Why It Is Crucial to Maintain Liquidity and to What Extent
As of the beginning of 2021, the S&P 500 has recorded a positive return of more than 20%. The Nasdaq has yielded about 18% YTD after fading from the record earlier this year. There is no need to be a longtime investor to remember such double-digit returns. Except for 2018, investors have become accustomed to positive and high returns in the past few years.
In accordance, warnings are being called everywhere, depending on the high value and soaring prices traded on stock exchanges. Such headlines as “Winter is coming” or “the bubble will burst” can be read often over the news. Is that true? Without getting into the question of markets’ multipliers, in any case, it is advisable to be ready for more challenging times. One known way to deal with long periods of bull markets is to keep a significant cash share of the portfolio.
The Case of March 2020
March 2020 is an excellent example of the importance of maintaining the portfolio’s liquidity. Wall Street’s main indexes were down about 20% in about three weeks. The leading cause was the first and most significant outbreak covid-19 in the Western world. At that time, investors in the Israeli market cashed in mutual funds and ETFs totaling more than 42 billion NIS. These actions expressed the fear sentiment in markets. But still, there was an investor who bought equity on the other side for every investor who sold shares. In other words, a buyer always believes that the market will rise despite the specific circumstances.
Investing in a declining market is possible under two fundamental conditions. The first is believing the market will rise relative to the investment point. The second is liquidity. Without the latter, the investor may desire to invest but won’t be able to.
In March 2020, those who bought at the market’s low point returned their investment within a few weeks. Later, they recorded a positive return of tens of percent, which means those who saw this crisis as a temporary short episode succeeded in earning some “smart” money.
Liquidity – To What Extent?
One of the most significant challenges for investors during bull market periods is to set the exact ratio between liquidity and non-liquidity. How much liquidity should the investor maintain under current market conditions? I checked several institutional pension portfolios to answer this question, following the assets reports as of Q1 2021.
This random check shows that these portfolios’ liquidity ranges from 6.5% to 49.1% relative to their total value, with an average of 19.5% and a median of 14.7%.
A look at the cash share in solid investment tracks shows a reduced share rate compared to the risky ones. For example, in “Excellence” up to 20% stocks plan, the cash share is about 7% (as of the first quarter of this year). As of Q2 this year, the cash share in “Lapidot” was 20% (compared to 50% in the stock plan). This means that cash share decreases following the risk level.
The Bottom Line
Liquidity is crucial for an investment portfolio, especially when stock prices are record high. Following institutional portfolios, a 15% %- 20% cash share should provide investors with average protection from downsizing. Moreover, it grants recovery ability from the unpredictable declining stock market and maximizes portfolio returns.
