Portfolio power: Cash management

In this section, we assume that cash is invested in cash-like assets, such as Treasury bills or money market funds. We highlight 3 key reasons to hold cash.

Safety

The first and most obvious reason to hold cash is safety. Perhaps you have an expense coming up soon, like a wedding or a dream vacation, and you want to make sure the funds are available when you need them, with very low risk of loss. When it comes to safety, cash is the clear winner. Stocks are too volatile to meet immediate expenses; even short-term bonds can lose value in a bad year like 2022.

Stability

A second reason to hold cash is stability. We consider price stability and portfolio stability. The following table shows index returns of Canadian 3-month Treasury bills — equivalent to cash — and Canadian short-term bonds.

Table 1: Index returns of Canadian 3-month Treasury bills and Canadian short-term bonds, 1980 to 2024

Treasury bills provided remarkable price stability, since they did not have a single down year in the 45-year period. They enjoyed remarkable success in the early and late 1980s, as well as recent success in 2021–22. At the same time, the return of Treasury bills was only slightly lower than that of short-term bonds.

However, when we focus on performance in stock market crashes, short-term bonds provided greater portfolio stability.

Table 2: Index returns of Canadian 3-month Treasury bills and Canadian short-term bonds in stock market crashes, 2000 to 2024

Treasury bills provided greater price stability, with relatively little change in price and no down years. Short-term bonds provided greater portfolio stability in stock market crashes, rising by more than Treasury bills and helping to reduce a portfolio’s downside risk.

Cash can also provide behavioural stability. Having very low volatility in the cash part of their portfolio can help investors remain invested during volatile times, rather than react emotionally and sell out of stocks at the bottom of the market. While short-term bonds can also play this role, cash tends to be less volatile.

Flexibility

A third reason to hold cash is flexibility. When risk assets like stocks sell off, an investor with cash can potentially buy at attractive prices. Famous investors like Warren Buffett are known for keeping cash as “dry powder” for exactly these opportunities.

This sounds reasonable in theory, although 2 questions apply:

• Will investors actually buy when stocks are down? It can be hard to tell if a declining stock is a bargain or a dud. The challenge is that investors keep cash aside for large pullbacks, only to find it’s too difficult to pull the trigger when the time comes.
• How often do these opportunities come along? While 10% corrections are common, investors may end up waiting a while for 20% bear markets or 30% crashes. In the meantime, investors may have missed the opportunity to invest their cash in assets with a higher expected return.

In the previous section, we assumed cash was invested in cash-like assets, such as Treasury bills or money market funds. We now turn to a different situation, where cash is uninvested with a return of zero. Uninvested cash can drag down a portfolio’s return. This is known as “cash drag.”

Say an investor expects a 10% return. If they hold 2.50% of the portfolio in uninvested cash, the investor’s portfolio return is reduced by 0.25%, since they’re not getting that return on the uninvested cash. As a result, the portfolio return is 9.75%, not 10%.

Here are some definitions:

• The 0.25% reduction in portfolio return is “cash drag.” Think of this as how a portfolio’s return is dragged down by holding uninvested cash.
• The 9.75% return after the effect of cash drag is the “effective return.”

The following table provides a hypothetical example of cash drag. In this example, we assume a $1 million investment and 10% annual return; we also assume that all cash is uninvested.¹ We show the cumulative balance after 10, 20 and 30 years of investment growth, at different levels of cash position and cash drag:

Table 3: Effect of cash drag, based on $1 million investment and 10% annual return

Let’s look at the column titled “After 10 years,” showing the cumulative balance after 10 years of investment growth. Each time the cash position increases by 2.50%, the cumulative balance decreases by about $50,000.

Let’s look at the column titled “After 30 years,” showing the cumulative balance after 30 years of investment growth. Each time the cash position increases by 2.50%, the cumulative balance decreases by about $1 million — equivalent to the entire value of the initial investment. 

Investors can reduce the effect of cash drag by setting a target allocation to cash and regularly deploying any unused cash.

Cash deployment includes investing cash that the investor has set aside as a cash position, as well as allocating cash that accumulates from dividends, income and other distributions.

Investing cash

The first point is investing the cash position. If an investor is holding for the very short term or trading very actively, they might choose to hold uninvested cash. However, for this discussion, we’ll assume that an investor is holding beyond the very short term and not trading very actively.

We’ve already noted that the long-term annualized return of Canadian 3-month Treasury bills was 5.20%, compared to 6.70% for Canadian short-term bonds.2 In comparison, uninvested cash has a return of zero. The key point is to invest the cash position. Investors have simple and convenient ways to invest cash, including money market funds, high-interest cash ETFs and Treasury bill ETFs.

Allocating cash

The second point is allocating the cash that accumulates from dividends, income or other distributions. Consider a two-pronged approach.

• Sweep cash: Go into your portfolio regularly, for the specific purpose of sweeping cash from all accounts. Remind yourself by setting an alert, say for the first Tuesday of each month.
• Activate cash: Decide ahead of time how you want to activate your cash or put it to work. Say you own a Canadian stock portfolio of 20 names. The activation asset could be a Canadian stock index ETF.

This two-pronged approach makes cash deployment a simple process. Instead of noticing cash all the time but thinking you’ll get to it later, sweep cash at regular intervals. Instead of second-guessing how to allocate cash, have an activation asset ready to go. This approach can help you deploy cash efficiently, reducing cash drag in your portfolio.

Cash-like investments include Treasury bills, money market funds and high-interest cash funds. Reasons to hold cash include safety, stability and flexibility. Safety is the clearest reason to hold cash, while stability and flexibility can also be appropriate reasons.

Cash drag is the reduction in portfolio return as a result of holding uninvested cash. This can significantly affect long-term wealth accumulation. Investors can reduce cash drag by setting a target cash position and regularly deploying spare cash.

Cash deployment includes investing the cash position, as well as allocating cash that accumulates from dividends and income. Investors can make cash allocation into a simple process, regularly sweeping cash into a pre-selected activation asset. 

¹ We assume no contributions or withdrawals after the initial investment. For simplicity, we ignore inflation, taxes, fees and costs. For ease of presentation, we round all amounts by $1,000.

² Past returns are significantly higher than current expected returns, reflecting the tremendous bull market for bonds in the 1980s and 1990s.