Education

As we approach some critical dates in terms of global financial risk, I have been asked about the pros and cons of being “out of the market”. By that I mean having all or a large part of your portfolio in cash.

FOMO

The obvious disadvantage in recent times to holding cash is that it generates a very low return, but that is usually taken as read and the ‘quid pro quo” for not carrying the risk of a loss of capital value. What people worry about in addition is the possibility that the market might go up a worthwhile amount while they are not fully invested. Our old friend FOMO – the fear of missing out.

Actually, it is good that people have this worry. Recent data from the Financial Conduct Authority shows that a high proportion of people who access their pension fund to get out the tax free lump sum, then go on to leave the balance in cash or a totally unsuitable default investment fund. This really reduces the chance of their pension being even as good as an insurance company pension annuity.

Before going anyway, know from where you are starting!

For those who want to know whether it is sensible to have loads of cash, some cash or no cash in their portfolio, I would suggest that one ought to think about where we are in the market cycle. In other words how are markets valued – have they been going up for ages, have they just collapsed, or something else?

An example

I will explain this with an example. Let’s say there is 40% of a well diversified portfolio in cash The rest is exposed to what we will call the ‘market’ although in reality returns will come as an average from lots of differing assets.

Let us say ‘markets’ are currently near an all time peak and we assess the possible further increase in the next 12 months as being a maximum of 10% – we read of strategists predicting “high single digit returns’ (they really do say that sort of thing).

So if 40% of our money misses out on a 10% return, we will only get 6%. and will have missed out on 4%.

If the market is really high, we can say from past experience that a setback of 30% plus is also entirely feasible. If the market fell 30%, we would lose 60% of 30%, so 18%. That means our cash reserve has ‘earned’ 12%: the amount we did not lose.

Clearly in this example, which reflects where we are now in my opinion, the risk/return ratio is not symmetrical. There is a better risk/return ratio on holding cash than not.

Why then would I not suggest holding 100% cash? The reason is that if we had all the portfolio in cash the ‘missed return’ if the market went up would be the full 10% and that might be psychologically painful. In other words, we need to get as near as we can to having our cake and eating it, or to hedge our bets and the desired balance will vary from person to person.

Some people might say it is fine to miss out on 10% upside after a very good run, rather than take the risk of a 30% loss, especially if they need access to the investment quite soon.

I must emphasise that if markets had recently sold off, like in 2008, the estimates in the example would have to be quite different. Perhaps not surprisingly, at such times people want to carry on holding cash (another recognised psychological bias) and in fact they really need to be brave.

Surely, there is a clever option?

It would be great if there were assets you could buy that gave you a modest return and went in the opposite direction to the main investment markets. Clever people have been working on that for many years and almost completely failed. What is available is complicated and hard to analyse. I have commented on Absolute Return funds in other posts and the article ‘Real World Risk’ may interest you.

Even if you could buy an asset that always went in exactly the opposite directions to stock markets (to a degree you can if you understand derivatives), then if you put 50% of your money into that asset you would only ever make a zero or lower (because of costs) return because the two parts would cancel each other out!

Cash is still the best defensive asset and the opportunity cost of holding it is best thought of as an insurance premium well worth paying when risks are high.

With insurance, when the house has burned down to the ground, you don’t pay the premium again until you have re-invested in a new structure! If the site is just a charred heap of rubble or two years, there is no need for insurance. So after a market sell off, cash can get switched to assets that are nice and cheap!

There are other ways of dealing with the loss of return from a cash element in a portfolio notably the ‘bar bell’ approach, where some high risk assets are retained at the other end of the portfolio volatility range and then if markets do shoot up, they make a geared return that compensates for the dull cash element not contributing much. Because the return is ‘geared’, or much greater than the market average, you don’t need to have as much money in such assets and if things go wrong you won’t lose much.

Such strategies require a good knowledge of markets and asset types or a skilled adviser. Some ready made multi asset funds will use this strategy, but it is not commonplace.

In conclusion

In simple terms, a good adviser will help you fight your natural psychological biases. You will need to hold cash after making sales to bank profits following long periods of growth and conversely to invest rapidly after a market sell off. You won’t want to do either, but if you can be persuaded, your long term returns will be rather better.