Why keep cash in the portfolio?
Cash is more than what you think
Why keep cash in the portfolio?
Keeping “idle cash” in the portfolio could seem counterintuitive, especially in a context of fast currency depreciation (i.e. strong inflation). But you shouldn’t regard cash in the same way as you do with stocks in the portfolio.
Cash is, of course, the ultimate safety (at least in nominal terms!). Even though at Horizon Income we are working hard to create what we think is a safe and efficient portfolio for you to replicate, we know for a fact - because history tells us so - that sometime in the future we will have to deal with “dividend accidents”.
Yes, portfolio quality is what will keep this kind of accident rather rare. Yes, diversification of holdings will prevent this kind of accident from sinking the whole portfolio. But cash is the only 100% safe asset. Cash is what will enable us, when an accident occurs, to react right away, to avoid being like the rabbit in the headlights and ultimately to stay focused on our unique goal: let time work for us to predictably generate the level of income we have chosen to achieve, when we have chosen to achieve it.
What is this rabbit story? Let’s imagine you invest in a stock, paying $10. A few months later, the stock is down to $8. You have 3 possibilities then: you buy more, you sell the stock, or you do nothing. Most people would probably do nothing! Why?Because they would look at their bank report, see that red color showing the loss of 20% on their investment, get scared and decide that the best way to go from here is just to do nothing, wait for the stock to recover to $10 and then sell it. You can’t sell at a loss, right? Well, this is a very irrational - and fully emotional - attitude. Who said the stock will ever go back to $10 again? Most investors don’t have strong convictions about why they own this or that stock. Or, who said the stock will break even under a reasonable time frame? Yes, because all the time it takes to go back to $10, your money is not really working for you. Actually if it takes years to recover and inflation during this time frame is high enough, this decision to do nothing turns out to be a disaster for your capital.
No! When faced with a loss on an investment, the only question you need to ask yourself is: is this price decline deserved or not? Said differently, is this a rational decline or an irrational one?
“An irrational drop in price makes a stock cheaper. A rational drop in price makes it more expensive.”
- Gautam Baid
If there’s no deterioration in a company's fundamentals and its stock price goes down 20%, it makes the stock cheaper and thus more attractive. The only rational thing to do is to buy more! After all, if you liked it at $10, you should like it 20% more at $8. But to do so….you need cash.
If, on the contrary, the price decline is deserved because it reflects a deterioration in the company’s economic model, its financial structure, its competitive position, its growth prospects, or whatever similar, then the drop in price is rational and, unless you think it’s just a bump in the road or that the decline is exaggerated, you should sell. Yes, selling at a loss hurts. Studies in behavioral finance have shown that the pain associated with a $1 loss is actually 3 times stronger than the satisfaction associated with a $1 gain. When you hear that the worst enemy of the investor is himself, this is what is meant. And yet, selling is the rational thing to do.
Now, two questions may arise at this point: 1) how do I know whether the fundamentals have deteriorated or not?, and 2) how do I manage to keep my emotions at bay when I invest? Two questions but one answer: dividends.
Dividend is probably one of the best existing indicators to assess the current and future state of a company’s health. Many others exist but this one has several crucial advantages. First, it is set and paid out by the company itself (not by financial analysts, media, law makers or else). Knowing the kind of punishment a company can endure if it has to cut its dividend, a serious management tends not to over promise on that front. Second, a dividend is true, cold, hard cash. There’s no number massaging here, no adjusted KPI: dividend is real money and a company can not pay it out if it doesn’t have the cash in store (we would not consider a company that goes into debt to fund its dividend policy; it has to come from cash flow!). Therefore, if you see the stock price go down 20% but the dividend keeps being paid or, even better, keeps going up, then your degree of confidence about the solidity of the business is strong. Confidence is what you need in this kind of situation because it gives you the courage to buy when others are selling or drowning in doubts.
Dividend is also a very important “psychological indicator”. You can be a growth investor, a value investor, or anything in between, it doesn’t really matter: truth is that price volatility is very hard on your emotions. It’s very difficult to escape the pressure to sell your holdings when panic sets in and everybody around you is selling because, well, the end of the world is near. It’s very difficult as well to escape the pressure to buy when everybody around you is buying because, well, this “time is different”. Dividends are crucial especially in those contexts of heightened volatility: they are the beacon that help you sail your ship through the storm because, again, dividends are not set by market participants but by companies themselves. They reflect the health of the business. And who better than management knows the real state of the business? As Daniel Peris likes to say: “dividends are a business outcome while capital gains are a market outcome”.
Now back to cash in the context of a dividend accident.
If the “ dividend accident” appears to be just a bump in the road, then there’s an opportunity to seize and we will buy more shares (and for that we need cash!). If, on the contrary, we understand that we were wrong with that equity story from the beginning, then we will sell and recover whatever money we can get from that sale. Doing nothing is not an option! What we will do is take the money we recovered from the disposal, bundle it if needed with some cash always available in the portfolio and create a new position that will start generating a new income stream right away. No looking back. No “let’s hope and wait”. You can buy or you can sell, but waiting is oftentime the worst option as it frequently reflects a lack of conviction. Without convictions, fear and doubt set in. M. Market will regularly test your convictions: you want to be ready when that occurs.
But then, one day, a sought after event happens: the market crash. What makes a market crash really attractive to us is that when panic takes over, rationality quickly goes out of the window and in their rush to the (narrow) exit door, investors frantically dump their stocks. All their stocks: the good, the bad and the ugly.
And it’s precisely in that very moment that if:
1) you know what you are doing (ie you can tell the difference between good, bad and ugly stocks),
2) you have a clear plan in mind (again, hoping for prices to recover to break even and sell is not a good strategy, but having a clear income target to achieve, is),
3) most important of all, you have cash available to be put to work,
then you are in the enviable position to seize some of those once-in-a-lifetime kinds of investment opportunities.
Cash is the crucial component here: even the best portfolio in the world only generates frustration if you can’t buy more of that wonderful company that you first bought at an attractive 7% yield a few years ago and that M. Market is offering to you today at 10%, 12%, 14% or more!
That’s what cash is all about: optionality. The cost that cash has on your portfolio performance represents the cost of the optionality it provides you with in those very special moments. Cash gives you the courage and the dry powder to seize fantastic opportunities when others are bleeding and the media is all doom and gloom.
How much cash is enough? Very few of us can really put to work that very wise advice from Charlie Munger:
“The way to get rich is to keep $10 million in your checking account in case a good deal comes along.”
Charlie Munger
As for us at Horizon Income, nothing is set in stone regarding cash but we are content with a cash allocation that equals that of any stock in our portfolio (assuming it’s equally weighted).
Why? Because it puts us in the position, if needed, to replace an underperforming company in the portfolio with a new one which would hopefully help us quickly get back on track to achieve our long term income target.
Highly resilient holdings, portfolio diversification, cash availability and a real time alert system when we deviate from the defined path is what makes Horizon Income powerful and predictable to achieve YOUR financial goals.
Let Horizon Income become your income manager!