light of what we just reviewed then "Maybe Cash Is King" for those investors.
For those of you who are technically and visually minded the following chart will illustrate this issue. It is a 20 year chart dated 03/18/1995 to 03/18/2015:
This chart illustrates the relationship between the inflation rate (measured by CPI) in the United States and interest rates on cash (measured by 3 month treasury rate). We have named the blue line US Inflation rate which is the monthly inflation rate measured by CPI. The Orange line is the cumulative growth of the consumer price index which illustrates the cumulative effect of inflation on goods and services. The Red line is the average monthly rates of return on a 90 day treasury bill, our proxy for interest rates on cash.
What we see is that although inflation rates and 90 day treasury bill rates diverge, cumulative inflation continues to increase, showing that our goods and services get more expensive over time and interest rates on cash do not always help us combat this phenomena. Furthermore, we can be in periods of time, which are multiple years in length, where cash interest rates are lagging behind the rate of inflation. This greatly reduces the effectiveness of our cash as a purchaser of goods and services. Also important to understand is that these negative divergences require us to spend more money on an item in times of low interest rates or negative real interest rates on cash, further hampering the ability for our money to grow when cash rates of return are higher. Why is this, it is because we have to spend more of the cash during these times and we have less of it saved for when rates are above inflation helping us actually grow our money.
Ultimately we must all be comfortable with our investment portfolios and cash is a major component of the mix of assets we own. Hopefully next time you here the phrase “Cash is King” you remember that maybe it truly isn’t as safe as you once thought.
Disclaimer: The Charts provided in this article was produced by Ycharts a third party provider of analytical data and charts. We believe that the information used to create this chart is accurate to the best of our knowledge however we cannot guarantee the accuracy of its content.
ETF's offer clients a great opportunity to put together a tax efficient asset allocation that is well diversified, lower cost, low conflict of interest, tactically tradeable and very liquid. Building a core asset allocation using ETF's can provide exposure to all the necessary portfolio constituents without high minimums. At Prominence Capital we use ETF's to generate core portfolios that strategically expose our clients to investments that meet their risk tolerance and investment objectives.
Retirement, time to sit back relax and enjoy life. Wait for many people retirement will last 30+ years. This often means needing equities in a portfolio, riskier assets...Relax again you have an asset allocation designed to generate the needed returns, balancing risk, to get you through retirement. Wait what if when you go to generate needed income from your investments and the market is in a downward trend, multiplying the effect of the downward pressure on your portfolio...Can this significantly reduce your ability to achieve your retirement income goals because now you have less working toward those goals?
Positive returns over loner periods of time for a portfolio although very important often do not show the truth of how generating returns effect a persons ability to use their money and meet their real goals of a specific lifestyle. Yes you will here that the stock market averages a certain rate of return annually, 7% or 8% or..., and that over time history has shown us stocks will go up and we can plan based off of these potential returns. This is true for most assets. The problem with this thinking while in retirement is understanding that most assets do not generate these returns in a "sequential" fashion. Meaning that although the market may historically return any given rate of return over time the course that those returns take are not predictable and reliable.
This was particularly on display for many investors nearing or in retirement in the 20008 to 2010 period. Recently in an article I read online written by a wise advisor, this concept was well articulated by using a rain fall analogy. I being a skier will give one using snow fall....
My favorite ski resort advertises a long season typically starting in early November and running all the way through the end of June and often as far as the 4th of July. They also boast about 400+ inches of seasonal snow fall...Wow...50 inches of snow per month not bad, 4 feet of snow each month no wonder they can make it to July often. Wait, there are years they close early and often the conditions are lousy. Why? The answer is that 200+ inches has fallen in any given month of the season at a time and some months there is none. This can make for a tough season especially those of us who travel 5+ hours to get there on the weekends when we have the time during the season. Would be nice to be able to enjoy the powder when it falls. Alas I cherish the days I get when their is fresh powder. I have gone seasons with out it!
Now back to the point of investing, retirement and understanding the need to manage for downward returns...
While in retirement it is good to invest at least some portion of your retirement assets in investments or with investment managers that have a mandate of minimizing the effect of the decline of the asset(s).
Understanding the concept of maximum draw down and using strategies and managers that seek to minimize the effect of this on a portfolio of investments can be extremely important for investors nearing or in retirement. You need your assets to last. Looking at managing the depth of your portfolios downward performance can greatly enhance the potential of your meeting your true investment goals, which are to live the lifestyle you want or can for as long as you can.
Selecting the right bonds, mutual fund managers, ETF's, Separately Manged Account Managers or using sophisticated options strategies to structure a portfolio in order to help minimize draw downs can limit upside but it can also help with making sure the portfolio is less depleted in a down market when income generation is needed.
Understanding how to invest money to appropriately meet a clients needs and expectations is the job of an Investment Management Professional. Determining where clients are in their life cycle needs to be determined in order to make appropriate decisions. Typically concepts such as Time Horizons, Risk Tolerance, Investment Knowledge, Current Income and Years of Investing Experience are discussed to determine how to appropriately allocate capital.
There are many other concepts often discussed along with these but an understanding of where someone is in their investment life cycle can also be very helpful to making decisions.
What is the Investment Life Cycle?
It can be defined many ways but I find the following three phase approach to be simple and helpful when combined with other concepts for deriving portfolio construction and selecting specific investments.
- Accumulation Phase-earliest stage in an investors life cycle where the investor is accumulating assets. There is a long time horizon and often more risk can be accepted because there is more time to achieve objectives. In this phase there can often be short term needs that must be considered and the appropriate amount of investment risk taken: such as when a large purchase is looming. For instance the purchase of a home.
- Consolidation Phase-this phase is typically when wealth accumulates more rapidly. In this phase many of life's large purchases and immediate cash needs are already addressed and income is often significantly out pacing expenses allowing for more rapid building of wealth. Time horizon to the next phase (Spending Phase) is getting shorter over this phase.
- Spending Phase-this phase is signified when earned income has ended and investment income from accumulated wealth is now the primary source for living expenses. Typically called retirement. Longer life expectancies can lead to long time horizons in this phase. Some would say this is the phase where one would now enjoy the utility of the wealth they have created. Risk tolerance tends to be significantly lower as asset fluctuations are less desirable. However some risk is often required for potential growth to combat the prospects of long time horizons in this phase.
Understanding which phase you fit into can greatly help with understanding why certain investments are necessary and how they fit into your overall investment portfolio. Knowing what phase you are in can make the uneasy feelings about investments more understandable as to why they may be necessary.
To discuss your specific situation please contact Prominence Captial at 310-433-5378. We can also be contact via the web at www.prominencecapital.com
How could the Dow Jones Industrial average be up over 100 points and the NASDAQ and S&P 500 be down for the day.On 10/30/2014 this was exactly the case in the early morning hours.
One of the 30 Dow Industrial constituents, Visa (V) reported wonderful earnings and the stock was off to the races....up over 9%. Visa also happens to be in the S&P 500 and the Russell 3000, so why were both down. Reason was due to the way the index is derived. In order to understand this phenomena we need to understand how the indexes methodology works. Then we will discuss picking and index to measure performance of a portfolio.
Price Weighted Method: The Dow Jones Industrial Average is a price weighted average of the 30 stocks that make up the index. "The prices of constituent stocks are aggregated strictly based on quoted prices. Securities that are combined in this manner influence the index in proportion to the magnitude of their price per share." (Shilling) The price-weighted method is the average of current prices of the stocks in the index. All stock prices are added up and the total is divided by the number of stocks in the average. This method gives higher-priced stocks more influence than low-priced stocks.
Capitalization Weighted Method: Also known as the market-value-weighted method, is the method used for the indices that most investment professionals use as benchmarks to measure portfolio performance. Indexes such as the S&P 500 and the Russell 3000 use this methodology. These indexes are generated by determining the total market capitalization of all stocks in the index and dividing by the total number of shares of all the stocks. Capitalization is a company's outstanding shares multiplied by its share price, better known as "market capitalization".
Equally Weighted Method: "Security prices are equally weighted to give as much weight to a 1% fluctuation in the price of a stock that sell sat $108.50 as to a 1% move in the price of a stock that sells for $15.13 regardless of capitalization." (Shilling) Value Line Index is an example of this type of index method. Movements in the index are based on arithmetic or geometric average of the percentage price changes for the stocks in the index. Price or market value does not make a difference.
Now that we understand the methodology behind the types of indexes; we need to look at them to understand how to measure performance in our portfolios. As we can see Capitalization-Weighted Indexes such as the S&P 500, Russell 2000 and Russell 3000 are constructed in a way that is most accurate when using them for benchmarking portfolio performance. So which one do we choose...many professionals talk about and use the S&P 500 as the benchmark of choice. This bench mark represents 500 of the countries largest companies and addresses about 75% of the domestic investable market. Using this index is very common but may not be entirely appropriate especially if you own a portfolio with Large Cap, Mid Cap and Small Cap stocks. Small Capitalization Stocks are not well represented by the S&P 500 and this index may give you a false indication of how you are truly doing. Often people use a blend of the S&P 500 and the Russell 2000 (small cap index) to get a better idea of performance. One index that is potentially more reliable is the Russell 3000. This index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.
Benchmarking is important and we must understand what our portfolio is made up of in order to truly know which benchmark to use so we can determine how we are doing.
Prominence Capital (310)433-5378 or www.prominencecaptial.com
A free portfolio review is a common service many advisor's offer. At Prominence Capital we offer a free portfolio review designed to provide information on 4 key questions:
- Are you taking too much risk in your portfolio?
- How much are you paying in fee's?
- Are you invested in unsuitable or inappropriate investments designed to generate returns that are not aligned with your objectives?
- How did my portfolio perform during periods of extreme stress in the financial system?
Answering some of these questions can help you in determining if you have the right asset allocation and investments selected to meet your goals and objectives. Stress testing can be a useful tool in understanding your investments performance during times when markets are experiencing extreme levels of stress, such as during the aftermath of the World Trade Center attacks.
Some investments are difficult to stress tests, we help identify those assets so that you can make informed decisions as to the appropriateness of owning them. Certain investment products commonly owned, such as mutual funds, have fee's and expenses associated with owning them. Often there are alternatives that may provide similar investment objectives and the desired risk and return objectives with more advantageous fee structures. Fee's can significantly impact the long term performance of an investment. Along with fee's looking at the tax efficiency of a portfolio will also help you keep more of the return your portfolio generates over time.
Contact us at 310-433-5378 to find out more or find us on the web at www.prominencecapital.com and click on the Free Portfolio Review button.
Example Asset Allocation:
- Safety: The safety of an investment is the investments ability to maintain its principal value (initial investment amount) before it provides either income or appreciation. Investments that exhibit small price fluctuations are perceived as safer, however the tradeoff is that the returns from the investment (income, capital appreciation or both) are generally lower.
- Income: The ability of an invested amount (principal) to generate a stream of cash flow typically in the form of periodic interest or dividend payments. The higher the percentage income generated on the principal amount the riskier the investment tends to be.
- Capital Appreciation: The ability of an investment to grow in value over time. Investments that tend to deliver higher rates of capital appreciation tend to be more risky and rank lower on the measure of investment safety.
- Tax Efficiency: is an essential part of investment success. Taxes can significantly lower the actual amount of the return an investor keeps. Generally investments that rely on income generation as a means of providing returns are less tax efficient than those investments that provide capital appreciation. Note investments held for one year or less will incur tax treatment at the taxpayer’s marginal income tax rate.
- Liquidity: often also referred to as marketability, is the ability to turn an investment (asset) into cash quickly. Investments in most company stocks that trade on the national exchanges have a high degree of liquidity. Real Estate on the other hand is not readily liquid and takes a longer period of time to convert to cash.
INVESTMENT: The use of money for the purpose of making more money in order to gain income, increase capital, or both.
- Investment Planning is only part of FINANCIAL PLANNING. It’s concentrated on the central definition of what an investment is, as stated above, and is typically the place where most people spend the majority of their time when it comes to planning financially.
INVESTMENT PLANNING: The core of investment planning is one’s asset allocation. A well derived asset allocation can be achieved after one discusses more specific issues of financial planning such as goals, objectives and needs. Other influences such as tax considerations and legal structure are all part of financial planning and can strongly impact investment planning, strategy, decisions and execution. Listed here are a few commonly referred to theory’s that drive the investment planning process and ultimately its execution.
Asset Allocation: An investment strategy that aims to balance risk and reward by taking into consideration time horizon, tolerance for risk and apportioning a portfolio’s assets to specific classes of assets in order to meet financial planning goals, objectives and needs. Asset Class: an asset class is a general term for investments with similar return, risk and time horizons. Three main asset classes are equities (stock), fixed-income (bonds), and cash and equivalents. Other common asset classes are real estate, commodities, private equity and collectibles often referred to as alternative asset class.
- Strategic Asset Allocation: A long range plan for a portfolio that takes into consideration overall long term goals, objectives and needs. Assets are apportioned generally by a percentage to each appropriate asset class with respect to that asset class’s long run mean rate of return. The strategic allocation typically is not altered to take into account short-term issues, such as market conditions. Instead the portfolio is rebalanced periodically to conform to the overall strategic allocation. Strategic allocation evolves as time horizon to achieve goals, objective and needs changes.
- Tactical Asset Allocation: In contrast to strategic allocation, tactical asset allocation attempts to capitalize on changing market conditions. The overall asset allocation will be changed frequently in the short term but the overall strategic asset allocation is not abandoned from a longer term perspective.
Diversification: True diversification means to reduce risk by investing in a variety of assets that have a low correlation of return to each other. Most commonly referred to as “not having all your eggs in one basket.” Diversification can be achieved many ways within asset classes, amongst asset classes, by sector, by size, by industry and so on. The idea is not to have all of your money exposed to the risk of one single investment.
Dollar Cost Averaging: investing in equal monetary amounts regularly and periodically over specific time periods (such as $100 monthly) in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
Rebalancing: is the action of bringing a portfolio that has deviated away from one's asset allocation back into line. Under-weighted securities can be purchased with newly saved money; alternatively, over-weighted securities can be sold to purchase under-weighted securities.
Example Asset Allocation