It has been a volatile last month, especially this past Thursday and Friday. Since the July 20th highs, we have seen the S&P 500 decline more than 7% and Emerging Markets decline more than 15%. A falling market is never fun and it is often at a time like this that an investor can feel the tug of fear and uncertainty. An instinct to pull a little or maybe even a significant amount of your funds out of the market and into cash until the market blows over begins to creep in. However, there are consequences to every decision and I would argue that the consequences of holding cash could be the most dangerous of them all.
Cash as an asset class
When we talk about asset classes, generally speaking, the most commonly mentioned are stocks and bonds, but sometimes you'll hear others included such as commodities and real estate. It is possible to break the classes up even further into sub-asset classes, such as emerging stocks or inflation-protected bonds. Occasionally you will see cash listed as an additional asset class. While I believe this is well intended, my experience has shown that cash is one of the quickest routes to not only underperformance but can also create a significant amount of anxiety for investors.
I believe it is important for all investors to understand the risk of sitting in cash, inflation is the primary concern. What can happen after you sell out is that while prices are going up, your cash sits stagnant, and soon you can’t afford to maintain your lifestyle. The picture becomes clearer when you consider our current interest rate environment where saving accounts are barely out-earning the stuff-cash-under-your-mattress option. Staying in cash is one of the easiest ways to come up short in retirement, but there are other, possibly direr consequences to contend with. The danger I am concerned with in this article goes beyond the failure to keep up with inflation. I believe that cash leads to decision paralysis.
The lure of cash is easy to understand: cash doesn’t go down. Losing money hurts and one of the easiest ways to stop that hurt is to pull out of an investment. However, it is usually in these painful moments that selling is the worst decision. Take a look at the chart below:
The minus signs represent the 10 largest outflows of money from stock funds. As you can see, typically it is right as investors pull money out that the stock market recovers. This essentially locks in the losses and prevents your portfolio from recovering. But the danger doesn’t end there.
In my experience, it is actually after the sell that the anxiety really hits hard. Since everybody knows that cash loses to inflation over the long term, they know they have to reinvest. You start looking for signs that the sell-off is over, but in reality, those signs don’t exist. The market doesn’t follow a set pattern. There is nearly an infinite set of variables and trying to gauge them to know when to reinvest is impossible. Can you get lucky? Absolutely, but your retirement is not something to flip a coin on.
More likely than not, the market will recover and eventually it will pass where you sold out. You, however, will continue to wait for reassurances that the economy has truly recovered. By the time you feel confident enough to reinvest the cash, you will have missed out on significant returns. Take a look at the pluses on the chart. This is when investor flows come back into the market. As you can see, they often wait far too long into the cycle and not only have missed the returns but are now set up to fall again.
The average blended investor has returned 2.6% from 2004-2013. This is remarkable given that bonds have returned 4.6% and stocks have returned 7.4% during that same period. This massive underperformance mostly comes from investors mistiming the markets. You would think that having a professional manage you in and out of cash can be helpful right? Absolutely not. The 2.6% figure includes professional managers. Moving in and out of cash is a losing proposition for professional and retail investors alike.
So what should I do?
Stay out of cash; it really is that simple. The risk is too great and the more time you spend in cash, the greater the chance you mess up. If you or your advisor keep moving to cash as the market is selling off, stop and make a change. Great investors are not afraid of volatility, in fact, they look at volatility as the greatest opportunity to make money.
So what should you do? First, find a financial planner you trust to build you a plan. There is an optimal asset allocation out there to achieve your goals. Hopefully, once the plan is built, you can have confidence in your strategy and no longer be fearful of volatility. Then look for opportunity as sell-offs occur. At Cedarstone we use a fundamental investing approach and have an overweight in companies that we believe have been oversold in this market, especially in the energy sector. Finally, confidence is incredibly important as you invest and cash is an easy way to get robbed of that confidence. Making the hard decisions early can keep you from having to make them in a difficult market. If you or someone you know is stuck in cash, please feel free to reach out to us or a CFP® you trust. Take advantage of the down market and re-take control of your portfolio.
"Buying High and Selling Low: What the Equity Flows Show." Goldman Sachs Asset Management. July 16, 2015. https://assetmanagement.gs.com/content/gsam/us/en/advisors/resources/gsam-connect/2015/buying-high-and-selling-low-what-the-equity-flows-show.html.
Hanlon, Sean. "Why The Average Investor's Investment Return Is So Low." Forbes. April 24, 2014. http://www.forbes.com/sites/advisor/2014/04/24/why-the-average-investors-investment-return-is-so-low/.