Balancing amount of liquidity held

10 Dec 2012 10:18
TEH HOOI LING

Keeping a lot in cash is risky but the market rewards you if you can supply it in a liquidity squeeze
The stock market, like life in general, overvalues glitz, glamour and grand promises. It undervalues groundedness, consistency and conservatism. People and companies which just do the work and deliver results are oftentimes overlooked. Consequently, we have the phenomenon of low-risk, high-return investments.

But one risk that the market seems to price more accurately, or in other words, one risk that the market will reward investors for taking is liquidity risk. That is the risk of you not being able to cash out any time you want without losing part of your capital.

Cash and bank deposits have little liquidity risk. You can take your money out any time and in exactly the same amount that you put in – unless of course the bank has fallen into financial difficulties and is in danger of going kaput. Then you may lose your deposits.

Otherwise, you are assured of getting back your money. This is one reason why bank deposits’ returns are so low. They are “safe”.

“Risk” assets, or assets whose prices fluctuate with the market, are different. These assets include equities and real estate. Mr Ben Inker, co-head of the asset allocation team at US asset management firm GMO, put it this way: “Equities cost you money at such an inconvenient time. The worst returns to equities come in recessions (bad), financial crises (very bad), depressions (very, very bad), and major wars (not good at all).

“While the average return to the S&P 500 since 1900 was a reassuring 6.6 per cent real, at those times when you were most at risk of losing your job, your bank account, your house or your life (during wars), you could rely on equities to be piling on the misery.”

Therefore, it is only rational for equity holders to demand, and be rewarded with, a decent return for taking that very unfortunate return path. Such a path of return also applies to assets like investment real estate. At a time when the economy is bad, your rental income is falling, you are not sure if you can hold on to your job, and you want to raise cash by selling your property, there are no buyers – unless you sell it cheap.

But there is a flip side. The flip side is, if you have cash when everyone else is trying to raise it, your money can go a long way. Put another way, if you can provide liquidity when the market most needs it, you will be amply rewarded. It’s the same with help extended to someone in dire straits. That help will be well-remembered and appreciated and, most times, repaid generously.

So when do we usually see a liquidity squeeze in the market? Well, when there is a shock and panic and everyone is rushing to get out of the market at the same time.

Do we have a liquidity squeeze now? Perhaps in a small way, in the sense that everyone is hoarding cash and not putting that liquidity to use, especially in the equity markets. This suggests that those who are willing to take that risk may be well rewarded.

Shocks and panic typically happen at the least expected times. In stock markets, it usually happens in the midst of a euphoric bull market when the last sceptic has been won over. We haven’t had that feeling in the stock market since 2007.

A savvy investor told me once: Bull markets are the time to accumulate cash.

“A lot of people have got it wrong,” he said. “They borrow more and more during a bull market. This goes back to school, which tells us that, in a bull market, we must gear up in order to get a high return on equity. Of course, if it is a sustained bull market, one can make a lot of money.
“But it is usually hard to tell whether you’re at the top, middle or just starting. It’s only when it ends, then you know, oh, the end is here.”

So your cash in the bank does serve some purposes. It meets your liquidity needs – your daily expenses as well as when you need emergency funds. Also, over and above the funds kept for your own liquidity needs, some can be set aside to meet the market’s liquidity needs.

In one extreme case, a friend told me of someone he knows who keeps cash all the time only to pile it all into the market when there is a crash. He exits completely when the market recovers. Apparently, he hasn’t done too badly for himself.

It takes a rather extraordinary person to be able to do that. For mere mortals like us, a sensible thing to do, as with everything else in life, is to have a balance.

A disproportionately high cash holding is a risk in itself. With inflation of about 4 per cent, and banks paying you less than 1 per cent, you are losing purchasing power by some 3 per cent a year. At this rate, $1 million cash kept in the bank will decline in value to just $740,000 in purchasing power terms in 10 years’ time. It is like dropping coins as you walk, eat and sleep.

So keep some cash to meet your own liquidity needs as well as to seize any opportunity that may present itself. Put some at “risk” so that it can work for you. How much to put on each side will depend on how cheap you deem an asset class to be.

hooiling@sph.com.sg