Holding cash in one’s portfolio can be very controversial. Elliot Turner gives his ideas on how cash can be very beneficial for one’s portfolio and states that some people are just writing it off too quickly before considering it properly. However, the part of his post that I think is most important has to do with the actual ideas on how to view cash and how some investors perceive holding cash differently than others.
Alice Schroder discusses in another article how Warren Buffet looks at cash differently than most investors. Buffet’s approach to cash with regard to investing has to do with viewing it as a call option. To quote Schroder, “he thinks of cash differently than the conventional investors. This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.” This approach is good because it doesn’t make one think of cash as an full fledged investment on its own. Rather, an alternative place to hold money while earning a small percentage on it and having it readily available for other investments.
The second approach has to do with Claude Shannon, the founder of information theory, and his ideas on how to invest in a random walk. In William Poundstone’s book, “Fortune’s Formula,” he discusses Shannon’s ideas on how to use cash in a portfolio to beat the random walk of a stock. The portfolio he talks about is counter-intuitive and may be tough for some investors to stomach, however, it has interesting payoffs for a stock that is highly volatile. It is a portfolio based on 50% invested in a stock and 50% in cash. Then as the price changes the investor would rebalance the portfolio at a specified time each day to ones again reflect the 50/50 proportion of stock and cash. This can be clarified by the example Poundstone gives in his book.
“Imagine you start with $1,000, $500 in stock and $500 in cash. Suppose the stock halves in price the first day. (It’s a really volatile stock.) This gives you a $750 portfolio with $250 in stock and $500 in cash. That is now lopsided in favor of cash. You rebalance by withdrawing $125 from the cash account to buy stock. This leaves you with a newly balanced mixed of $374 in stock and $375 cash.
“Now repeat. The next day, let’s say the stock doubles in price. The $375 in stock jumps to $750. With the #375 in the cash account, you have $1,125. This time, you sell some stock, ending up with $562.50 each in stock and cash.
“Look at what Shannon’s scheme has achieved so far. After a dramatic plunge, the stock’s price is back to where it began. A buy-and-hold investor would have no profit at all. Shannon’s investor has made $125.”
Both of these approaches seem to be a very interesting ways to think about using cash when investing in stocks or other assets. Whether it be thinking of cash as a call option as Warren Buffet or as a way of better allocating and reducing volatility as Claude Shannon, it is good to remember that there are always other ways of looking at things.
Link: In Defense of Cash
Related Link: Is the Cash Option Priceless for Warren Buffet
Related Books: Fortune’s Formula by William Poundstone
Great Minds Discuss 