Cash has been caught up in the generational divide. Many members of younger generations have fully embraced the notion of a cashless society. This notion is not as popular with older generations and there’s a strong movement in Australia objecting to moving towards a cashless economy. I have an aversion to cash from another perspective – I don’t hold it in my investment portfolio.

I’ve written about my investment strategy which you can find here. It is simple and focuses more on the primary drivers of wealth creation including asset allocation, minimising fees and taxes and my savings rate than the investments that I hold. This model suits me and my temperament, and will over the long-term, lead to more successful outcomes.

Part of this strategy is reducing the complexity of my portfolio. All of my financial goals have an ultra-long time horizon until they are to be achieved.

There are a few reasons why I don’t hold cash, I go through them below.

Of course I still have an emergency fund

When I speak about not holding cash, I’m speaking purely about my investment portfolio. I do not count my emergency fund (which is all in cash) as part of my portfolio. I categorise this as insurance, and not an investment. It is not included when I calculate my portfolio performance, and it is not assigned to achieving any particular financial goal. In short, my aversion to holding cash is not an endorsement to chuck your emergency fund in the share market. It is critical to the foundations of a strong investment portfolio.

Volatility is not a concern

Cash has a few purposes. It provides liquidity, reduces volatility, and can be used for tactical allocations when opportunities arise.

None of these uses for cash align with my investment strategy or fit into my goals as they currently stand. I do not need cash to fund any withdrawals from my portfolio. I’m agnostic to market volatility as I have no plan to sell any of my investments for decades. Although I am buying and will do so during times of volatility, I know that markets trend upwards over the long-term, and timing the market can significantly reduce returns.

This brings me to tactical allocations.

Tactical allocations

The AFR recently released an article that includes the opinions of Tim Toohey from Yarra Capital Management. He declared that he was going to switch his portfolio to cash, and that he started to increase his cash position in September last year. He is considering taking long bond positions in the US and Australia. He doesn’t believe that the levels are compelling at the moment, but he is waiting for an entry point.

This is a key tool for professional investors who are expected to make tactical allocations to earn their management fee. There is nothing wrong with this if you can get it right, although many managers struggle to do so. Personally, I don’t have faith in myself that I can get it right consistently. The other consideration for professional investors is that they have to consider liquidity in their portfolios. There are hundreds, and sometimes thousands, of investors in their funds that have competing goals, financial situations and reactions to market volatility. They have to ensure that they have cash so they are able to fund withdrawals in their portfolio. I am not a professional manager, and I do not need to manage anyone’s financial situation, goals or temperament but my own.

My portfolio focuses on strategic allocations. It is ensuring that the asset classes and investments that I have in my portfolio are aligned with my goals. Rain, hail or shine, I will make my additional investments at set intervals into these allocations. Tactical allocations are made based on market conditions. They focus on finding the best opportunities possible, and usually involves having a cash allocation to take advantage of these opportunities.

The approach that Tim Toohey is taking is very risky. Over the last 30 years, if you miss the S&P 500's 10 best days, your return would be cut in half. If you miss the best 30 days over 30 years, your return would be 83% lower. Tactical allocations, especially to cash as a way to have dry powder when opportunities arise, is timing the market.

I would rather be invested over the long-term and take the guesswork out of picking the best days in the market. I don’t believe that this can be done consistently and don’t think it’s worth missing out on the potential returns.

Inflation

The fact that I am invested for such a long-time horizon means that inflation is likely to erode my capital if it sits in cash.

Diversification is often touted as the only free lunch in investing. A diversified portfolio in an academic example will always contain a mix of many asset classes – cash, international and domestic fixed income, alternatives, international and domestic equities. They will be adjusted proportionally in models depending on either risk capacity or risk tolerance.

In reality, outside of the academic models, such a complicated mix is often not necessary to construct a portfolio. Diversification is the process of removing single security risk from a portfolio. Once that is accomplished many investors pick and choose which asset classes and investments are going to help them reach the outcomes that they want, and for me at present, that does not include cash.

I’ve previously written on the marked impact that inflation, and other investment ‘costs’ have on your total return outcomes.

For my model, I looked at a $100,000 initial investment, and $1,000 additional investments every month over the course of 20 years (with returns reinvested). With a 10% p.a. return, I would have $1,391,009. Of course, this scenario completely ignores all of the realities of investing, including inflation. Inflation is the largest detractor of returns in this example, reducing the 10% return by 4%.

Returns over the long term

Many asset classes and investments can give you a return above inflation. Cash often does not, and asset classes such as equities have consistently done so. I don’t want to maintain the purchasing power of my money - I want to grow it.

My aversion to cash is not for a lifetime

My aversion to cash is based on my personal circumstances. It is not a universal rejection for everyone. I believe that cash is crucial for many investors and can serve several purposes in a portfolio. I don’t hold cash now - that doesn’t mean that I will always not hold cash. For example, I will hold ample amounts of cash to fund withdrawals in retirement and provide a buffer for market volatility.

As I get closer to achieving finite financial goals that have a pre-determined end date, my asset class mix will change drastically as I transition out of my equity focus. This will include cash and fixed income products. Like any part of your investment strategy think carefully about why you are doing what you do and what purpose it serves for accomplishing your goals.

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