The following content needs to be prefaced with two things.
First, around here, we view money as a tool. Nothing more and nothing less. And its job is to promote happiness. No need to get into the “Can money buy happiness?” hippie debate because anyone with a pulse knows the answer is “Yep. Kinda.”
Which is to say you can just as easily be made miserable as happy by money. Like you can use a hammer to drive a nail just as easily as you can to shatter your thumb. It’s all about using the tool to accomplish the task at hand the best way possible.
Second, for as much as it pains me to make this admission, economics is a…social science. Facepalm.
To an economist, that’s pretty much as bad as an astronaut being told space travel isn’t so much aeronautics as it is commuting. That’s because the other social sciences are fields of study like psychology and art history flocked to by hippies who like to debate whether money can buy happiness over chai lattes at a cool-because-it’s-dirty café in a part of town where nobody’s showered in a week.
Nevertheless, for all its cool math and pretty words and graphs and charts and sure-sounding quantitative assertions, economics is still just a scientific inquiry into people. And people, it turns out, are ever so slightly more complex than the homo economicus stick figure used in conventional economic modeling.
Even one of the founding padres of modern microeconomics was willing to admit as much. So if Vilfredo Pareto (i.e., the guy after whom stuff like “Pareto efficiency” and “Pareto optimality” and “the Pareto rule” (aka “the 80/20 rule”) is named) can do it, well, I won’t put up too much of a fight. After all, I don’t even have a park bench named in my honor.
“The foundation of political economy and, in general, of every social science, is evidently psychology. A day may come when we shall be able to deduce the laws of social science from the principles of psychology.” –Vilfredo Pareto
Jeez, bro, that’s a screamin’ endorsement for a field that gave us lunacy like penis envy and dream journals.
More and more it appears there’s something to this whole psychology thing in economics. The area of intersection between psychology and economics generally is called “behavioral economics.” But I’ve never liked that name much. Because behavior’s just the part of the iceberg we get to see. It’s all the psychology below the surface where things get interesting. Plus, “behavioral economics” doesn’t really capture the schism from traditional economics represented by embracing psychobabble. To traditional economists, it’s nothing short of psycho.
So let’s call it “psycho-economics” and just agree that there can be a “traditional economics” answer to a question that differs ever so slightly from the “psycho-economics” answer to that question. And both can be right.
But sometimes, as much as it may pain us, the psycho-economics answer can be right-er.
Turn Right Here
Which brings us now to the question at hand. Which is this: Is there any reason to hold cash as part of your portfolio?
The conventional economics answer on this matter is very clear and can be concisely expressed in monosyllabic efficiency.
And this applies equally to holding efectivo in a checking account or “emergency funds” in the mattress or money market funds in the brokerage account.
Summarily, cash drags on returns and doesn’t sufficiently make up for it with risk mitigation benefits. This is because its yields are so far below the returns of alternative investment vehicles that any volatility-reducing benefit is buried under a mountain of opportunity cost.
And there’s no question that, for homo economicus, the traditional economics answer is right. And complete. And irrefutable. (If you still doubt this at all, just take my word for it.)
But hmmm… What does psycho-economics have to say about all this?
Turn Left In 300 Feet
Before turning to the psycho side of things, let me first fudge one little detail. It’s a minor detail in the end, and fudging it’s not wrong per se. But makes things a helluvalot simpler.
That fudge is this: Let me simplify the position of traditional economics to say that a rational and prudent investor should hold exactly zero dollars in cash at all times.
(Technical note: This “fudge” isn’t wrong per se because, in most modeling of the cash question, the mathematical outcome for optimization would show $0 in cash for most investors’ long term portfolios. But then there’d maybe be some real-world adjusting to that outcome for an individual’s overall holdings, done to account for trivialities like buying snacks at bus stop vending machines and tipping folks at the bar, and so the traditional econ answer to this question would be “around zero.” Or, there’d be a stochastic treatment of returns, and maybe an argument for holding cash periodically across the business cycle would be made. But most treatments like that also allow for negative cash holdings, and so the average would still be “around zero.” Like I said, not wrong per se but a lot simpler.)
Anyway, back to task.
Why does psycho-economics think we should punch our financial selves in the throat and hold a non-zero sum of cash?
I’ll outline three reasons that, in sum, suggest to me that holding up to three months’ worth of spending needs in cash is about right for us humans who are ever so slightly more complex (and stupid) than those homo economicus stick figures. And because, according to psycho-economics research, holding some cash in our portfolios has a discernible positive effect on our happiness. Which we like.
1. Real-World Efficient
Holding some change in the old checking account means autodraft bills get paid, checks don’t bounce, and ATMs don’t laugh in your face when you want green for vending machines and tips. Having a wad of bills in your pocket also means there’s not a bunch of transactional effort required in reshuffling equities funds every time you hit the cash bar at your cheap cousin’s third wedding.
In other words, the real world still uses cash. And, as far as I know, you can’t pay credit card or mortgage bills from a brokerage account (though that’d be cool, so lemme know if I’m wrong on this count). And there are often transactions costs associated with selling equities, etc. that make moving funds across investment vehicles expensive.
So there’s a real-world argument for having some cash around for “frictional smoothing” of the consumption problem. Which is an efficiency argument that doesn’t rely very much on the “psycho” side of psycho-economics but which nevertheless escapes the stylized zero cash condition of traditional economic modeling. And so I mention it to help get things started.
But even smart and knowledgeable investors don’t behave this way. They watch SquawkBox and visit the MarketWatch website and have brokerage apps on their phones and fret about whether the market’s overpriced and swap stock tips at the cash bar at your cheap cousin’s third wedding.
And when people worry they do stupid crap. Like how your well-meaning but fearful elderly aunt would turn down the radio volume to zero every time she drove into a busy parking lot. She was worried about finding a parking space, and she muted her Def Leppard 8-track like it would help get a spot in the shade. Stupid. But utterly human. I’ve even done that. And I have great respect for Def Leppard, so turning it down really only makes me worse off.
Same kinda thing with investing. People are fearful of stock market collapses, corrections and general volatility. They crave certainty. They want a smooth ride. And they’ll do damn near anything to get it. Even smack their financial selves in the face. And sometimes they do it really sneakily.
That sneakiness means it can sometimes be psycho-economically efficient to hold some cash, even though the homo economicus math says otherwise. Here’s how.
A perfectly rational investor would look at the investment optimization problem by considering alternative vehicles’ anticipated returns and volatility, given some investing horizon. They’d more or less assemble a plate of investments from the menu of relevant options available to them. And they’d end up on some efficient frontier somewhere, probably with a beach and a daiquiri. And they’d trust their math and they’d let time and compounding do their thing.
But real-world human investors don’t actually do it like this. They fret volatility and they buy and sell at the wrong times and they “de-risk” their portfolios by pulling back from the efficient frontier to somewhere that feels safer (but isn’t) and which provides lower returns.
In other words, they turn down the Def Leppard when they have no reason to, and only make themselves worse off as a result.
Here’s where holding some cash can be useful for fearful and lizard-brained humans.
If it’s given that a human investor is gonna be fearful and stupid and back away from the efficient frontier with their portfolio allocation (which is a pretty safe bet), then it can be a good idea to hold some cash since doing so can be a “cheap” way of indulging/overcoming our fearful human stupidity.
Take a human investor who holds zero cash. But, because he’s fearful, he over-allocates his $1 million portfolio into “safe” and non-volatile bond funds that yield just 1%. Instead of holding an optimal, say, $100k in such funds with the balance in equities, the investor buys $300k in bond funds for the (artificial) sense of safety. The cost of that safety is the long-run returns differential between the bond funds and equities. Let’s call it a 6% annual average differential.
In a single year, that’s $12k in forgone gains. It gets much nastier over a longer time horizon because of compounding.
Now let’s look at a similar human investor who holds some cash. This cash acts as a salve against the fearfulness factor in the broader portfolio because it soothes the human worrywart and allows cold calculation to reign in the broader non-cash portfolio’s allocation decisions. It has the same calming effect as the first investor’s $300k in bond funds. But it can have that same effect much more inexpensively.
Let’s say this investor keeps three months of cash on hand, which cash would otherwise have been invested in equities. And let’s further assume this investor is a big spender. She incinerates $10k a month, so her zero-yield cash safety fund is a giant $30k.
Since she pulls that $30k from what would have been invested in equities, she reduces her but-for equities allocation from $900k to $870k. The remaining $100k is in bond funds. Her forgone annual gains are accordingly $30k times the 7% return she’d have gotten in stocks, or $2,100.
Which, yes, means she’s worse off than she would have been if she didn’t have a lizard brain. But which also means she’s way, way better off than the zero-cash bro who bought himself some peace of mind by hoarding “safe” bond funds (or any other low-returning and “low-volatility” investment) in a proportion that pulls back from an efficient allocation.
Which means holding some cash can be a really inexpensive and easy way of overcoming human fearfulness when it comes to investing. By holding some cash, the broader non-cash portfolio can be analytically optimized because the lizard brain is calm and content knowing that, if the market’s bottom falls out, there’s still a good chunk of cash in the bank.
Does this mean that the psycho-economics investor ends up wealthier than the homo economicus investor? No. But it does mean the psycho-economics investor ends up wealthier than the regular human investor who suffers from – but does not adequately calm – lizard-brained fearfulness, and ends up better off than the lizard-brained investor who calms his nerves by “de-risking” the entire portfolio.
The substance of the analysis is this: People with more liquid funds available to them (i.e., greater checking account balances) are happier and more satisfied with life than those with lower checking account balances.
And the effect remains when all other potentially relevant variables are controlled for – like earnings, overall wealth, debt, demographics, etc., etc. Those chaps at OxBridge rarely miss a beat, so we shouldn’t question their analytical methods anyway, but I glanced at ’em and they seem solid to me. So we can take the study’s findings at face value.
And since those Brits (like Def Leppard and the hombres at Judge Business School) are so eloquent, I’ll just borrow some lines from their paper’s abstract in summation:
“Individuals with higher liquid wealth were found to have more positive perceptions of their financial well-being, which in turn predicted higher life satisfaction, suggesting that liquid wealth is indirectly associated with life satisfaction… Our results suggest that having readily-accessible sources of cash is of unique importance to life satisfaction, above and beyond raw earnings, investments, or indebtedness.”
The suggestion to me is that on-hand cash provides a profoundly current sense of security. This study is another facet of the “salve” argument outlined above. Like finance bros always say, “Cash is king.” And it would appear being kinged makes people very happy.
So people can be happier with the money they’ve already got if they just keep a bit more of it liquid than traditional economic theory would recommend.
You Have Arrived
And here’s where we are. The conventional economic approach to holding cash is simple: Don’t. And there’s really no way to argue with the math without invoking some psycho-economics.
Psycho-economics pulls back a little from the wealth-maximization and returns-optimization paradigm. It asks a broader question that’s more in the spirit of using money as a tool to max out happiness.
And when that happiness issue becomes part of the question, then it would appear there’s some room for cash in the portfolio. Because it makes us feel warm and fuzzy, which is what we want from our money in the first place. And because, if used strategically, cash can give us those warm fuzzy feelings really inexpensively – because it can save us from more costly lizard-brained mistakes we’d otherwise be tempted to make in our portfolios.
So, now, in the spirit of warm fuzzies and chai latte-sipping, unwashed hippies, let me suggest an amount of on-hand (i.e., checking account) cash that just sorta feels right, man.
Around three months’ worth of living expenses.
It’s enough to more than cover frictional cash needs to help keep transactional effort low. It’s enough to calm the chatter in your lizard brain that might otherwise cause you to de-risk your broader portfolio. And it’s enough to give you that immediate sense of security and happiness and life satisfaction those psychos from Cambridge told us about.
But it’s not so much that it’ll screw up your overall investing plan. It’s not so much that the opportunity cost will really get you down. And it’s not so much that you’ll fall prey to feeling wealthier than you really are and doing stupid crap because of that false impression. You know, stupid crap like turning off the Def Leppard.
Luchadores, holla at me! Agree with conventional economics? Agree with psycho-economics? Does FL need a shrink for advocating three months of cash in the checking account?!
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