Cash is king/queen
Note: this post is aimed at more active market participants
There are many approaches to downturn protection: this refers to an underappreciated source of portfolio protection in case the value of your investments falls down dramatically, as we’ve seen during some financial crises.
Most often people hold a portfolio composed in large part of stocks and bonds. The idea here is that when the stock market falls, investors fly to safety, namely government bonds (especially US government bonds), driving their price up. So in case of a financial crisis, the theory is that if your stocks portfolio falls a lot, your bonds portfolio will go up, somewhat, or entirely, compensating for stock losses at the portfolio level.
Perhaps the second most often used tool for portfolio protection is gold. Again, the idea is that during financial crises, and when uncertainty is high, investors fly to safe assets — and gold has been seen as a safe store of value for millennia. We explore the idea that gold protects investors in a downturn in more detail in our article on gold.
A third principle is to hold defensive stocks. Defensive stocks refer to companies in industries that perform well even in an economic recession. These are mostly companies selling essential products, such as detergent or food — even in a recession people will still consume a similar amount of food (hopefully). Therefore these stocks are expected to hold up a lot better than other, “discretionary” stocks, whose products consumers can cut down on.
However, an underrated source of protection (and gains) is simply to have cash (or cash equivalents) on hand. While each of the above assets have shown some uncorrelated behavior with stocks during periods of crisis, they’ve also happened to be severely correlated. For example during the Covid crash of March 2020, both gold (and bitcoin/cryptocurrencies as an aside for those who wonder) also fell dramatically. Ultimately, if you rely on these assets for protection, I would say you depend on the idea that historical behavior will also hold up in the future, and as just mentioned, this is not always true.
During bull runs investors forget the power of cash in times of crisis. They scrape the barrel for every cent to put in all those great opportunities. But this is how they get caught fully invested during a crisis. And how they quickly become overinvested and illiquid. Yes, you can spend your cash. And yes, furthermore if the apocalypse happens, you can fill your gas tank one more time, and buy a Chardonnay (for the end of times) at the local gas station with a nice crisp bill — chances are your local gas station will not have converted to demanding gold or bitcoin just yet. But most of all, if your portfolio goes down in value dramatically, as one would expect during many financial crises, if you have cash in reserve, you can buy the dip. As markets fall 10%, 20%, 30% or more, you can slowly start buying on the way down with the cash you have. Ultimately, as the bottom is reached and markets start to recover, all those who bought stocks close to the bottom, will immediately start seeing gains on those stocks and the fortunes of their portfolios will turn to the better.
Let’s take January 1st — March 1st 2020, when markets plunged due to the global spread of Covid and lockdowns, as a case study.
The stock market fell dramatically of course. The S&P 500 fell 19.9% during this period. A gold investment like GLD (one of the main gold ETFs) fell about 0.7%. US bonds were up 1.92% in January, and 1.8% in February, therefore showing lack of correlation with stocks (while stocks were going down, US government bonds were going up). Corporate bonds fell during this period. Bitcoin was up 26.4% during this period, before falling 31% during the first two weeks of March.
However, if you had cash on hand and bought the stock market dip anywhere near its bottom on March 1st, you would have made the following returns (all compared to your buying price on March 1st):
April 1st: +12.7%
May 1st: +17.8%
June 1st: 20.0%
July 1st: 26.6%
August 1st: 35.4%
March 2021, at the time of writing: 52.8%
Many additional arguments could be made here of course. The price of bitcoin increased about 10 times since its bottom in March 2020, in only 12 months… Technology stocks like Amazon, Microsoft, Pinduoduo all made returns between 50% and 400%. Tesla is up 565%. And yes, dislocations always give rise to great opportunities for those who follow the markets closely and have cash to deploy in these moments. Skillful asset selection always helps, but this is not the point. The point is that one of the best strategies to protect yourself from downturns is to actually be in a position to benefit from them by having a certain amount of cash on hand, for when the stock market dives. Buying cheap/close to the bottom of a market fall is very safe, and is a recipe for attractive gains in the future.
As a matter of fact, to take the second most recent financial crisis, namely the Great Financial Recession of 2008, the same thing happened then: investors who had cash on hand and bought as the market was reaching its bottom in December 2008, made a killing in the following year, and years.
It’s an underrated practice to always have access to some liquidity — to never be overinvested. To keep 10%+ of a portfolio in cash and cash like instruments such as highly liquid ETFs (which have daily liquidity meaning that you can sell your ETF position and receive cash, in these highly liquid ETFs, from one day to the next. Note: most investors who follow general best practices will be able to access such cash from either their cash balances or their existing holdings of cash like instruments such as highly liquid money market funds). And indeed, if you follow respected professional investors and fund managers, you will see that they have a much higher cash position typically and across time, than you would expect — typically invested in money market funds with a yield of course, not sitting idly on their bank accounts.
*All data retrieved from yahoo finance (^GSPC, GLD), wstam.com (BBG Barc US Aggregate for bonds), and coindesk (BTC) on March 22nd 2021.
