(FORBES) Excess Cash In Your Portfolio Is An Option, But What Is That Option Worth?

Most financial advisors will tell you that holding cash for a prolonged period in your investment portfolio is not a wise idea. Study after study shows that long-term returns are better when money is deployed into a diversified pool of assets. Attempts at market timing, in the long run, historically don’t work out too well for the average person. Yet most investors do hold cash. Rich valuations, desire for liquidity, and fear of volatility are all reasons why investors sometimes want dry powder. They are waiting for the proverbial “fat pitch”.

In some ways, surplus cash (above the cash set aside for near-term expenses or liabilities) can be considered an option on taking advantage of more attractive future investment opportunities. Is there a way to value this option like the way other financial options are valued?

Unlike options traded every day in financial markets, there is no Black Scholes formula to determine the “fair” price of holding cash. Nonetheless, we can look at the various inputs that go into standard pricing models — time, volatility, the level of risk-free interest rates, the current price, and the option strike — to form some form of qualitative judgment of the value provided by a tactical cash allocation.

Time is on your side

Most option traders are in a constant battle with the clock. All financial options have an expiration date, after which the premium is lost if the value of the underlying instrument does not move past the strike price. On the other hand, holders of cash can sit on their liquidity for as long as they want. There is no expiration date.

Still, cash is usually raised with a specific period in mind. “I’m going to raise extra cash going into year-end” or, “I think there will be a correction in the market within the next three months” put an implicit expiration on the option, but not an explicit one. No premium is lost if the money is not put to work and the timeframe can always be extended if the anticipated outcome does not happen. Opportunity cost is the only factor. An option without an expiration date is indeed worth a lot.

Higher volatility makes the option more valuable

Along with the time period, there is often a specific reason for a tactical allocation of cash versus other assets. An investor may want to temporarily exit the market with the hope of getting back in after a 10% correction. In essence, by doing this, the investor is long a put option, foregoing the upside to protect against the downside. If the market drops 10%, the investor will buy back shares at a lower price. That put option has value. Higher implied volatility makes the option more valuable, and lower implied volatility makes it worth less.

If volatility is high enough in the above situation, there could be more attractive alternatives. For example, the investor could choose to sell the put option and take in a premium rather than hold cash. If implied volatility is very low, holding cash may be a better choice. The higher the volatility, the greater the chance the market moves to the “strike price” or target.

Think back to the depths of the COVID crisis in March of 2020. Option premiums skyrocketed, thanks to the spike in implied volatility. A cash position was worth a fortune because it provided huge flexibility. So the level of current and expected volatility should play a role in the decision to retain extra liquidity.

Low interest rates make cash allocations less attractive

Let’s face it: cash balances are pretty much worthless today, from a monetary perspective. Yes, they provide optionality, but they certainly don’t provide income. With nominal interest rates hovering close to 0%, bank deposits and money market funds offer virtually no return. If interest rates were 5%, the decision to hold cash is a little easier to make. When interest rates are low, keeping cash is more costly.

There is more to consider than the nominal interest rate. The inflation-adjusted rate, or real rate, is even more critical. With inflation expected to stay above 4.5% for the next year, the true cost of holding a cash position is not 0% — it’s negative 4.5%. Purchasing power is eroded every day, month and year. This is why so many investors are piling into the equity market these days. The alternative is a negative real return. The certainty of a negative inflation-adjusted return on cash today must be weighed against the opportunity cost of being out of the market. The negative real-rate environment reduces the optionality of a tactical cash position, and is one of the main reasons investors feel the need to stay invested.

Relative valuation plays a role

Some would argue that the opportunity cost of being out of the market is declining. With most asset prices at lofty valuations, “taking a knee” and waiting for a correction appears quite appealing. Suppose forward-looking return expectations include a reversion to the mean in valuations, which many models do. In that case, the perceived “richness” or “cheapness” of the market should play a role in deciding whether to raise cash in a portfolio.

Hypothetically, if the long-term historical P/E multiple for the S&P 500 is 20x, exiting the market and raising cash at a 30x multiple intuitively makes more sense than when the P/E multiple is 10x. Again, market timing is tough to do, especially when using valuation measures such as P/E ratios. In this hypothetical example, however, including relative valuations as an input into the analysis makes sense to determine the option value of cash in a portfolio. The richer the perceived valuation, the lower the forward expected return, the higher the optionality of cash.

The level of excess cash should depend on the investment environment

Most investors hold at least some amount of excess cash in their portfolios for a variety of reasons. Yes, there is optionality to having liquidity that can be deployed at a moment’s notice, but waiting for such opportunities is also a cost. We can’t directly measure what each is worth, but by treating cash as an option and looking at it in the same way other financial options are valued, we can get a sense of the actual cost of extra cash in a portfolio. Expectations for higher volatility, the level of nominal and real interest rates, and current valuations relative to history all come into play.