‘A dollar today is worth more than a dollar tomorrow.’ This adage
used to describe a common desire of many investors to secure their
wealth rather than grow it is a good explanation for why we see so much
cash in investors’ portfolios at the moment.

Despite the return of a modest appetite for riskier investments in
recent months, investors still seem very much attached to cold hard
cash. This is despite historically low interest rates. The need for
security, a cultural bias as well as mistrust of many investment
products that exist are all valid reasons why investors hold on to
cash. But how much cash should one hold to prevent it from becoming a
destroyer, rather than a preserver of wealth?

Holding
excess cash can result in a sub-optimal investment portfolio and lower
the portfolio returns. Opportunity costs from lost alternative
investment opportunities and the effect of inflation on the yield of
the cash held are examples of how cash can turn into a wealth destroyer
if it is not managed correctly.

To determine the optimum cash allocation investors should view cash
as they would any other investment and apply a systematic approach to
the investment process. In this low interest rate environment investors
may seek extra yield pick up through the inclusion of alternative
liquidity solutions (ALS). ALS are often structured money market
products which behave much like cash, often providing the investor with
daily liquidity and capital and accrued interest protection but giving
much higher returns than typical call and fixed term deposit products.
However, even in the world of cash there is no such thing as a free
lunch and in return for these enhanced returns the investor will have
to bear some additional risks not typically associated with regular
cash deposits.

It is important to understand some of the psychological motivations
that drive investors to hold excessive cash. Cash provides perceived
safety and security. Compared to innovative products, cash enjoys a
reputation as being simple and has the key benefit of daily liquidity.
The easy to understand nature of fixed term and call deposits gives
cash a competitive advantage over more complex investments. As a result
investors feel more comfortable with cash and tend to neglect other
often more suitable products.

Cash is also closely linked to some of our most basic needs. Abraham
Maslow’s hierarchy of needs places the need for safety after our
physiological needs in terms of importance. In today’s society cash
provides investors with a sense of security against the many
uncertainties that we face. However, this sense of security is often
misplaced especially when considering the wealth damaging effects of
inflation.

With the knowledge that an investor will always hold cash, how
should they determine the appropriate allocation of cash within the
overall portfolio? By applying a systematic process to understand why
cash is being held, and if the levels of cash being held are warranted,
it is possible to determine an optimal cash portfolio allocation.

Cash allocation analysis

There are three major reasons for holding cash that can be looked at in the context of a cash allocation analysis.

• Consumption Cash (transaction motive): This is cash that is needed
  for financing future cash consumption, for example, to pay bills and
  consumption which goes beyond your monthly income. The higher an
  investor’s income, the more they consume, meaning that consumption cash
  typically increases with personal wealth. When considering the amount
  of consumption cash needed an investor should ask themselves whether or
  not they will be purchasing fixed assets in the near future or if they
  have any big-ticket expenses coming up such as tax bills, etc.
• Iron Reserve (Precautionary Cash): Iron reserve cash is cash that
  is held to provide security against unforeseen events. This is cash
  that is needed to sleep well. Even though this cash may remain
  untouched for many years it can be seen as a constant source of
  liquidity, providing a comforting element to an investor’s financial
  holdings.
• Asset Portfolio (Speculative): Cash should also be held as
  liquidity for future investments in stocks and bonds. This cash is
  normally of a speculative nature. As a rule of thumb, about 5 per cent
  of the value of your investment portfolio should be held as cash to
  service the needs of the investment portfolio.

An investor seeking to determine their optimum cash allocation
should then look at each of the buckets above and consider the
following questions:

• What are my annual consumption expenses and what should be set aside to cover this (eg. two times annual living expenses).
• What is my risk attitude and how important is it for me to have
  cash set aside to sleep well at night (ie. how much risk and return do
  I want).
• What does my investment portfolio look like, how much cash should I set aside to service this?

Once cash has been allocated into these three buckets, any cash that
is left over can be considered excess liquidity which should be
invested into a higher yielding diversified investment portfolio. To
assist with this process UBS Wealth Management has built a
research-based framework to help investors make better investment
decisions. The framework takes into consideration the investor’s needs
as well as the current portfolio allocation and provides fact-based
research about appropriate products.

Alternative liquidity solutions

It is clear that a systematic cash analysis is essential to define
an investor’s actual cash needs. By performing such an analysis it is
possible to identify excess liquidity for reinvestment into other
products, and it is possible to identify cash needed for near term
consumption as well as cash needed to sleep well at night. As cash in
both the consumption and the iron reserve bucket does not necessarily
get used straightaway (particularly true for iron reserve cash) this
cash runs the risk that inflation might lessen its worth (eg. 0.5 per
cent earned on a fixed deposit versus 2-3 per cent long term inflation)

Given the low interest rate environment and the superior returns
that can be achieved from some of the ALS products that are available
today, leaving cash in fixed deposit products is not the best option.

An ALS is typically structured in note or certificate form and
behaves much like cash in that it can provide the investor with daily
liquidity and typically provide capital and accrued interest
protection. The benefit is that the returns are often superior to
traditional deposits.

It is, however, only with some additional risks that some of these
ALS products are able to offer returns that are higher than basic money
market instruments. As ALS are not considered deposits they do not
enjoy the deposit protection schemes that many governments around the
world have implemented post financial crisis. They also require the
investor to take on the credit risk of the issuer of the product,
meaning he is fully exposed to the potential default of the issuer.

Some of the more complicated ALS products do not provide daily
liquidity. Investors should consider this liquidity risk and be
prepared for the fact that there may not be an active secondary market
or they may be charged a fee for early redemption. Finally, some of the
more complicated products may also face market volatility risk as the
daily value is marked to market.

Such products are therefore not for everyone, but if investors
understand the risks they can be an attractive addition to a cash
portfolio.

The recent market volatility has created a flight to safe haven
assets such as cash. However, with interest rates at historically low
levels, excessive cash holding might perhaps be doing more damage to
your wealth than good. Undertaking regular reviews of your cash needs
and carefully identifying the parts of your portfolio which can benefit
from investing in products such as ALS is key to avoiding the
undesirable effects of too much cash – value erosion through inflation,
and investment opportunity costs. More importantly, identifying excess
liquidity which can then be put to work in a well-diversified portfolio
can help to raise your overall return and should be considered a key
activity in the successful management of your investment portfolio.

The writer is Managing Director and Head of Products at UBS Wealth Management Singapore