Personal Finance

Separate emergency cash for optimal portfolios

B Venkatesh | Updated on October 01, 2011 Published on October 01, 2011

Investors need to choose between investments that are liquid and ones that have lock-in period while creating portfolios. An investor wanting to take bond exposure can, for instance, choose between open-end bond fund and fixed deposit. Investors often choose investments that offer easy exit, which may not always be optimal. This raises two questions. How should investors choose between liquid investment and locked-in investment? And how should they manage emergencies should they choose locked-in investments?

This article distinguishes between cash needed for liquidity and cash held for continual investments. It then shows why investors should consider locked-in investment. It also discusses how investors can meet emergency cash requirements.

Cash can be held in a portfolio for two reasons. One, a portfolio manager of an open-end fund has to meet redemption requirements from unit-holders. At the level of the investor, cash will be held to meet emergencies. Such cash is called frictional cash. And, two, a portfolio manager can hold cash after taking profits because she believes asset prices are currently overvalued. Such cash is called tactical cash.

We are not concerned about tactical cash as it is a deliberate choice of the portfolio manager or the investor (in case of a self-managed portfolio) to hold cash. Our discussion would, hence, focus on frictional cash. Now, individual investors have a choice on how to hold frictional cash. For one, they could hold such money in savings accounts. For another, they could structure their investment portfolios in such a way that some investments can be converted into cash when the need arises. Investors often choose the latter. And doing so has its costs.

Frictional risk

Suppose the portfolio composition other than cash for two funds are the same, except that one is an open-end fund while the other is a closed-end fund. From the discussion above, it would be clear that the open-end fund manager has to also hold frictional cash while the closed-end fund manager will hold only tactical cash. The open-end fund is, hence, likely to generate lower returns than the closed-end fund due to frictional cash; for cash returns are typically lower than the expected return on equity and bonds.

Of concern is the risk associated with frictional cash. Consider an investor wanting to create a portfolio to make a down payment for a house five years hence. An optimal investment may be a closed-end equity fund and five-year bank fixed-deposit. But the investor is most likely to invest in open-end equity fund (closed-end equity funds are exceptions) and one-year fixed-deposit, renewing it every year.

Such a portfolio is exposed to huge risk. If interest rate were to decline in the second year, the investor will have to renew the deposit at a lower interest rate. Besides, if the investor needs emergency cash, she may have to redeem her investment in the open-end fund.

And this could be sub-optimal for two reasons. One, the investor will be forced to incur heavy losses if asset prices decline. And two, liquidating the investment could jeopardise the individual's investment objective.

The compelling need to avoid investments that have lock-in period is driven by a behavioural bias called psychological reactance. That is, if an investor is told that she has to lock-in the investment for, say, five years, she will find reasons to require the cash earlier, even though her investment horizon may be five years.

One way to moderate psychological reactance is to preclude the need for intermediate liquidity by creating an emergency fund. This fund would have cash, which would typically be a multiple of average monthly expenditure. Investments should be made in assets that have near-zero risk such as money market mutual funds (liquid funds) or sweep facility that most banks offer between savings account and fixed deposits. Having addressed their frictional cash needs, investors will be encouraged to choose locked-in investments.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investorlearning solutions. He can be reached at >enhancek@gmail.com)

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