At any given point in time, the amount of cash you are sitting on has a huge impact on your future returns.
The market has had such a great run, not just this year but over the past 5 years, that it’s easy to get seduced by the bearish mantra of “we’re overdue for a crash.” Don’t fall for it. Smart investors understand that it’s not what happened in the past that matters to what happens in the future. It’s what investors as a group think is likely to happen, based on the health of the economy, and where we are in the business cycle. Getting out of stocks just because the market has been on a winning streak is not the way successful investors think.
In a year in which stocks have generated 25%-plus returns, many investors who loaded up on cash as a result of the last financial crisis might be wondering why they ever went ultra-conservative. Stocks, after all, tend to have an upward bias and have not been anywhere near the level of overvaluation that we saw in 2000 and 2007.
Seth J. Masters, the chief investment officer with Bernstein Global Wealth Management, a unit of AllianceBernstein, writes that “investors need to maintain an appropriate allocation to return-seeking investments such as stocks to reach their financial goals.”
After pointing to the folly of following the crowd by shifting assets into hot sectors s, (e.g. the move into dividend stocks in early 2013), he concludes “a more effective (and safer) approach is to establish your own investment strategy based on your circumstances, risk tolerance and market fundamentals, and to stick to it no matter what the crowd does.”
Masters also argues that “diversification means owning some things that underperform.” He cautions against selling off the portion of the portfolio devoted to non-U.S. stock markets, which sharply underperformed the S&P 500 in the past year.
“Next year, either developed international stocks or emerging-market stocks could end up on top,” he writes. “The real lesson here is that you can’t predict what’s going to do well in the future, so owning a laggard at any moment in time is critical to diversification.”
As far as Barry Ritholtz, the money manager and prolific financial blogger, is concerned, one big lesson coming out of the past year is how overinvested in cash many investors have become.
In a piece in the Washington Post that ran over the weekend, he refers to a recent BlackRock worldwide survey of investor attitudes which concluded that 48% of U.S. respondents’ investible assets are in cash deposits and savings accounts, and an additional 12% are in money-market accounts and certificates of deposit.
According to BlackRock, “despite their widespread pessimism about meeting long-term financial goals, half of respondents intend to stand pat over the coming year, while another third actually plan to increase their cash holdings.”
Ritholtz argues that holding on to that much cash is a mistake for most regular investors who lack the discipline of putting cash to work when stocks get undervalued. Exceptionally skilled investors are good at gradually selling into long bull market runs, and then waiting patiently to put that cash back to work when the right opportunity presents itself.
But most investors, Ritholtz writes, don’t know how to use cash opportunistically and it ends up sitting in a portfolio and dragging down returns for the long run.
Ritholtz goes on to say that most investors should be fully invested now, and only hold a small percentage of their money in cash. But there’s also a risk from being too aggressive (not holding enough cash) when the market is fully valued, as I think it is right now. There is a happy medium.
According to John Coumarianos, the founder of the Institutional Imperative blog, “Even if Ritholtz is correct that this rally is hated (and it would be the first time people got less excited, not more, as prices rose in my experience), shouldn’t higher prices beget some skepticism? Do you really want to pay more for the merchandise you buy? Don’t the best investors tap dance when prices get lower instead of higher?
The point is this – holding 48% of your assets in cash is way too conservative for all but the most savvy and opportunistic investors. If you are fearful of a big correction, 10% to 20% is all you really need. As long as the threat of a new recession is small, as it is right now, the odds of a major peak in the stock market are even smaller.