Cash Drag - Doug's Quiz Corner

Quizmaster, Doug Hutchinson, has come up with another great quiz for us regarding the cash we keep in our portfolios and its effect on performance. Test your investment knowledge of how your money is invested and what makes the most sense for your situation.

Good luck!

Cash Drag

If part of a portfolio is invested in cash (or a cash equivalent) then that cash portion of the portfolio can cause a drag on overall portfolio performance in a rising market, since the cash is either earning a very low return or not earning a return at all.

Consider the following scenario:

Asset A: 5% return each year for the next 3 years

Asset B: 3% return each year for the next 3 years

Cash: for this exercise, assume a return of zero for cash

Manager 1 invests $10,000 at the start of Year 1: 50% in Asset A, 50% in Asset B

Manager 2 invests $10,000 at the start of Year 1: 47.5% in Asset A, 47.5% in Asset B, 5% in Cash

What is the difference in performance between Manager 1 and Manager 2 after 1 year (in dollar terms)?

What is the difference in performance between Manager 1 and Manager 2 after 3 years (in dollar terms)?

Answer:

Manager 1: (0.50)*(0.05) + (0.50)*(0.03) = 4% return each year for the next 3 years

Manager 2: (0.475)*(0.05) + (0.475)*(0.03) + (0.05)*(0) = 3.8% return each year for the next 3 years

Manager 1: Starts with $10,000 at the start of Year 1

Year 1 return: $10,000 x 1.04 = $10,400

Manager 2: Starts with $10,000 at the start of Year 1

Year 1 return: $10,000 x 1.038 = $10,380

Cash drag after Year 1 = $10,400 - $10,380 = $20

Manager 1: Starts with $10,400 at the start of Year 2

Year 2 return: $10,400 x 1.04 = $10,816

Manager 2: Starts with $10,380 at the start of Year 2

Year 2 return: $10,380 x 1.038 = $10,774.44

Cash drag after Year 2 = $10,816 - $10,774.44 = $41.56

Manager 1: Starts with $10,816 at the start of Year 3

Year 3 return: $10,816 x 1.04 = $11,248.64

Manager 2: Starts with $10,774.44 at the start of Year 3

Year 3 return: $10,774.44 x 1.038 = $11,183.87

Cash drag after Year 3 = $11,248.64 - $11,183.87 = $64.77

In this example, the cash drag compounds over time. The cash drag for the first year was $20, but the cash drag for Year 2 was greater than $20 ($41.56 - $20 = $21.56). The cash drag for Year 3 was greater than the $21.56 in Year 2 ($64.77 - $41.56 = $23.21). This compounding effect will continue as long as returns for Manager 1 are positive.

Due to the compounding effect, cash drag on a portfolio can be damaging to wealth accumulation over long periods of time in a rising market.