When to Hold Cash or Defensive Assets

The Case for Defensive Positioning

Every investor eventually faces the question: should I reduce risk and hold more cash or defensive assets? The answer depends on your investment horizon, risk tolerance, current market conditions, and the opportunity cost of being wrong.

Defensive positioning means allocating capital to assets expected to preserve value during market stress or economic downturns. This includes cash, Treasury bills, short-term bonds, defensive equity sectors, and gold. The goal is not to maximize returns during good times but to minimize losses during bad times and maintain capital for future redeployment.

Defensive positioning is not market timing in the traditional sense. Rather than attempting to sell at exact peaks and buy at exact bottoms, defensive positioning involves modest allocation shifts based on observable market conditions and valuation signals. The objective is reducing regret on both sides: avoiding large drawdowns while not missing the bulk of market returns.

Understanding the Opportunity Cost of Cash

Cash and cash equivalents (Treasury bills, money market funds, short-term CDs) provide safety and optionality but sacrifice expected returns over time. Understanding this opportunity cost is essential for making rational decisions about defensive allocations.

Historical Return Differentials

Over the past century, US equities have returned approximately 10% annually, while cash equivalents have returned approximately 3.5%. This 6.5 percentage point gap represents the long-term opportunity cost of holding cash instead of stocks.

Cash's real return (after inflation) has been approximately 0.3% annually. This means holding cash for extended periods results in minimal wealth accumulation and potential purchasing power erosion during high-inflation regimes.

When Cash Opportunity Cost Falls

The opportunity cost of cash varies dramatically across market environments:

High valuation environments: When the Shiller CAPE ratio exceeds 30, subsequent 10-year equity returns have averaged 3-4% annually. Cash opportunity cost shrinks substantially.

Late-cycle periods: In the 12-24 months before recessions, defensive positioning has historically added value by avoiding drawdowns that took years to recover.

Rising rate environments: When short-term rates rise (as during 2022-2023 when T-bill yields exceeded 5%), cash provides meaningful nominal returns while equity valuations adjust.

The Optionality Value

Cash provides optionality that does not appear in simple return comparisons. During market crashes, investors with cash can purchase quality assets at discounted prices. This optionality has substantial value during the 15-20% of historical periods when markets experience significant declines.

The March 2020 crash illustrated this dynamic. Investors with cash reserves were able to purchase S&P 500 index funds at prices 34% below February highs. Those fully invested could only watch or sell at distressed prices to meet liquidity needs.

Treasury Bills and Money Market Alternatives

When holding cash, the specific instrument matters for returns, safety, and tax efficiency.

Treasury Bills

Treasury bills are the safest cash equivalent, backed by the full faith and credit of the US government. They offer several advantages:

• No credit risk: Unlike bank deposits above FDIC limits or corporate money market funds, T-bills carry no default risk
• State tax exemption: T-bill interest is exempt from state and local taxes, enhancing after-tax returns for high-tax-state residents
• Direct purchase: TreasuryDirect.gov allows direct purchases without brokerage fees
• Laddering flexibility: Bills are available in 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week maturities

T-bill yields closely track the Federal Reserve's target rate. As of late 2023, 3-month T-bills yielded approximately 5.4%, providing meaningful returns while waiting for better equity valuations.

Money Market Funds

Money market funds pool investor capital to purchase short-term debt instruments. Two main categories exist:

Government money market funds: Invest primarily in Treasury bills and government agency debt. These are nearly as safe as direct T-bill ownership and offer daily liquidity. Yields typically run 0.1-0.2% below T-bill yields.

Prime money market funds: Invest in short-term corporate debt and bank obligations in addition to government securities. These offer slightly higher yields (0.1-0.3% above government funds) but carry modest credit risk. During the 2008 crisis, the Reserve Primary Fund "broke the buck" when its Lehman Brothers holdings became worthless.

High-Yield Savings Accounts

FDIC-insured savings accounts at online banks often offer competitive rates (4-5% in high-rate environments) with daily liquidity. The $250,000 FDIC limit constrains their use for larger portfolios, but they provide a simple option for smaller defensive allocations.

Short-Term Bond Funds

Short-term Treasury funds and ultra-short bond funds provide slightly higher yields than pure cash equivalents while maintaining low duration risk. Vanguard Short-Term Treasury Index Fund (VSBSX) and similar products offer diversified exposure to Treasury securities with maturities of 1-3 years.

Defensive Equity Sectors

For investors who want to reduce risk without exiting equities entirely, defensive sectors offer a middle path. These sectors historically exhibit lower volatility and smaller drawdowns during recessions while still participating in long-term equity returns.

The Classic Defensive Trio

Utilities: Electric, gas, and water utilities provide essential services with regulated returns. Demand is relatively inelastic to economic conditions. The Utilities Select Sector SPDR (XLU) has historically exhibited beta of 0.5-0.6 relative to the S&P 500.

Consumer Staples: Companies producing food, beverages, tobacco, and household products benefit from steady demand regardless of economic conditions. Major holdings in this sector include Procter & Gamble, Coca-Cola, Walmart, and Costco. The Consumer Staples Select Sector SPDR (XLP) has historically exhibited beta of 0.6-0.7.

Healthcare: Pharmaceutical companies, health insurers, and medical device makers benefit from demographic tailwinds and relatively inelastic demand. The Health Care Select Sector SPDR (XLV) has historically exhibited beta of 0.8-0.9.

Defensive Sector Performance in Recessions

Defensive sectors do not avoid losses during bear markets, but they typically lose less than the broad market. Consumer staples has historically been the most defensive sector, losing roughly half as much as the S&P 500 during recessions.

Defensive Sector Trade-Offs

Defensive sectors sacrifice upside participation for downside protection:

• They underperform during strong bull markets, particularly technology-led rallies
• They may become overvalued when too many investors crowd into safety
• Interest rate sensitivity (especially utilities) can create unexpected drawdowns when rates rise
• Sector concentration increases company-specific risk

A reasonable approach is tilting toward defensives rather than concentrating in them. Shifting 10-20% of equity allocation from broad market to defensive sectors reduces portfolio beta modestly without creating significant tracking error.

Gold and Treasury Allocation for Tail Risk

True tail risk, meaning events that cause catastrophic and sustained losses, requires assets that appreciate during crisis rather than merely declining less. Gold and long-term Treasury bonds have historically served this function.

Gold as Portfolio Insurance

Gold has appreciated during most major financial crises, providing returns when equities collapsed:

The magnitude of gold's protective benefit varies with the nature of the crisis. Gold performs best during inflationary crises and loss of confidence in fiat currencies. It provides less protection during deflationary crises when cash and Treasuries may outperform.

A typical tail risk allocation dedicates 5-10% of the portfolio to gold, accessible through physical bullion, gold ETFs (GLD, IAU), or gold mining stocks (though miners add operational risk).

Long-Term Treasuries

Long-term Treasury bonds (20-30 year maturity) provide powerful protection during deflationary crises and flight-to-quality episodes. When investors panic, they bid up Treasury prices, sending yields plummeting and generating substantial bond returns.

Long-term Treasuries carry significant interest rate risk during normal times. The 2022 rate shock produced a -31% return for TLT, demonstrating that this hedge can inflict losses when inflation and rising rates are the concern rather than deflation and growth collapse.

Balancing Gold and Treasuries

Gold and Treasuries hedge different risks:

A balanced tail risk allocation might include 5% gold and 10% long-term Treasuries, providing protection across multiple crisis types. This allocation sacrifices approximately 0.5% annually in expected return relative to an all-equity portfolio while providing significant drawdown protection.

Redeployment Triggers and Discipline

The hardest part of defensive positioning is knowing when to redeploy capital into risk assets. Without predefined triggers, investors tend to remain defensive too long, missing recovery rallies that often occur quickly.

Valuation-Based Triggers

Valuation provides the most robust redeployment signal. When equity valuations fall to historically attractive levels, expected returns rise, justifying increased allocation:

During the 2009 and 2020 market bottoms, the Shiller CAPE fell to 13.3 and 24.8 respectively. The deeper valuation reset in 2009 justified more aggressive redeployment.

Technical Triggers

Price-based signals can complement valuation analysis:

• 200-day moving average reclaim: When the S&P 500 closes above its 200-day moving average after being below, bullish momentum may be resuming
• 10% rally off lows: Markets rarely bottom and immediately resume downtrends. A 10% rally from recent lows suggests the worst may be past
• VIX declining below 25: Falling volatility confirms panic is subsiding and normal conditions are returning

Time-Based Triggers

Simple calendar-based rules prevent indefinite defensive positioning:

• Maximum defensive duration: Commit to reviewing and potentially normalizing allocations after 12-18 months of defensive positioning
• Quarterly rebalancing: If defensive positioning was correct and equity allocations have fallen below targets, systematic rebalancing forces gradual redeployment
• Dollar-cost averaging: Deploy defensive cash into equities in equal installments over 6-12 months regardless of conditions

The Discipline Challenge

Document your triggers before implementing defensive positioning. Write down:

1. What conditions prompted the defensive shift
2. What specific triggers will prompt normalization
3. How much will you redeploy at each trigger
4. What is the maximum duration of defensive positioning

Without this documentation, behavioral biases (fear, recency bias, loss aversion) will undermine rational redeployment.

Practical Implementation Guidelines

Starting Point: Know Your Normal Allocation

Defensive positioning only makes sense relative to your strategic asset allocation. If your normal allocation is 60% stocks / 40% bonds, defensive positioning might mean 50% stocks / 50% bonds. If your normal allocation is 90% stocks / 10% bonds, defensive positioning might mean 75% stocks / 25% bonds.

Define "defensive" as a specific percentage shift from normal, not an absolute allocation level.

Sizing Defensive Shifts

Conservative adjustment ranges for most investors:

Shifts larger than 20% constitute market timing rather than tactical adjustment and are difficult to execute successfully.

Tax Considerations

Defensive positioning has tax implications that affect net returns:

• Selling appreciated positions in taxable accounts triggers capital gains
• Short-term gains (positions held less than one year) are taxed at ordinary income rates
• Consider harvesting losses during defensive shifts to offset gains
• Maintain defensive positioning in tax-advantaged accounts where possible to avoid taxable events

Avoiding Common Mistakes

Waiting for certainty: By the time recession is confirmed, markets have typically already declined significantly. Act on probability, not certainty.

All-or-nothing thinking: Modest allocation shifts are more sustainable than dramatic swings between fully invested and fully defensive.

Ignoring opportunity cost during recoveries: Markets often recover quickly. Being 20% defensive and missing a 30% recovery costs 6% of portfolio value.

Confusing volatility with risk: Short-term volatility is uncomfortable but not the same as permanent capital loss. Long-term investors can tolerate substantial volatility.

Key Takeaways

• Cash and defensive assets sacrifice expected returns for reduced volatility and optionality during market stress
• The opportunity cost of cash varies significantly with equity valuations and interest rate levels
• Treasury bills, money market funds, and short-term bonds provide safe cash alternatives with varying yields and tax treatment
• Defensive equity sectors (utilities, staples, healthcare) reduce portfolio beta while maintaining equity exposure
• Gold and long-term Treasuries hedge different crisis types; combining them provides broader tail risk protection
• Predefined redeployment triggers prevent behavioral biases from keeping you defensive too long
• Document your defensive strategy and triggers before implementing changes
• Limit defensive shifts to 10-20% of equity allocation; larger shifts constitute market timing