Cash, what a beautiful word. It’s music to our ears. Everyone loves cash. Without any doubts, cash is a powerful instrument that gives us freedom in various aspects of our life. Having cash on hand provides the investor with an opportunity to buy an interesting asset, at any time, they see the chance to strike a bargain.
In this context, cash means monies put into Treasury bills and other highly liquid instruments. Note that a call option provides a buyer with the right to obtain an asset at a specified strike price on the expiration date. The positives of call options are that they can bring the buyer unlimited upside at the same time limiting the maximum loss.
Cash as a Call according to Warren Buffett
Warren Buffett represents cash as a perpetual call option. His biographer Alice Schroeder says that Warren looks at cash as a call option without the expiration date. In general, he has a reputation of a patient long-term investor, who knows how to wait for a really good opportunity to stop by.
Over his career, his best opportunities occurred during periods of crisis and uncertainty. While others were afraid to invest, Warren bought companies in a number of sectors.
What about an average investor?
Thinking of cash as a perpetual call option, an investor should take into account at least 2 things: a significant amount of cash and a perfect sense of market timing. This scenario can bring a good amount of wealth indeed, however, such investors are more likely an exception rather than a regular occurrence.
Saying this we still should admit that there are periods when even an ordinary investor may receive more benefits from holding a large cash sum than hastily and immediately putting it into operation. In holding your cash, you should think of the value of opportunity against investing directly into trading, representing the potential difference in returns, that may see your money perform better.
Let’s say you decided to stay in cash and opt for a deposit paying 1% per year, instead of putting money in an equity index that will potentially return 10%. In this case, your opportunity cost would be 9%. However, if the equity index returns 2%, your opportunity cost will make only 1%. The opportunity cost means the option premium, which is paid for staying in cash, in other words, the cost for having cash as a call option. The cost of these call option may differ greatly. During the market crash, the opportunity cost for staying in cash is too high. In this case, investors usually start aggressively putting their cash into potentially profitable assets.
Let’s view cash as a call option strategy on a simple real estate example. Imagine that you have $50,000 in your pocket right now. Herewith, you expect to obtain $150,000 more in mortgage financing. All-in-all you get $200,000 for a house of your dreams. Unfortunately, the hot property you want starts from $300,000. Instead of searching for some additional variants to find extra funds you decide to wait. Sometime later a housing crisis happens, and suddenly you have the possibility to buy that property of your dreams at $200,000, the price you wanted. Several years later, when the housing market began recovering, you can sell the property for $250,000, making substantial gain in comparison with your initial funds: $250,000–$150,000 of a mortgage balance, which makes $100,000 in cash, doubling the initial investment.
Is there a happy ending?
Please, remember that cash can’t be considered an ideal long-term asset. Today, when the interest rates are very small, it’s especially true. However, periods of uncertainty happen. Having cash at hands makes you flexible and enables you to catch bargain assets.