Over optimizing the portfolio

I have often been asked by subscribers - what fixed income option would I recommend for the cash they hold?

My response is that I usually hold my cash in short term FDs or at the most in short term debt funds with high rating and from a well-known fund house.

The main criteria I use in selecting a fund are
-           Fund should have a high AUM (> 1000 Crs) for liquidity purpose
-           Should be from one of the well know fund house, preferably backed by a bank
-           Should have a low expense ratio (as far as possible)
-           Should have a 3-5 year operating history or more

You may have noticed that I have made no reference to returns. This is by design as I am looking at high safety of capital and liquidity in this case. The entire point of holding cash or equivalents is that it should be secure and can be accessed at times of market stress without any loss.

Some of you may be unhappy that these options provide ‘only’ 4-5% returns which are quite meager.

Do the math

Let’s do some math. I usually hold somewhere between 10-20% cash in my portfolio. In a crazy bull market such as now, it may go upto 30% level, but on average it hovers around the 15% mark. Let’s assume I get very creative and aggressive with the cash holding and can earn around 10% returns on it. Keep in mind, that the level of risk rises exponentially in case of fixed income instruments. A vehicle giving 10% when the risk free rate is 6%, is not 60% more risky, but carries several orders of magnitude higher risk.

Let’s say, that I still decide to move forward and invest all the cash in such a vehicle. So in effect I have made 4% extra on the 15% cash holding which translates to an extra 0.6% return on the overall portfolio. This additional 0.6% would translate to roughly 7% additional return over a 10 year period.

Is it really worth the risk? Does one really need the extra 0.5- 1% return when rest of the funds are already invested in equities?

There is no free lunch

One of the reasons for holding cash and equivalents is to lower the risk of the portfolio, especially when it is high in the equity market. If you are attempting to get higher returns via fixed income instruments, then you are just changing the label of the investment, but not the level of risk in the portfolio as a whole.

A fixed income label does not change the nature of risk. It is the characteristics of the instrument and its past behavior which defines the same. The worst aspect of investing is to take on higher risks unknowingly and then get shocked when it comes back to bite you.

Please always keep in mind – there are no free lunches in the market. There are absolutely no ‘assured’ high return fixed income options (the term itself would be an oxymoron). If someone tries to sell you one, please run away from the person as fast as you can.

It is not a race

I will never tell anyone of you what to do as you need to make your own decisions. However, let me share what I have been doing for the last 10+ years – I have my funds in safe and relatively secure FDs earning pathetically low rates of returns. This allows me to sleep soundly and have one less thing to worry about. If the equity portion of my portfolio does well, then I don’t need the extra 0.5%. If it does badly, the 0.5% will not save me.

In the end, investing is not a 100 meter dash where the winner gets a gold medal and the fourth place goes home dejected. As a long as I can make a decent return (being 18 %+) over the long run, I would rather exchange a few extra points for much lower risk. The journey would be far more pleasant and I will still reach my financial destination (maybe a year later).

Ps: This does not refer to any investment options such as real estate from a diversification point of view. This is mainly about the desire to optimize the cash portion of the portfolio.

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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.