Tuesday, 11 August 2015

Portfolio Construction - Holding Too Much Cash?

In part two of my series on improving portfolio construction I raised the issue of why would you hold any asset that has a low return. The corollary of this is that why would you hold significant portion of your assets in the low risk but low return cash?

The average private investor holds quite a lot of cash. The AAII asset allocation survey puts the average at 24% over the last 30 years. Given that the average equity fund held just 3.5% in cash and both equities & bonds have outperformed cash over most long periods Cullen Roche makes the argument that this is one of the main reasons that private investors underperform their professional equivalents:

Now a sensible investor will of course have cash holdings for any short and medium-term expenses and will only invest long-term in the stock market. However the AAII survey is looking at investors dealing accounts so this is primarily cash that is looking for an investment home but not found one.

So why do private investors tend to hold so much cash? Cullen Roche suggests that this is short-term thinking with investors (over-) valuing the certainty of large cash holdings. While I’m sure this is true I think there is a subtler effect at play here as well. When you ask investors why they hold cash it is usually to take advantage of market weakness.

We feel clever when the market sells off and we are holding a lot of cash and dumb when we are fully invested!

While the aim is laudable we pay a high price for this feeling. The problem is that the average investor is very bad at calling the short time direction of the market. They spot too many crises and sell up too often. A problem originating from our history as hunter-gatherers. If you spotted an imaginary tiger in the jungle and ran away the consequences were a bit of unnecessary spent energy. However if you failed to spot a real tiger the consequences for you would be very severe. Hence we tend to see tigers in the market far more often than they actually appear.

Then compounding this error we succumb to fear and fail to actually buy on real market weakness. A number of investors spotted the 2008 financial crisis, realised its severity, and sold all their equities. However it's a much smaller number who then spotted that the market was historically cheap in the spring of 2009 and reinvested. There are many who missed out on the early rises and never got back in. Given that the FTSE total return index has returned c.40% since end of 2007 and cash has paid virtually zero in this time even these most prescient of investors may have been better off simply remaining fully invested.

I think the only time that one should hold a significant proportion of cash is when one cannot find any investments that are potentially undervalued with a margin of safety. Given the cyclical nature of the most industries and market sectors it is rare to find a time that the overall market valuation provides no scope for investment opportunities. I'm not saying that the indices are always a buy just that if you are a stock picker you should be deploying your capital into undervalued stocks not holding large amounts of cash hoping for a market crash.

And while having some cash on hand to take advantage of market weakness can be a good strategy it only works if you have the mental strength to deploy it when the market does sell off. So if you are holding a large amount of cash you should ask yourself if you have a good record of identifying when assets are over-priced? And do you have a good track record of actually deploying that capital quickly on market weakness? Unless you can answer both questions positively you may be better off simply remaining fully invested and heeding the old adage that it’s time in the market not timing the market that really pays off.


  1. Th problem right now is that I find my view of what IS cheap compromise by high market valuations.That suggests that the market must be too high.

  2. Hi Daniel,

    Yes you may be right - a form of anchoring where the companies that appear cheap only do so in comparison to vastly overpriced peers. However equally you could be suffering from a form of anchoring on valuations that may have been cheap over the last few years and now everthing seems expensive in comparison. It's actually quite hard to tell the difference and the point of my article is that unless you have a history of calling it well believing too strongly either way can easily lead you astray.

    Also if, as a stock-picker, you become too focused on the overall level of the market you can miss opportunities. Although the indices peaked in 2000 led by the tech boom there were old industry value stocks selling at historically low values and the likes of Warren Buffett did very well even as the indices fell heavily. Today the multiples of the large recently IPO'ed growth companies can seem high but that certainly isn't the case in the Oil & Gas or Mining sectors at the moment. That's not a recommendation because the low prices may be a fair reflection of the current commodity pricing environment I'm just pointing out that sentiment & valuation can be company and sector specific even in in times of very high and low index pricing.