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An old saying that I certainly have used in many different articles I’ve written over the years, is that cash is king. But one scenario where it truly is king, is when we look at the correlation between cash and other assets.
I track a number of local and offshore indices and currencies and one of the things that I track is the cash rate. Cash steadily (and boringly) moves higher every day while all the others bounce around like crazy.
Correlation is a mostly ignored but important concept in investing. It’s not that we want correlated assets. In fact, we largely want uncorrelated assets.
Correlation is a relationship between two different things. As an example, we can look at the relationship between the price movement of different assets or stocks. The formula for correlation results in an answer of between -1 and +1.
Zero, right in the middle, means that there is no relationship between the price moves (they move totally independently of each other). A result of +1 means they move pretty much in lockstep and -1 would mean they move inversely to one another.
In a diverse portfolio you want lots of stocks that have low levels of correlation so that when some are doing poorly others can be doing well. Of course, stocks are themselves fairly highly correlated. Think of a market crash. During a market crash, everything goes down. But this is why a diverse portfolio will include some financial stocks, miners, retailers, offshore, local and so on. The different sectors all have different drivers, so will respond differently to different data.
Then we can add other assets to further diversify a portfolio with, say, bonds and property, which typically have a lower or even negative correlation with stocks. But this lack of correlation breaks down when markets crash and everything tends to move weaker as investors sell whatever they can to avoid losses and to generate cash.
So, then, we’re back to cash. Cash is the most uncorrelated asset against the others. It moves to its own beat, steadily increasing every day regardless of what happens around it. Cash does not go down. Your one rand can’t be less than one rand due to a crash.
The only thing that can reduce, is the spending power of that rand due to inflation. At worst, cash earns nothing if kept under your bed. But if put into an interest-bearing account, it earns interest and increases in value. That said, the increase in value, thanks to the interest earned, may not exceed the decrease in purchasing power if the interest rate is below the inflation rate. If that happens, then your spending power is going backwards.
But, certainly, cash holds its value when markets crash. And that’s why you’ll often hear the phrase of “moving into cash”, because people are concerned about a market crash – or even just a correction. If timed right, moving into cash just ahead of a crash will protect the value of what you own. But getting the timing right is an almost impossible game.
This is why short-term financial requirements such as a large deposit, purchase, wedding budget or an emergency fund need to be in cash. That is: 100% in cash.Cash is also needed in retirement. The theory is that you can draw down on your equity portfolio.
But what if the market crashes just as you need to draw down some money? Then suddenly all carefully made plans go out the window. A retiree should, ideally, rather have a couple of years of living expenses in cash to protect them against adverse market conditions.
Even youngsters should have some cash handy for the unexpected so that, if something goes wrong, you don’t have to sell assets, but can dip into the cash pile – a cash pile that carries the singular risk that you may spend it.
This article originally appeared in the 12 September edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.
