Cash – A Call Option With no Expiration Date
I really like the way this article describes how Warren Buffett thinks about cash. I think of it similarly (see below), but I never thought of it as a call option. It says:
“Ms. Schroeder argues that to Mr. Buffett, cash is not just an asset class that is returning next to nothing. It is a call option that can be priced. When he thinks that option is cheap, relative to the ability of cash to buy assets, he is willing to put up with super-low interest rates, said Ms. Schroeder, who followed Mr. Buffett for years before she became his biographer.
“He thinks of cash differently than conventional investors,” Ms. Schroeder says. “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.”
It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.
Suddenly, an investor’s asset allocation decisions are not simply between earning nothing in cash and earning something in bonds or stocks. The key question becomes: How much can the cash earn if I have it when I need it to buy other assets that are cheap, versus the upfront cost of holding it?”
This is a good insight. Holding some cash is not necessarily a bad thing. What’s bad is holding most of your money in the form of cash. That is a nearly guaranteed losing strategy. The purpose of an investment portfolio is to serve as a place where you protect the wealth you’ve amassed. You achieve this by protecting it against the risk of permanent loss and the risk of purchasing power loss. Cash is guaranteed to avoid one (the risk of permanent loss) and guaranteed to lose the other (purchasing power). So having an excessive allocation in cash at all times makes no sense. There’s no point investing if you’re doing that (unless you’re investing it in yourself or in something other than an investment portfolio which is a totally different matter).
On the other hand, if you’ve designed a portfolio that is properly allocated across different strategies in a risk managed macro approach then you can achieve not only protection against purchasing power, but also reduce the risk of permanent loss. But an important feature of investing is maintaining the plan and capturing opportunity when it is confronted. This might mean dollar cost averaging for some investors and for others it might mean more actively buying depressed assets (or other approaches). Having a steady cash flow or a cash hoard is essential to being able to achieve this.
That’s why, the other week, when I discussed this portfolio building concept, I mentioned that you should never view your investment approach as being investment portfolio centric. The best investment you’ll ever make is in yourself and in your primary form of output. Ie, how you generate the cash flow that then gets invested. As I said last week, an investment portfolio is actually a residual of your primary cash flow. So it’s all about understanding how the portfolio is a stock from your primary output flow. Build that cash flow and it’s like having a perpetual call option machine at your disposal. Of course, you need to actually design the portfolio correctly, but that’s a slightly different matter.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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15 Comments
I don’t think I’m alone when I say that I wish you’d write about the markets a lot more. You have a unique understanding of how all these things are intertwined, but lately you’ve been focusing too much on politics and economics.
I would actually be inclined to agree with the above comment. I have been a dedicated follower of this site since 2009 and I am incredibly grateful for your continued contribution to myriad debates however, I appreciate the market analysis (not necessarily “calls” or the “algo”) the most.
>>>As I said last week, an investment portfolio is actually a residual of your primary cash flow.<<<
Agreed, if you are of employment age. If you are retired, it's a different thing altogether. . .
It’s a heckuva thing, really, that we have a system in which cash is essentially not worth holding. Inflation essentially makes it worthless. And our system of driving up asset value (to unlock future dollars) essentially makes labor worthless, too.
Great post with a few thoughts that are simple on the surface, but worth giving some real contemplation to.
Cullen,
James Montier of GMO wrote a great piece on this subject in June 2011:
“A Value Investor’s Perspective on Tail Risk Protection:
An Ode to the Joy of Cash”
https://gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIA6KcUdqlSIwEgyohGQxhh7bRXD4xyxMHJ0yKJp8UmLQbB%2b96yuKzHmQPVU8fCau6aDZCTV5JgnttLdI9Ykx5M4tg8YZOVTH3o%3d
This was the most insightful piece I have read on the subject.
Thanks for posting this. I immediately changed my approach when this piece came out, it really is fantastic.
Thanks!
Cullen,
You are welcome. Always nice when we can offer something of value to you.
I/we greatly appreciate your blog.
Not sure if I would call it a “call”. He “is in the money” only if his expected future return is >0. It is a low-cost, perpetual “call” but you get what you pay for and is dependent on the person making the call to exercise the call.
It is a call. The underlying is the excess return you get from an opportunity that may arise, so for example it would be the opposite of the market (the lower the market the higher the future excess return). In “normal” times, the option is out of the money and as time goes by there is time decay, as with all options, in this case in the form of opportunity cost and/or purchasing power erosion. In a market crash, the option increases in value and may in fact go in the money and you can choose to exercise it by buying traditional assets at bargain levels.
Well, one circumstance in which a mostly cash “portfolio” is good is during periods of deflation, correct?
This is a great point, and one that needs to be discussed more often.
Cash gets a bad rep mainly because most people are conditioned into thinking “Strategic Asset Allocation”. Cash does not play a big role in SAA and it is viewed negatively. However, in a dynamic/tactical framework, cash plays a dominant role. The option analogy, or any portfolio insurance illustration, help understand the point: in a dynamic strategy, cash plays the role of ‘store of optionality’.
Interestingly, one of the practical challenges that prevents some funds, e.g. pension funds, to hold on to cash is governance. Being able to hold cash also means being able to deploy it when needed, which is very difficult to do currently.
Holding cash is also a concept that many product providers abhor. You will hardly ever see a big provider of passive mutual fund recommend that investors should be holding more cash. Instead, they prefer to scare investors into remaining invested at all times….
This is a great point, and one that needs to be discussed more often.
Cash gets a bad rep mainly because most people are conditioned into thinking “Strategic Asset Allocation”. Cash does not play a big role in SAA and it is viewed negatively. However, in a dynamic/tactical framework, cash plays a dominant role. The option analogy, or any portfolio insurance illustration, help understand the point: in a dynamic strategy, cash plays the role of ‘store of optionality’.
Interestingly, one of the practical challenges that prevents some funds, e.g. pension funds, to hold on to cash is governance. Being able to hold cash also means being able to deploy it when needed, which is very difficult to do currently.
Holding cash is also a concept that many product providers abhor. You will hardly ever see a big provider of passive mutual fund recommend that investors should be holding more cash. Instead, they prefer to scare investors into remaining invested at all times….
It is interesting to see how this simple idea of holding cash may have far reaching consequences …
This is exactly the way I have always felt. Cash is an option waiting to be exercised should the right opportunity come along. There is no worse feeling in the world than to see the opportunity of a lifetime come along only to find no cash available to act on it.
It’s all in The Black Swan… for those of you who haven’t read it.