Any portfolio of assets will invariably contain a cash position. You need some to pay the bills and you always need some in reserve, because you never know and, in any event, cash is always good to have. The question is of course: how much? Before the credit crisis, there was a free lunch and we were earning 5% in our checking accounts, whilst inflation was comfortably at 2%. Nowadays, this situation is very different. Inflation hasn’t gone away and we are not making anything on our cash, which means we are losing money in real terms, and even more so if we hold Euros or Swiss Francs.
So what to do? Clearly, we need to reduce our (idle) cash positions and the way we do that is by borrowing against our assets. Here are the numbers: let’s say we keep 25% of our money in cash. Not unusual, and according to one study (by This is Money), that’s what more than half of wealthy individuals in the UK do for a rainy day. According to another study, these same wealthy individuals put the rest of the money into equities (55%) and bonds (20%). Bonds are currently yielding around 1% and equities have averaged about 7% for the last 100 years, giving us return expectations (before costs) of about 4%. Nice, but could we have done better if we didn’t leave so much of our money on the side-lines doing nothing?
Absolutely, and if you can’t get anything for your cash, then why not heed the words of Dire Straits and get Money for Nothing instead. It’s called buying on margin and here is how it works: Back to our example, we want to buy equities and bonds, which give us a yield of 4% on our portfolio (including cash). If we borrow money from our broker and put up our assets as security, we could easily increase our exposure by 50%. That means we could have 112.5% (75% * 150%) of our money earning 6.075%. Of course there is a cost, but money is cheap and last I checked the cost of borrow is about 1.5%. That means we would only have to pay 0.55% for the money we borrow, giving us a net return of 5.5%.
Ah, but what happens if the markets fall and our margins get called? That’s where the cash kicks in. Remember we are still keeping 25% of our money in cash, and we also have 30% (20% * 150%) of our money invested in bonds (which go up when markets crash). All of which gives us plenty of cushion to withstand any shocks to the system. Why doesn’t everybody do this? Because leverage is evil, cash is king and people think a hard Brexit is a good idea. The point is, rather than paying an opportunity cost on our cash, we can take advantage of the low interest rates and use our money much more productively. There are always two sides to every trade, and if one of those isn’t working, it means the other is there for the taking.