Capital sitting idle and not earning a return, negatively impacts performance

One of the most important concepts in investing is the time value of money. This means that money available today is worth more than the same amount of money in the future, because it can be invested and earn interest or returns. The longer the money is invested, the more it can grow and compound over time.

However, this also implies that any delay or interruption in investing can have a significant opportunity cost. Every second that capital is sitting idle and not earning a return, the more negatively it impacts performance. This is why investors should always seek to minimize cash drag, which is the amount of uninvested cash in a portfolio that reduces the overall return.

Cash drag is the negative impact of holding cash in an investment portfolio. It occurs when the return on cash is lower than the return on the rest of the portfolio, reducing the overall performance. Cash drag can be a significant drag on long-term returns, especially in periods of high inflation or low interest rates.

Cash drag can occur for various reasons, such as holding cash for liquidity needs, waiting for better market conditions, or simply being unable to find attractive investment opportunities. While some cash drag may be unavoidable or even desirable in certain situations, it should always be monitored and managed carefully to avoid eroding the long-term performance of a portfolio.

There are several ways to measure cash drag, depending on the type of portfolio and the benchmark used. One common method is to compare the portfolio’s return with the return of a similar portfolio that is fully invested, without any cash allocation.

The difference between the two returns is the cash drag. Another method is to compare the portfolio’s return with the return of a market index that represents the portfolio’s asset allocation. The difference between the two returns is the cash drag plus any active management fees or expenses.

Cash drag can be reduced by minimizing the amount of cash held in the portfolio, or by investing the cash in higher-yielding assets that are consistent with the portfolio’s risk and return objectives.

For example, an investor can use a sweep account that automatically transfers excess cash into a money market fund or a short-term bond fund. Alternatively, an investor can use a margin account that allows borrowing against the securities in the portfolio, reducing the need to hold cash for liquidity purposes.

Reducing cash drag can enhance the portfolio’s long-term returns, but it also involves some benefits and risks. The benefits include:

Higher compounding effect: By reinvesting the cash into higher-returning assets, the investor can benefit from the power of compounding over time, increasing the portfolio’s value.

Lower opportunity cost: By avoiding holding cash when the market is rising, the investor can capture more of the market’s upside potential, reducing the opportunity cost of missing out on gains.

Lower tax liability: By holding less cash, the investor can reduce the tax liability from interest income, which is typically taxed at a higher rate than capital gains or dividends.

The risks include:

Higher volatility: By holding less cash, the investor can increase the portfolio’s exposure to market fluctuations, increasing its volatility and downside risk.

Lower liquidity: By holding less cash, the investor can reduce the portfolio’s ability to meet short-term cash needs, such as withdrawals, rebalancing, or margin calls.

Higher borrowing cost: By using a margin account, the investor can incur interest charges and fees for borrowing against the securities in the portfolio, increasing the portfolio’s expenses and reducing its net return.

Cash drag is an important factor to consider when managing an investment portfolio. By measuring and reducing cash drag, an investor can improve the portfolio’s efficiency and performance.

However, this also involves trade-offs between risk and return, liquidity and opportunity cost, and tax and borrowing implications. Therefore, an investor should carefully assess their goals, time horizon, risk tolerance, and cash flow needs before making any changes to their cash allocation.