This post was previously published on thestreet.com
Here is the answer from ChatGPT:
Cash plays an important role in an investment portfolio as it provides liquidity, flexibility, and acts as a risk management tool. Here are some key considerations regarding the role of cash in your investment portfolio:
- Liquidity: Cash is highly liquid and readily accessible, which makes it useful for meeting short-term financial needs and unexpected expenses. It provides a safety net and ensures you have funds available when necessary.
- Emergency Fund: Maintaining a portion of your portfolio in cash helps create an emergency fund. This fund should cover three to six months of living expenses and serve as a buffer during unforeseen events like job loss, medical emergencies, or unexpected repairs.
- Opportunity Fund: Holding cash in your investment portfolio allows you to take advantage of investment opportunities that may arise. Market downturns or undervalued assets may present attractive buying opportunities, and having cash readily available enables you to capitalize on them.
- Portfolio Rebalancing: Cash facilitates portfolio rebalancing, which involves adjusting the allocation of your investments to maintain the desired risk and return profile. When certain assets become overvalued, you can sell them and hold the proceeds in cash until more favorable investment opportunities arise.
- Risk Management: Cash acts as a risk management tool by providing a buffer against market volatility. During periods of market decline, cash holdings can help mitigate losses and provide stability to your overall portfolio.
- Diversification: While cash itself does not generate significant returns, it is an asset class that diversifies your investment portfolio. Holding cash alongside other investments such as stocks, bonds, or real estate can help reduce overall portfolio risk.
It’s important to note that the optimal allocation to cash depends on your individual financial goals, time horizon, risk tolerance, and investment strategy. While having some cash is beneficial, holding too much cash for an extended period may result in missed investment opportunities and potential inflation erosion of purchasing power. Therefore, finding the right balance between cash and other investments is key to aligning your portfolio with your specific needs and objectives. Consulting with a financial advisor can provide personalized guidance tailored to your circumstances.
Dr. Massi’s Answer
And here’s the critique of ChatGPT’s response from our expert, Massi De Santis, Ph.D., CFP, the founder of DESMO Wealth Advisors and lecturer of finance and economics at Texas State University:
Model, User, and Application
Before we can evaluate the answer, we first need to establish a fair framework. Chat GPT is a tool, and to assess the usefulness of any tool, we need to understand both the user of the tool, and the particular use or application of the tool.
In our cash question, If the user is an advisor or an expert that wants to get a summary of how other experts think about cash, the answer offers a list that reflects a number of views in personal finance. The advisor is likely to follow up with other questions, which depend on the application they have in mind.
If the user is a DIY investor trying to figure out how much to allocate to cash vs other investments, it is unlikely that they would be satisfied with this answer. They would also follow up with other questions, but would they know which aspects of the answer they can rely on and which questions to ask?
Details
The “bot” didn’t offer a precise definition of what cash is or is not. I would expect a definition to avoid confusion at the beginning or in explaining item 1 in the list. The concept of cash is often used vaguely in the financial industry, and the answer we got partly reflects that. But a good advisor would clarify that, typically, cash is money deposited in a checking or a savings account. This is important because when we define it this way, we can narrow down both the uses of cash and then how much cash an investor should have. When we look at the list of uses given, for most people the right answer is the first use. A good follow up suggestion for the user could also be that by budgeting and lining up your short term needs you can figure out how much cash you should keep.
I would also correct that in 1, cash is not a good instrument for unexpected expenses. Unexpected expenses fall into item 2, the emergency fund. However, an emergency fund is a goal (investor dependent), which is funded from the portfolio, not a cash reserve. Most advisors would recommend some liquid, low risk investments other than savings accounts for emergency funds. Here the bot is probably influenced by some financial literature that has a broad definition of cash, which might include money market funds, stable funds, and bonds, none of which is cash.
Items 3 and 4 are similar and misleading as stated. The answer assumes investors can successfully time the market and so can speculate when to get in and out. There are advisors who believe in this investment philosophy, but it is a highly debated subject and most evidence suggests otherwise. Items 5 and 6 are linked, and both about risk management. It is hard to make a case for cash defined as money deposited in checking or savings accounts as a diversifier. Cash is subject to inflation risk and has a low or zero nominal return, so it is dominated by other assets as an investment vehicle. Here as in item two, better risk management can be achieved with more appropriate instruments that depend on the goals of the investor and their financial situation.
Conclusions
Chat GPT is a remarkable research tool to find answers quickly. It is more than one step away from search engines because it eliminates the process of going through search results and summarizing them in a coherent way. However, it is important to recognize gaps or misunderstandings in the answers, and iterate with additional questions to iron out the wrinkles. This will be highly dependent on the expertise of the user about the subject. A DIY user can be misled if they do not recognize the inaccuracies. In this example, an uninitiated reader may be led to believe that having an amount of cash available for speculative purposes is a viable long term investment strategy, which could be an unsuitable position for many investors. The creators of the bot know that and they suggest consulting with an advisor at the end of the answer. I agree with that!
