Cash: The Third Big Asset Class
We have learned what investing is, what portfolios are and started to talk about how to manage one. We have seen the two main asset classes, stocks and bonds. In this section, we will discover the third core asset class: Cash.
In order to refresh your memory a bit, an asset class is simply a group of assets that have a similar behavior over time and share similar characteristics. We will briefly go over stocks and bonds since we’ve explained them in previous videos, and will discover the other four broad asset classes:
They are essentially pieces of ownership of a company (you get partial ownership in exchange for capital). They are a risky asset and are generally volatile, but typically generate high returns.
They are “backward loans” since you lend money to an institution and receive periodic installments and the money lent back at the end. They can be somewhat risky, but generally less than stocks, and typically yield lower returns.
Now, let’s discover the other asset classes:
Cash is the third main asset class in investing. It is simply the fiat currency you own, simply put: money. The cash asset class also comprises several types of investment securities that behave like cash, which are called money market securities, or cash equivalents. Cash and equivalents have extremely low risks (basically negligible for the most part) and very little returns. These assets are typically held for short periods of time and are highly liquid. The most common cash equivalents are the following:
- Treasury Bills (or T-Bills) are short-term securities issued by the Government of the United States, specifically the Department of Treasury. They are sold at a discounted price but don’t pay any interest. The return one gets from trading them is the difference from the purchase price to the face value, at the end of the contract. The US government uses T-Bills to borrow cash from big corporations.
- Short-Term Government Bonds are used by governments across the world to raise capital for public projects, like building infrastructure.
- Commercial Paper is used by corporations as a source of funds to cover their short-term debt obligations.
- Marketable securities are very liquid financial instruments, they can be easily transformed into cash because their maturities are of very short terms.
- Money Market Funds are funds made up of a combination of short-term debt securities that are very stable and yield higher returns than cash.
You must be wondering, if they yield virtually no returns, why should I invest in them? Here are a few reasons why:
1. Increased Purchasing Power in Defletionary Environments
First, we must learn that deflation is the opposite of inflation. It is the decline in the overall price level of goods and services over a period of time, when the inflation rate is below 0%. Since inflation reduces the value of cash, deflation increases it. This is not an ideal scenario, very high inflation isn’t good, but deflation is generally a bad sign of an economy decreasing. However, a good way to increase your personal purchasing power in this environment is by holding cash and equivalents, which won’t yield a high return on paper, but they will appreciate over time in reality. Let’s see a quick visual example to understand this:
Cash vs. Inflation
Above is a chart that represents the comparison of the returns of cash equivalents and the real and expected inflation levels in a certain country from 2015 to 2024. We can see that as inflation increases (inflationary environment), the real value of cash decreases; however, when inflation decreases (deflationary environment), cash and equivalents gain value. Therefore, it can be a good asset to hold in a period like this.
2. Riding Out Any Market Downturn
An investor that is focused on long-term results may want to consider allocation some percentage of his assets to cash and equivalents in as a way to protect himself from market turmoil. More often than not, investors think they can withstand more risk than they actually do, which results in mistakes and tremendous losses when markets go south. In order to keep your portfolio safe, holding some safe assets like cash can help you do well in the long run and ride out any bad market scenario. With the example below, you will understand how having a portfolio with some cash can be beneficial:
Cash vs no cash in your portfolio
The above chart shows us a scenario where the market (the orange line) was in an upward trend that shifted to a downturn in 2019. In a growing market (a bull market) as we see from 2015 to 2019, stocks and bonds did well and the market grew to almost 30%. As for the other two portfolios, the one with no cash grew at a very similar rate as the market, and the one with 10% cash grew at a slightly slower pace, up to 27%. However, when the market is expected to start decreasing, from 2020 to 2025, the portfolio with cash decreased less than the market and the portfolio with no cash. It remained more stable, which is a characteristic provided by cash-like securities (or cash equivalents).
3. Pursuing Market Opportunities
Having cash in your portfolio sometimes is good if you are looking for new investments that you believe are sound and will yield substantial returns. If you are following a company that you believe is solid but its price is too expensive, you may prefer to hold some cash for a little bit and wait for the right time to buy that company’s stock, for instance, when its price goes down due to irrational market behavior (which some believe it happens very often). This way of using cash to bank on possible opportunities is extremely risky and it requires a high level of expertise and some luck.
Alright, although it is a really important topic, we are done blabbering about cash. In the next section, we will go over all the other broad asset classes and then we will finally dig into diversification.