Portfolio analysis and management theory focuses on risk-return profile, balancing of debt and equity portions and managing risk. However, one portion of the portfolio that is not given much attention even though it warrants greater consideration, especially in an under-invested country like India, is cash.
Some investors feel that holding cash is like holding an option—the option to take advantage of volatility in the market. Thus, when the volatile stock market provides you an opportunity to buy wide-moat companies at bargain prices, you will have cash in hand to take advantage of the irrationality. The most important role that cash serves in a portfolio is that it enables investors to take advantage of opportunities that may arise suddenly. For most people, the absolute minimum level of cash to keep in hand is an emergency fund amounting to six months’ expenses. How much cash you should hold depends on who you are, how you are investing and your investment horizon.
Cash can be a temporary parking place for funds awaiting investment. When you have a large sum, you should not rush to invest it but rather take the time to plan a strategy and, if appropriate, get into the market in a staggered way. When you are invested in an asset class that has had a big run-up in prices and seems overheated, you might take some risk off the table by converting some of your investment to cash (which may have tax implications), even if you have not yet decided where to reinvest.
Cash holding depends on age
The percentage of cash holdings also depends upon the age of the individual, more importantly whether he is in the working age group or the retired age group. While cash holding of 7-10% of total financial assets is sufficient for the former, retired people should keep a higher percentage, say 10-15%, of their financial assets in cash in order to meet recurring expenditure or any medical emergencies. Holding cash carries its own costs as well. Cash does not any earn any interest, except for that lying in savings account deposits or liquid funds. As a result, inflation eats into the purchasing power of idle cash. Another drawback of holding cash in a rising market is the opportunity cost in the form of foregone returns in the equity market.
Timing the market
Trying to time the market more often than not ends in investors missing the best days and hence earning significantly less than what they could have earned by staying put. Most investors get out when it’s too late and wait way too long to get back in, compounding losses and missing out on gains. Investors need to understand the difference between buying specific assets that are attractively valued after a dip, and the odds of successfully timing the market as a whole. Although holding on to cash in order to wait for that right opportunity may sound tempting, it is extremely difficult to implement in the real market scenarios. Even experienced mutual fund managers are not immune from taking wrong calls every now and then. In such a case, it is advisable to maintain only as much cash as is necessary for emergency situations. An investor should first decide his broad financial asset allocation among equities, debt and cash depending on his risk return profile and liquidity requirements. He should at intervals keep reviewing his portfolio and rebalance it, but refrain from increasing his cash position as much as possible. This will enable him to participate in the market moves and prevent him from underperforming.
The writer is head, Retail Research, HDFC Securities