Holding cash may mean risky business

Below is a commentary I wrote that was published by The Straits Times here

The renewed decline in yields and cash rates across global markets in recent weeks leaves investors in a conundrum.

The safest assets, like cash and government bonds, now guarantee real (or inflation adjusted) wealth destruction if held to maturity. Non-dollar bonds in developed markets even have a negative nominal yield, on average.

Meanwhile, more volatile assets, like equities, seem vulnerable to a myriad of risks, ranging from global recession, to a US-China trade war, to Brexit.

It is more important than ever to have a clear idea how much money you really need to keep in safe assets.

It is therefore more important than ever to have a clear idea how much money you really need to keep in safe assets, which means accepting negative real yields, and how much you can afford to invest for the long term in higher return, but higher volatility assets, like real estate, private markets, or equities exposed to sustainable trends or long-term themes like emerging market infrastructure.

In most cases, holding five years' worth of net expenses (after deducting your regular income) in liquid cash and short-term bonds is more than sufficient to cover your near-term liquidity needs. Since 1945, a diversified 60:40 portfolio of US stocks and bonds has never been underwater for more than four years. With five years' worth held in liquid assets, investors would never have been forced to sell their portfolio at a loss to fund their needs.

Behavioral traps can do most harm

Yet we find that many investors continue to hold far more cash in their portfolios than this. And this isn't because they think it's a good idea.

Our recent Investor Sentiment Survey showed that 73% of investors globally do not consider cash as the safest investment for the long term, instead favoring investments like stocks and bonds (48%) or real estate (26%). Yet average cash holdings among investors surveyed in our Q3 Investment Sentiment Survey were 26%.

The only explanation is that investors are falling prey to "behavioral biases", such as loss aversion and decision paralysis, which over a long enough time period can do more harm to an investors' wealth than any stock market crash.

One of the biggest reasons why investors hold a high amount of cash is "waiting for the right investment opportunity", cited by 48% of investors in our survey.

But such drawdowns tend to be much less common than many investors think. Since 1945, investors in a simple balanced portfolio (60% US large-cap equity, 40% US government bonds) would have never seen their investment trade in the red from the original purchase price in 35% of cases, and would only have seen a greater-than-20% portfolio loss in about 5% of cases. The result is that investors waiting for the right opportunity often face the worst of both worlds: a high opportunity cost, and being forced to eventually buy at even higher levels.

73% of investors globally do not consider cash as the safest investment for the long term.

Another reason cited by 42% of investors was "protection against a market downturn". Downturns are, of course, a valid concern. But cash is an inefficient way of managing portfolio downside risk over the long term. Cash reduces the portfolio's return during bull markets, and provides very little "crisis alpha" during market drawdowns: cash holds its value very well over the short term, but doesn't appreciate when markets fall.

Over a third of investors say that cash "helps them sleep at night". Cash offers a stable return profile, so it helps investors be more certain about the future nominal value of their cash. But, in a negative real yield world, depending on how much of their portfolios they spend each year, investors may in fact be sleepwalking into depleting their portfolio.

The good news is that there are simple steps investors can take to overcome these biases.

Discipline, rebalancing and diversification

1. The first is to acknowledge that ad-hoc market timing is almost impossible, and focus on disciplined, systematic strategies. One such strategy that all investors can do is rebalancing. By rebalancing equity holdings back to a target allocation within your portfolio on a regular basis, investors can ensure they are always "buying the dips" and "selling the rallies", without having to second guess the next presidential tweet or central bank policy move.
2. Second is to look to use diversification to insulate your portfolio against market shocks, rather than cash. Diversified portfolios that hold longer-duration high grade bonds alongside equities have historically provided much better portfolio protection than cash in the event of stock market declines. Despite low yields, this is still proving to be the case – long-duration government bonds have been among the best-performing assets amid the recent market volatility.
3. Third is to remember that volatility and risk are not the same thing. Volatility is how much an asset moves up and down day-to-day. Risk is the probability that you fail to meet your objectives. The least volatile assets, like cash, by failing to grow, may actually increase the risk you fail to meet a target you have, like buying a vacation home. Meanwhile the most volatile assets, like equities, may be the only investments that provide the growth you need to reduce the risk you run out of money in your retirement. Investors should ensure they have a healthy mix of volatile and less volatile assets in their portfolio to combine stability and growth.

Unorthodox monetary policy has turned much of traditional financial theory upside down. The idea that cash, the least volatile asset, may in fact be the most risky, could be just the latest.

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