Although investing entails uncertainty, there are things you can do that definitely make you a better investor, e.g., lowering the markups or markdowns you pay on certain fixed-income transactions and lowering the expense ratios you pay on index funds. Usually minimizing the amount of cash you keep on hand is one of these things.
It is not uncommon to hear or see people talk or write about how they are adding to their cash position because they are concerned about this or that (e.g., U.S. fiscal cliff), waiting for this or that (e.g., a 10% stock market correction), et cetera. Usually, the person talking or writing comes off as intelligent, as, even though they may not be correct in adding to their cash position, they describe a legitimate concern or possibility in support of the move. For the vast majority of retail investors, however, adding to your cash position, or, even, maintaining a substantial cash position, is best avoided. There are two reasons for this.
(1) Retail investors are, generally, relatively bad at determining things like whether the stock market is going to rise or fall in the nearer-term. It has been shown that retail investors mistime the stock market more than they time it. Retail investors tend to give too much weight to what occurred more recently, versus what occurred historically, how well-priced investments are now, and what investments are likely to do in the future. The fact that retail investors did not jump back into the stock markets to the extent they should have in 2009 when the markets bottomed is one of a plethora of examples of this. The fact that retail investors are currently behind in making their fixed-income investments to-maturity-then-cash investments is another. Also, retail investors react too much to news that they do not or cannot, due to a lack accurate details at the moment, sufficiently understand; and they sometimes fail to understand that the news is already priced-in or overly priced-in. More so than other investors, retail investors do not like uncertainty; but uncertainty leads to miss-pricings that should be taken advantage of, not furthered.
(2) True investments, like fixed-income and stock investments, are designed to produce a profit. The smaller the amount you have invested and/or the less time you spend invested (and, hence, the more cash you maintain), the less exposed you are to this profit. If you are neutral at timing markets, you cost yourself money in attempting to time markets by being in cash. You need to be significantly better than neutral at timing markets to make money in attempting to time markets by being in cash. If you regularly maintain a substantial cash position, this is money that is not working for you as it could. The larger the cash position you regularly maintain, the lower your profit will tend to be over the long haul.
A relatively simple example well-illustrates the impact of an investor, who is neutral at market timing, maintaining a substantial cash position. Let us assume you recently retired, you have a $750,000 investment portfolio, you are going to spend $30,000 a year in today’s dollars of this portfolio for living (and partying) expenses, a 2% inflation rate, and the invested portion of your portfolio will earn 6% in the first year descending down evenly to 2% at the end of the life of the portfolio. Also, let us assume you will earn 0% on your cash going forward―which is about true today, but is a condition that will not last forever.
|Year||Portfolio Change Given the % Invested|
As you can see above, the negative effect of maintaining a substantial cash position, whether you do so on a regular basis or via jumping in and out of the markets, compounds over time. In the example above, if you maintain a 0% cash position, your portfolio lasts about 42 years. If you maintain a 25% cash position, your portfolio lasts about 31 years. With a 25% cash position, you need to lower spending by about $6,000 a year in today’s dollars to make the portfolio last 42 years. If the person in the example passes away after 25 years, with a 0% cash position, they will have more money than they originally had to hand off to their children, donate to charity, et cetera. With a 25% cash position, well over half of the original portfolio will be unavailable to hand off.
Yes, you will have less volatility in your portfolio if you maintain more cash; but part of being a good investor is accepting uncertainty to an extent. If an investment is too risky to be appropriate for you, invest in something less risky. Some investments, like CDs, when you do not have too much money invested in a single financial institution, are no riskier than cash.
Yes, the example above is too simple in that, in reality, markets move up and down, versus on a straight line. Your investments will not earn 6% to 2% a year (or some like figure) every year. Sometimes your investments will earn more, and sometimes they will earn less. Sometimes you will have a negative return. Regardless, the negative effect of maintaining a substantial cash position remains. If the invested portion of your portfolio performs better in the early years, the negative effect of maintaining a substantial cash position tends to be greater. If the invested portion of your portfolio performs worse in the early years, the negative effect of maintaining a substantial cash position tends to be less.
Some people think that maintaining various substantial levels of cash is good because it enables them to readily invest in good opportunities when they arise. Unless you already have the cash and the opportunity is relatively around the corner, it is better to be invested in something else good until you are ready to pull the trigger on the new investment. You may never make the new investment. Even if you do, if you had cash waiting in support of making the investment, you probably lost earnings in having the cash waiting. It is generally better to remain fully invested and, when you want to make a new investment, sell something to enable the new investment. You do not need to have cash waiting to make new investments.
For some people, having cash on hand to live off of is an issue. This is less of a concern now than it was in the past. For example, you can generate the cash to pay additional living expenses by selling some stock or stock ETF shares each month. This is definitely practical if you get free trades, as many of us now do. Sometimes prices are up when you sell, and sometimes prices are down. Over time, your luck tends to even out regarding this.
Above I wrote that cash should be usually minimized or avoided. These words were carefully chosen. I did not say you should never maintain a substantial cash position. There are exceptional situations where it this warranted. A fairly recent big example involved the U.S. financial crisis. A recent small example involved the possibility of municipal bonds interest being taxed.
During the stock market collapse in late 2008 and early 2009, many people established and held a substantial cash position. It became clear that stock prices were likely to continue to fall, and that it was probably better to be on the sidelines for a while waiting for what seemed to be a bottom. There is rarely a genuinely clear likely stock market direction, other than choppily up, but this was one of those instances. The problem is that it can often seem like you know which direction prices are likely headed in, but you do not. Jim Cramer advised certain investors to sell stock holdings during the collapse. Unfortunately, Mr. Cramer did not advise these investors to reenter the market until prices had returned to about where they were when he advised them to sell. You would have done equally well staying invested. If you reinvested nearer the bottom, though, you benefitted.
More recently, there has been talk in Washington about limiting or ending the tax break on municipal bond interest. At least one source said the odds of this occurring were about 30%. If one of your municipal bonds matured, you are in a high tax bracket, and, instead of immediately rolling the returned principal into another municipal bond, you waited a couple of weeks to see if the 2013 budget agreement would change the municipal bond tax rate, you may have been smart to do so.
Do not maintain a substantial cash position on a regular basis. If you do so, you very likely lessen the amount you will earn over time. If you are considering establishing and maintaining a substantial cash position for a while, ask yourself how certain you actually are maintaining the position will be advantageous. If your actual certainty is not strong, stick with the simple rule of thumb that it is better to be invested in something good than not invested.