Financial

Liquid Courage: The Biggest Benefit Of Cash

Liquid courage is sometimes needed to talk to a person you fancy. The more alcohol you drink, the more your inhibitions tend to go away.

In the finance world, liquid courage is also what’s needed to make risky investments or investments during risky times. The more cash you have, the more liquid you are and the more guts you have to put money behind your beliefs.

Even though holding a lot of cash can be a drag on performance, you just never know when investment opportunities may arise. As a result, I believe it’s prudent to always have roughly 5% of your investable capital in cash.

The Courage To Invest Starts With Having Lots Of Cash

Since I left work in 2012, I’ve considered myself a conservative investor for my age (34 to 44). Without a steady paycheck, my cash flow is unpredictable. Further, my wife doesn’t have a job either and I also have two young children to feed.

When it comes to measuring my risk tolerance using the SEER methodology, I’m unwilling to give up more than six months of my life to cover potential bear market losses. Whereas some of my friends my age are willing to give up two years or more of their lives to make up for any losses.

Given my situation, my public investment portfolios are diversified. I own a lot of equity-linked structured notes in one portfolio because I wanted to hedge against downside risk. In another portfolio, I have almost half the portfolio in individual municipal bonds.

Further, I’m more interested in investing in real estate because it is a tangible asset that is less volatile and tends to produce more income.

While you won’t find me going on margin buying equities, I have no problem leveraging up to buy real estate. A seemingly paradox, but one that is ground in my belief that real estate is less risky than stocks.

Despite my belief in being a conservative investor, maybe I’m mistaken. The other day, I was discussing the investing landscape with a friend who made me reconsider my risk tolerance. Perhaps I’m more aggressive than I think.

If you talk through your investment moves with a family member, you may realize you are much more aggressive as well. If so, changes may need to be made in order to not lose an unexpected amount of money in the future.

Examples of some of the riskier investments I have made since early 2020:

All these investments required courage, especially buying the house on leverage right after lockdowns. I’ll discuss my house-buying process in a future post as it was a real knee-knocker.

I’m not sure a truly conservative investor would have made these investments. Rather, perhaps a conservative investor would have just kept raising cash or bought bonds instead.

The only way I could have made these investments is if I had some cash left over AFTER making each investment decision. The leftover cash would serve as my buffer in case the investments went sour. In other words, having cash gave me the confidence to take risks.

It’s worth recognizing that in a bull market, everything tends to go up. Therefore, making the above investments wasn’t anything special. What’s important is having the liquid courage to put capital to work during downturns.

It is the mobilization of capital and the appropriate asset allocation of capital that makes up the most important part of your returns over time. If you can recognize long-term investment trends and invest accordingly, you will likely do very well.

Researching and buying individual investments is fine. Just make sure you mainly focus on your overall asset allocation.

The Ideal Amount Of Cash An Investor Should Hold

The answer to the ideal amount of cash an investor should hold is subjective. We all have different risk tolerances, objectives, obligations, and cash flow. But let’s try to figure out an appropriate level anyway.

Every day, as stock, real estate, and other risk asset prices go up, you might feel bad about missing out. However, this bad feeling only starts occurring when you hold a certain amount of too much cash.

On the flip side, every time there is a major correction, you may feel bad not being able to invest if you don’t have enough cash. Therefore, the key is to figure out the ideal cash amount where you feel neutral.

Let’s highlight some following points to figure out how much cash we should hold:

  • Stocks tend to increase in value each year by 10% on average
  • Corrections of 10% or more tend to occur every 1.8 years
  • Bear markets of 20% or more tend to happen every 4-5 years
  • Real estate tends to increase in value each year
  • Real estate tends to go through cycles every 7-10 years
  • New cash is always being added to your investment portfolio
  • The longer a bull market extends beyond the average duration (4.8 years), the more cash you should have
  • Differentiate between cash in your investment portfolio and cash used to pay for life’s emergencies

Over the past 72 years, there have been 13 bear markets, lasting an average of 13 months, with declines averaging 25.8% before markets recovered. In contrast, the 14 bull markets since 1949 lasted an average of 49 months and gained an average of 131.8% according to Putnam Investments.

Given these facts and assumptions, it would be wise to always have a majority of your capital invested and a minority of your capital held in cash. A minority of your capital in cash can range from 1% – 49%.

Personally, I believe the right percentage of capital held in cash should generally hover around 5%. It can go up to 10% in an extended bull market. Again, this is different from the cash you hold to pay for life’s emergencies.

Ideal Cash Amount: 5% Of Investable Assets

Let’s say you have a $1 million portfolio. 5% equals $50,000 in cash. Does that sound appropriate? It depends on your portfolio composition and investment outlook. You also need to calculate how much new cash you are contributing to your investment portfolio each month.

If your “cash replacement rate” is 100% each month (contributing $50,000 each month), then perhaps having 5% in cash is unnecessary. You can have more than 95% of your capital invested. However, you probably shouldn’t be 100% invested since you never know when another opportunity will arise.

Let’s say the portfolio is 100% invested in the S&P 500 and the S&P 500 goes up 10%. The return would be $100,000. Now let’s say 95% of the portfolio was invested in the S&P 500 with the same 10% increase. The return would only be only be $95,000.

However, let’s say the S&P 500 corrects by 10% in month six and still closes out the year +10%. If you were able to use 100% of your 5% cash to buy when the S&P 500 was down 10%, your $50,000 in cash would have returned ~22%. The total return would be ~$110,000 or $10,000 greater than if you had invested 100% in the S&P 500.

Of course, this scenario means you need to perfectly time your cash investment. And as we all know, retail investors have poor investment timing.

Therefore, if you believe the bull market has a lot of room to run, you want your portfolio to always be as close to 100% invested as possible. Having no cash can also save you from making bad investments.

The below chart shows the intra-year decline in the S&P 500 from 2000 – 2019. Having cash to buy the dips or use as a buffer is helpful.

Ideal Cash Amount: The Case For 10% Of Investable Assets

Given we’re about seven years past the average duration of a bull market, increasing your portfolio’s cash to 10% may be prudent. Does having $100,000 of your $1 million portfolio in cash sound unreasonable? Given where valuations are today, I don’t think so.

Everybody is expecting at least another 10%+ correction at some point. Therefore, if it happens, saving $10,000 in losses by keeping $100,000 in cash should be comforting.

If you were to invest the entire $100,000 during the correction, then your portfolio would get an extra boost from such an investment if the S&P 500 eventually recovers.

However, if the S&P 500 goes up another 10% while you’re holding 10% of your portfolio in cash, then buying during the correction and seeing a rebound back to 0% would be close to a wash.

Below is a chart from Putnam Investments that shows the historical duration and performances of bull markets and bear markets. What jumps out immediately is that our current bull market still has a lot of upside if it were to replicate the bull market of the 1990s.

How long do bull markets last? How long do bear markets last? A look at historical bull and bear markets

Cash Buys You Time To Wait: Investing In Chinese Tech Stocks

You’re certainly welcome to raise a lot more cash in your portfolio if you think a bear market is coming. In one 2020 CNBC survey, it found the average investor held roughly 23% of their portfolio in cash and cash equivalents.

Alibaba (BABA) stock - liquid courage to buy Chinese tech stocks after a big meltdown

The reality is, nobody knows when the next correction will happen. At the same time, we know there are always investment opportunities every day.

For example, I’m currently accumulating a ~$50,000 position in various Chinese technology stocks (Baidu, Alibaba, Tencent). The stocks have been getting beaten down and valuations are attractive compared to their U.S. peers. The higher U.S. tech stocks rise, the wider the valuation gap grows.

Buying Chinese technology stocks is very risky right now. The government is imposing artificial restrictions such as limiting the number of hours under-18s can spend on online gaming to three. The government also has a target out for flamboyant billionaires who do not know their place. Who knows when the government will stop?

At current levels, I see 20% downside and 80% upside over the next three years. In three years, we can look back to this post about liquid courage and laugh at my poor investment decision. Or, we can dissect this case study and recognize that making money takes guts.

I’m willing to take this risk because I have a lot more cash behind. If Chinese tech stocks do go down another 20%, I will likely double my position to $100,000.

When it comes to measuring investment risk, calculate your potential loss and compare it to your remaining cash. If your remaining cash is 5X or more your potential loss, you will likely have the courage to invest.

More Cash Gives You More Courage To Do A Lot Of Things

Besides cash giving you more courage to invest in risk assets, having more cash also gives you more courage to make a change in your occupation, start a family, be more giving, and so much more.

Feeling financially secure is wonderful. And if you find yourself waiting too long for a correction, then you can always use the cash to pay down debt if any.

In conclusion, I say it’s worthwhile to aim for the following goals:

  • Have 5% – 10% of your investable capital in cash so you always have the ability to take advantage of investment opportunities that occur every year
  • Have at least six months worth of living expenses in cash or cash equivalents so you never have to sell down your investments at inopportune times

Achieve all four financial goals and I dare say you will have achieved the ultimate level of financial freedom. No longer will you worry much about your day-to-day financial needs. People won’t stress you out as much either.

Having a lot of cash is an integral part of your financial well-being. Embrace your cash to the fullest!

Related: The Need For Liquidity Is Overrated If You Are Financially Competent

Readers, how much liquid courage does cash provide you? How much cash do you think one should have at any moment? Are there examples where having cash gave you the confidence to invest in something you otherwise wouldn’t?

Note: the other way to gain investing courage is to just hire a financial advisor or digital wealth advisor to manage your money. Once you farm out your investment responsibilities or at least a portion of it, you also transfer a lot of the emotion when it comes to investing.

Source
Liquid Courage: The Biggest Benefit Of Cash is written by Financial Samurai for www.financialsamurai.com

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