Cash is the best asset class for diversifying your portfolio. This goes against a lot of the traditional investment advice which most of the time recommends bonds as the diversifying asset class. This is particularly true for retirement portfolios. In this post I want to take a look at bonds vs cash as a diversification tool.
Diversification is often touted as the only free lunch in investing. The basic principle is that you want to allocate portions of your portfolio to asset classes that ideally move inversely to each other (negatively correlated), i.e if one asset class has positive returns, then the other has negative returns. When one then re-balances a portfolio to preserve a fixed percentage asset allocation, say 60/40 stocks/bonds, one is basically forced to sell high and buy low thus enhancing future returns. Sounds great. What’s the problem? The problem is that asset classes do not perfectly move inversely to each other, i.e correlations are no where near -1.0. In the real world outside academia asset class correlations are not smooth and steady. The chart below shows rolling stock vs bond correlations through time for the US and the UK.
Reality is bumpy to say the least. The benefits of diversification among stock and bonds varies over time ans is rarely negative. So, most of the time stocks and bonds are positively correlated. When stocks go up, bonds go up, when stocks go down, bonds go down. It’s cold comfort to me that when stocks go down bonds don’t go down as much thereby still benefiting from diversification. There has to be a better way.
Lets take a step back and design the perfect diversification tool. What would we want? I want an asset that has positive returns when stocks go up and positive returns when stocks go down. I want negative correlations only when I need them which is when stocks go down. Is there such an asset class? Of course there is. It’s called cash! Cash always has positive returns even if they are close to zero like today. When stocks go up, cash goes up but not very much. When stocks go down, cash goes up as well. After a big move down in stocks one can re-balance a portfolio and enhance returns. Even better one can change portfolio allocations to take advantage of big negative moves in stocks. For example, starting with a 60/40 stock-cash model, after a big negative stock move, one can re-balance to a 80/20 stock cash model and even further enhance returns.
In addition standard diversification tends to fail at the exact time you need it most. In the financial crisis of 2008 as in other big crises, asset correlations basically went to 1.0. Basically everything moved together, in this case down. This is particularly detrimental to retirement portfolios that are subject to withdrawals every year.
In short, cash is over looked as a diversification tool. In fact it is the ultimate diversification tool.
5 Comments
J Carroll · April 14, 2011 at 6:15 pm
Paul, what to do with one’s cash is an area I have struggled with for some time now. With interest rates so low, I have considered ultra-short term bond-like products such as MINT as potential places to keep cash. Do you think the ultra-short term products are viable places for cash? Thank you.
libertatemamo · April 14, 2011 at 11:43 pm
Hi J. I think it depends on what your time frame is for cash usage. For example, I want my cash at the ready all the time so I can sell a cash secured put, take advantage of a major sell off in a stock I like etc….. In this case, even ultra short bond funds wouldn’t work for me. For me the yield on the cash is not important.
However, if your are using your cash as a rainy day fund, or for an annual rebalancing, where you wouldn’t use it very frequently then ultra short funds would be fine. I think even going out in duration to 2 yrs or so would be fine, like with VFISX, the Vanguard short term treasury fund.
My 2 cents.
Paul
Doug · April 17, 2011 at 9:56 am
Another great article Paul. One day I hope to learn and possibly implement your options strategy to increase the yield on my portfolio. The current holdings stand at 70% cash and waiting to see if we can breakout here or breakdown to the land of lower prices and improved dividend percentages.
As always, thanks for the blog!
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