Cash is seen as a safe haven. Somewhere to run to when things get bad. Keeping some of your portfolio in cash as a ‘buffer’ helps you to feel comfortable that when the value of your investments falls, there’s a portion of your portfolio that will be there for you, no matter what.
This characterises cash as a defensive asset; a meek and meagre second-tier asset class good for providing shelter but not entertainment.
It is true that cash provides shelter. It provides you with a pot of money that you can use to meet real spending needs at times when other assets have fallen, or are falling, in value. It can be relied upon when other assets can’t. But these are not the only reasons why you should build up a cash chest. Cash is also the only asset that has true firepower when you want to make a new investment. A popular investment notion is that you should buy when others are selling, but how can you buy if you don’t have any cash? You’d have to sell something. If you’ve built up a cash chest, then when other asset classes are falling – which often means they’re getting cheaper – you can deploy your cash to take advantage of the opportunity. This is indeed the ‘opportunity’ half of every crisis, that you can only harvest if you don’t panic amidst the ‘danger’ part of the crisis, and if you have some cash that you can put to work.
Two things are crucial for building up a cash chest, as opposed to a ‘cash buffer’. First, the size of it shouldn’t significantly exceed what you would have otherwise held as a cash buffer. That is, only hold as much cash as you would need to cover expenses in a regular financial emergency, for a period of your own preference, say 3-6 months. A regular financial emergency is one such as losing your job but still having to pay rent/mortgage. An irregular emergency (these are our own definitions, but the way) is one which is difficult to quantify financially or estimate the length of, such as the unexpected loss of a family member. If you try and plan for the latter, you’ll never take any risk with your money, so it’s probably not worth planning for.
The second crucial element is that you need to be prepared to deploy your cash chest into the market when an extraordinary investment opportunity arises. That is, when equity markets fall 30-50% as they did in the second quarter of 2020, you need to seriously consider putting your cash to work. This means being without your cash ‘buffer’ for a short period of time, until it is built back up again, or until perhaps you sell back down some of your stock after the market has recovered from the crisis low-point. ‘Risk’ here means being without your buffer for a period, but the investment ‘risk’ is actually as low as it will ever be. After a catastrophic fall in the market, the chances of further falls are actually at their lowest probability, so the path of least resistance is really for the market to go back up. That seems counterintuitive, but it is true, every single time. However, having said this, you will need to assess your financial situation holistically at the time of the crisis. If the stock market fall has gone hand-in-hand with your losing your job, or there is a heightened risk of that happening, then you need to keep your cash chest as a buffer. The more important ‘firepower’ it has is to pay your living expenses, not make new investments.
Treating your cash as a ‘cash chest’ rather than as just a ‘cash buffer’ allows you to be ready to deploy it into the financial markets and take advantage of infrequent opportunities. It is a shift in mindset that gives you flexibility while still maintaining prudence in the face of lifestyle risk.
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To the pound 