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.
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.
ReplyDeleteHi Daniel,
ReplyDeleteYes 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.
Cheers,
Mark