Adriaan Pask, Chief Investment Officer at PSG Wealth
Cash allocations in portfolios are a hotly debated topic. Cash is typically held either to manage volatility or as a war chest to seize market opportunities that present themselves. In the context of wealth management, cash also provides for income requirements or emergency funds for the client.
The cash debate highlights the value that financial advisers bring to clients, especially when deciding on cash investments. For long-term investors, evidence shows that including cash and cash equivalents in a portfolio is often optimal. These solutions provide stability, flexibility, and risk management, hence increasing the investment strategy’s resilience and efficacy. The level of cash you should hold in your portfolio also very much depends on where one is in the market cycle.
Despite the fact that fixed-income products are on the low side of the risk spectrum, risks do exist and are often misunderstood.
It is important to note that, while fixed income investments are less volatile than other asset classes, even some of the more conservative fixed-income asset classes still exhibit some meaningful levels of volatility over time.
Looking at South African bonds for example, when rates started moving up, we witnessed significant capital losses, in tandem with the coupons moving higher. Cash on the other hand is less volatile but the yields are lower. This makes it a good counterbalance to mitigate against any volatility in a portfolio, however, the trade-off is that cash will not generate inflation-beating returns over the long-term.
From a wealth management perspective, it is important to consider clients’ short-term cash needs, and budget accordingly. This also helps with client behaviour by ensuring they don’t panic when a market downturn occurs, since they know their income needs are adequately met with their cash on hand.
Another risk to consider relates the yield you earn on a fixed income product. If it has an enhanced yield, investors should consider the origins of that yield. In most cases, the source will be from increasing the duration in the portfolio.
In other instances, it could be from exposure to assets issued by counterparties that are associated with more risk. In other words, buying into instruments that aren’t necessarily of high quality. That is something that investors should be particularly aware of, especially in an environment where there is a chase for yields, at higher risk.
This counterparty risk can be material and should not be overlooked. Compare for example the risks associated with secured debt that’s issued by one of the big South African banks, and private debt.
Private debt is not listed on the JSE, it’s not freely traded, and you might not even have a daily updated market value that’s tested in the market. Liquidity and transparency constraints therefore exist and liquidating your position might not be possible when you need to.
Bearing this in mind, the average investor typically approaches risk by looking at the return of a security in relation to its volatility. From our perspective, volatility itself is not necessarily an indicator of risk.
In fact, the most volatile asset class in a portfolio, equities, is the growth engine of a client’s portfolio. It is important to note that the real underlying risks of a security do not necessarily exhibit themselves in the volatility of the asset class. For example, illiquid debt as mentioned above, will have low levels of volatility by the mere function of it not trading.
A further risk associated fixed income assets worth considering, particularly in an environment of declining interest rates, is reinvestment risk. This risk arises when maturing assets from a portfolio are reinvested in a market now offering lower yields. Investors need to understand to what extent their portfolios are exposed to this risk, and how it could impact their financial plans.
This further emphasizes the necessity of seeking financial advice. From a financial planning standpoint, as wealth managers, we believe your portfolio should ideally include enough cash to cover short-term liabilities and needs, while the remaining assets align with your broader risk profile.
With the guidance of your wealth manager, taking into consideration your financial-planning goals, one should look for solutions that strike a balance between risk, return, and value for money. Also avoid getting swayed solely by top performers boasting high returns, as these often come with increased risk, which tends to be underestimated.
Finally, if you are considering investing a substantial sum of cash but are unfamiliar with the risks outlined, it’s wise to consult a wealth manager or financial adviser. They can provide suitable guidance in navigating this complex investment environment, which is often more intricate than commonly perceived in the market.
ENDS
