Cash and a Sleep-Well Strategy

04/29/2015 9:00 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

In our safety-first investment philosophy, cash plays a dynamic and critical role, explains Jim Stack, money manager and editor of InvesTech Market Analyst.

The cash allocation in the Model Portfolio is adjusted relative to the measurable risk in the market. When market risk is elevated, we advise holding a higher cash position.

And when market risk subsides, as in the early stages of a bull market, we recommend being more aggressively invested with very little cash reserves.

Over the past 15 year time frame, the cash allocation in our model portfolio has varied from well over half the portfolio to almost no cash (i.e., fully invested) in the first years of this bull market.

Unfortunately, cash and cash equivalents yield very little today as interest rates have been declining for over three decades and currently sit at generational lows. The 10-year Treasury bond yield has been in a steady decline from double-digit levels over 15% in the 1980s to below 2% today.

Yields on shorter-term instruments are even more dismal; cash equivalents with maturities of less than one year have negligible yields lower than 0.5%.

This has led many investors to think of cash as trash. In search of better yields, investors have flocked to bond funds, perhaps not understanding the additional risk they are assuming.

Because bond prices move up as interest rates decline, bond investors have benefitted from the declining rate environment; however, they will be hurt when interest rates begin to rise.

With the Fed poised to begin raising rates, the bond party of the last 30 years may finally be coming to an end and, when that time comes, interest rates could rise very quickly.

The risk of losses in bond funds is perhaps higher today than at any time since the 1970s. Because interest rates are so depressed, the interest payments will provide very little downside protection.

When investors start to realize losses in their safe bond funds, outflows will be significant. That will only exacerbate downward pressure on prices as fund managers are forced to sell bonds at a loss to meet redemptions.

Although rising rates will be more detrimental to funds with longer maturities, when severe stress occurs in the market, bond funds—even ultra short-term bond funds—don’t provide the safety of cash and will lose value.

There is no substitute for the safety and flexibility that cash offers and the small increase in yield one may obtain currently by using bond funds is not worth the risk.

Higher yielding investments always carry a higher degree of risk. This is not the time to stretch for yield in bond funds or in any instrument that promises safety with a higher return.

This bull market is now entering its seventh year—a feat that has been matched only three times in the past 85 years—and we have noted definite signs of overconfidence among consumers and investors.

Although we do not see characteristic bear market warning flags that would indicate a market peak is imminent, it is prudent to hold approximately one-quarter of the portfolio in cash or cash equivalents.

The cash allocation is not intended to be permanent, but it is a critical component of a safety-first investment philosophy. As interest rates rise, the yield on money market funds will rise faster than in bond funds due to the shorter duration of the underlying holdings.

More importantly, though, is that this cash portion of the portfolio is out of harm’s way and helping to mitigate the risk profile for the entire portfolio.

The safety of this cash reserve will be the ultimate treasure as the next bear market unfolds. And, in today’s rising risk market, it’s also the treasure that will help us all sleep better at night.

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