- I’ll explain how the key hedge for the retail investor is the cash component.
- Further, we’ll discuss how much cash one should have now, and there is a method. In the end, it depends on one’s age.
- Forget about options and derivatives as they are extremely sophisticated strategies for retail investors.
Volatility has really spiked in the last few weeks and the stock market is in correction territory. The main question everybody would like to know the answer to is whether this slump will continue.
Of course, even if fundamental indicators have been showing the market is overvalued for quite a while now, you can’t precisely know what will happen. However, the market isn’t risky because of volatility, it’s risky due to extremely high valuations and rising interest rates.
Interest rates impact asset prices like gravity, the higher the interest rate, the lower the price. Not much to debate there. So as the global economy has been doing well, and inflation rising, we should expect higher interest rates in the future. Higher interest rates should make stocks less attractive and consequently lower their values. When higher interest rates increase debt burdens and we see an inevitable economic slowdown, we could see a normal, cyclical stock market crash.
Age & Cash
I hear many retirees who are extremely fearful of a stock market crash and they should be because just before retirement or in retirement, if you are hoping for stocks to go up forever, you are risking too much. Therefore, one should have in stocks only the part of their portfolio that can decline 50% or even 70% in a year and lead to minimal 10-year returns.
If you are younger and are still adding to your nest egg monthly, you can tolerate more volatility and be exposed to higher risk as you don’t have imminent needs from your portfolio.
Cash As A Hedge
Nobody likes to have cash sitting around doing nothing, but things have changed significantly. The 1-year Treasury yield went from 0.1% in 2014 to the current 1.91% which is already something.
Now, exchanging the S&P 500 with a 2% dividend yield for a 1-year Treasury shouldn’t be that painful and would eliminate lots of risk. In the last year, both stocks and bonds have moved higher but bond yields (left) still weren’t significant compared to stocks.
Now, onto the more important question. How do you determine how much cash you should be holding now?
You should look at cash as a call option that allows you to invest and buy what you like and when you like it. Let’s say you are young, have a portfolio of $50,000 and have a goal to reach $500,000 in 20 years. For that you’d need to add $500 per month and achieve an annual return of 7%. A 7% investment return implies a price to earning ratio of 14.28 which would require the S&P 500 to drop to a level of around 1,500.
So as you require a return of 7% and the stock market offers 4% now, you can invest only a fraction of your monthly additions and save the rest. As the S&P 500 is 73% above your required level, what you can do is invest only 25% of your monthly investment in stocks and save the rest.
When stocks fall, you can invest more in stocks. As you have a very long term horizon, there will be a time somewhere in the future when stocks will yield 7% or more. Further, you can diversify across the globe, the MSCI Emerging Market ETF has a PE ratio of 15.9 at the moment. I only use this ETF as an example that better yields exist, but I hate ETFs and they also exclude loss making companies from PE ratio calculations.
What would I do if I had such an investment horizon and required return? I would invest 25% of my monthly contributions now, 75% of my monthly investment money in stocks when they match my required return of 7%, would increase it to 100% when the return is 10%. By doing so, you don’t care much about what happens in the markets and have the cash to take action when the market offers bargains again.
In such a situation, if I go back to the $50,000 portfolio and $500 monthly investments, the portfolio would be 75% cash and 25% stocks if we take into account only the S&P 500 to keep things simple.
The 25% in stocks would probably deliver a 4% return over the next 20 years.
Now let’s imagine that some time in the next 5 years, the stock market drops to a level of 1,400 where the yield would be 7% and probably even higher if you own global stocks. At that point, you could invest 100% of your monthly contributions into stocks. As you have been saving for the past 5 years with a yield of 2%, you would have a cash position of $65,035 after 5 years.
When you invest that money into stocks and keep adding $500 with a yield of 10% for the subsequent 15 years, you would still get to the goal of having half a million.
The saving method would lead you to a portfolio of $470k + $72k = $542k which would mean you’ve reached your goal.
If you just invest everything in the S&P 500 and get to a 4% long term return, your retirement basket would be only $291,447.
All of the above is just food for thought and not investment advice. Nevertheless, really think about how much cash you should keep now in relation to your financial goals and stock market fundamentals because if you are al long term investor, that is all you need to know.
The more sophisticated you are and the more time you spend on research, the easier it will be to find better investments and you’ll be able to increase the required average returns. However, always keep the same weights in relation to the S&P 500’s overvaluation as when the S&P 500 falls, all stocks usually fall even more. Also, the more sophisticated you are, the more opportunities you will find. Two years ago, with the S&P 500 already overvalued, commodities and emerging markets were extremely cheap. I wonder what the next cheap sector will be.
Further, if you can, when stocks are cheap again, you may want to buy as much as you can. Maybe even refinance your home or something and invest to take advantage higher yields.
The more cash you hold, the more your mind is free and can think rationally. The key to long term investing success is to be patient, look at what your needs are, and invest accordingly. Unfortunately, very few do that as most chase market trends and hot stocks.
Don’t forget that Warren Buffett has more than $100 billion in cash sitting around waiting for better opportunities. Keep that in mind when your hand is itching.
Now a note on options as a hedge.
It might look attractive to have options as a hedge now, but they are usually a part of a long term investing strategy and if taken from that perspective, you should have been owning put options for 6 years now which is extremely costly. So if part of a well planned strategy, yes. If options are a random experiment for you, no, because they will work here and there but the cumulative returns will most likely end up negative.