So when choosing to set aside cash, one has to make a similar judgment: what is the drag on the cash? Avoiding risk assets and saving a large amount of cash creates an opportunity cost for the investor. The saved cash cannot be deployed into attractive investments and, if inflation is high, the cash loses real purchasing power. Indeed, the costs of holding cash as a safety vehicle becomes more expensive in both nominal and real terms.

Customising risk factors

Another aspect of cash as a safety vehicle is that while cash is often seen as king, it is also colourless – or independent of the risks and asset mix in the portfolio. When buying cash, you decide on the quantity, but not on its quality or composition.

However, most portfolios are much more complex. To evaluate the risks to these portfolios, at PIMCO we apply a risk factor-based approach – looking through the portfolio in an effort to identify the risks that drive the assets and hence the portfolio. Knowing the details of the exposures, we believe, allows us to design custom strategies that use a proper combination of cashand options-based tail hedges from different asset classes dynamically. The goal? Proper matching of appropriate risk factors to portfolios.

The use of only cash as a safety vehicle also depends on the ability of investors to time the markets. Investors have overconfidence in their ability to time the markets and also tend not to follow through on plans.

The dynamic liquidity cushion

The solution to these biases is to follow a strategy of delegation and pre-commitment – to “rent” a process and hardwire it so that plans are implemented when optimal to do so. The options market achieves this precommitment and delegation strategy. One difference between holding cash and dynamically rebalancing and purchasing options is the ability to execute the dynamic rebalancing plan. After all, as market risks change, the liquidity cushion we need changes; it needs to be fundamentally dynamic.

Let’s compare two drivers. One keeps cash in his pocket in case of a flat tire or other mishap, but carries no insurance. The second driver carries some insurance. In order to cover himself for all possible contingencies, the first driver needs to hold lots of cash. He should also make sure his cash is of the highest quality and will be sound and liquid in the event of the worst catastrophe. Of course, the second driver would want some cash as her insurance cannot cover all scenarios, but the amount she needs is relatively small compared to driver one. Given that she wants the insurance to pay off in the worst circumstances, she must take care to purchase her insurance from a reputable provider. While it may make sense for some to self-insure – or drive more slowly – in the aggregate, it would be inefficient to hold large sums of cash to adequately insure against catastrophic outcomes.