What is cash good for?
When investors allocate assets, they’re usually trading off between return and security. The more secure assets are bonds; the higher-return assets are equities. We’ve discussed why this is so before: equities represent the last claim on the cash-flow generated by an enterprise. This claim isn’t fixed contractually, so it gets to benefit if the firm grows. At the same time, because it’s last in line, it’s the first one to suffer if things go wrong.
The “security” side of the allocation is usually given over to bonds. Bonds are contractual senior claims on a business. Uncertainty grows as you go out in time, and so longer bonds usually pay more than shorter bonds. The important thing to remember is that there is not as much downside or upside to these investments.
Very short term bonds are what we call “cash.” It’s not risk-free; nothing is risk-free. (Even government guarantees can be altered.) But it is typically the lowest risk item in an investment portfolio. Since its risk and return are so modest, some folks wonder why to have a cash allocation at all. The reason is simple: cash is a statement of humility. It says, “I don’t know what the future holds.” It’s flexible, allowing you to move quickly. It’s simple, typically consisting of senior zero-coupon obligations and bank deposits. It’s ready when you are.
A cash allocation is crucial, not just for paying your bills when they’re due, but also to capitalize on investment opportunities as they arise. It may not be king, but it’s sure not the joker.
Douglas R. Tengdin, CFA
Chief Investment Officer
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