With all the professionals holding cash when stock opportunities get scarce, you would think that maintaining a large cash position is a smart investment strategy.
Unfortunately this move costs investors billions of dollars in lost investment returns over the course of their lives and is one reason for the terrible investment returns individual investors achieve. After studying investing for nearly two decades, it’s clear that individual investors who choose to hold cash are making a major mistake.
Times are tough - markets are expensive. At the end of June 2017, Star Capital listed US markets at a cyclically adjusted price to earnings (CAPE) ratio of 28x. That’s extraordinary. The historic average is 16.8x so the market is nearly twice as expensive as its historical average based on its cyclical PE ratio. Unfortunately, America’s price to book ratio shows supports this, coming in at 3.1x versus America’s historic average (since 1979) of 2.5x.
Add to that the fact that recessions seem to occur every 4.5 years on average and that it’s been 8 years since the Great Financial Crisis… and it’s easy to see why investors are nervous.
The best course of action seems to be to step out of the market altogether, opting for a savings account or short term government debt in order to sidestep a major market meltdown. But, after some reflection, that plan has some very serious pitfalls and investors who follow that strategy run the risk of losing a large amount of money in eventual investment returns. It’s pretty clear that the the common belief that an investor should hold cash is a major investment mistake.
Let me be clear: I’m not talking about cash that you need to survive a layoff or economic problem. You should have cash set aside for an emergency. Rather, I’m specifically talking about cash held within a stock investment portfolio …keeping dry powder on hand.
The first issue with the dry powder strategy is that nobody can actually predict the market with any sort of regularity. Sure, there’s always someone who called the previous crisis correctly - but I know of nobody who has ever had a consistent record of calling crises in advance or earned a large fortune by diving in and out of the market at opportune times. They’re always a one-hit-wonder. Investors also ignore all the false positives that those same market “gurus” called previously, or since. Jim Rogers is a great example of someone who is aways calling for a massive downturn only to see the market advance.
You don’t want to base your investment decisions on someone who’s gotten it right 5 or 10% of the time. It’s just as insane to base your investment decisions on guessing that the market will tumble soon.
As I’ve written in detail before, things don’t get much better when you try to base your investment decisions on current market valuations. And this is where things get dangerous. We all invest to secure a better future, an early or comfortable retirement, or to help our loved ones out when they need it. You put this at risk when you step out of the market because you inevitably earn lower long term returns.
Take low price to book value investors, for example. Since 1926, low price to book investors earned a compound annual 20% return. These investors could have earned this return if they had remained fully invested through thick and thin, despite predictions made or crises suffered. Low price to book value investors who stepped out of the market when the CAPE ratio started to climb to 2 standard deviations earned 19.36%, while those who exited at 1 standard deviation above the mean earned 18.15%… and those who sold their positions once the CAPE ratio edged above its historic average only earned a compound 13.4%. As I showed, the more investors danced in or out of the market, the worse their long term performance.
It’s very important to understand the effect that these lower compound returns have on the size of your portfolio long term. Take a look:
$100,000 compounding for 20 years…
@ 20% = $3,833,759.99
@ 18.15% = $2,809,794.25
@ 13.4% = $1,236,690.69
You lose over $1 Million in investment savings by earning just 1.85% less over 20 years… and a staggering $2.6 Million if your returns dropped to 13.4%. When it comes to errors of omission, cash is dangerous.
Part of the problem is that a good chunk of the overall market’s return was earned in only a handful of years. As I wrote on The Broken Leg, “if you had missed the best 30 days for the ASX between August 1995 and August 2015, you would receive just a 2.7% return vs a much larger 9%.”
The same is true of value strategies. Tweedy, Browne found that 80 to 90% of an investment’s returns occur in just 2 to 7% of trading days. They later went on to write how poor their decision was to hold cash all these years, “It is a little painful for us to write this section because, in our past, we often sat on our thumbs with too much cash in clients’ portfolios before empirical research and 3 our own analysis convinced us of the error of our ways……
Over the last 22 years, the after-fee return on the portion of our clients’ portfolios invested only in stocks (not cash), 21.4%, beat the return on cash, 7.1%, by 14.3% per year.” It takes a brave investor to admit this kind of mistake.
Still not convinced? That’s fine, but realize that you could be waiting a while to get back into the market. Buffett suggests that interest rates may be low for a lot longer than we think. Since interest rates act as “financial gravity,” that suggests that stock prices could be high for some time… What would it mean to your portfolio if you sat out of the market for 10 years waiting for prices to drop back down to more modest levels?
I know what you’re thinking. Buffett, Schloss, Klarman, Munger, and others say to hold cash… so who am I to argue with them?
The reality is that they are playing a different investing game than you should be. The pros are forced to invest in large companies because of the amount of money they have to invest. They’re often forced to concentrate their investing on the top 500 or perhaps 1000 largest publicly traded companies. There is A LOT of money chasing a small number of great value opportunities given the small pool of stocks and intense competition. In that environment, it makes sense to hold cash because the alternative is buying terrible investments.
But small investors can pick from a pool of 40,000 or more publicly traded firms in the US. That grows once you start to include other trustworthy First World countries. Since most investors are following the pros into massive companies - the Wal-Marts, Amazons, or IBMs of the world - there’s thin competition among the market’s smallest firms. That means great deep value opportunities, which is why I prefer