By James B. Runey III, CFA®
During the recent market downturn, the number one question we have received is, “Should I move to all cash?”
This question is a good one and exemplary of a natural feeling investors experience to provide safety when they perceive unstable global or economic events unfolding. The reality is that the success of these switches is very low and hinges upon the investor being able to successfully time market corrections, both in getting out, and then again in getting back in.
In other words, to accurately time the market, the investor must make two consecutive correct decisions. First, the investor must correctly decide when to move into cash. However, even if the investor is correct about when to move into cash, it may not do the investor any good unless the investor also can correctly decide when to move back into investments.
Think of it this way. You are statistically much less likely to flip a coin and have it come up heads twice in a row (25%) than you are to have it come up heads only once (50%), yet that is what you must do. In order to break even, the investor must be right significantly more often than the investor is wrong.
Will you know when to get “back into the market”? Probably not, if the basis of your decision is that you need to wait for times to become more settled. By then it will be too late. You will probably have to get back in when times are at their worst, yet that is exactly why you got out of the market in the first place.
Moreover, trying to time the market is not a free ride. The average investor would tell you that their objective would be to sell at the peak and buy back in at a much lower point. However, in practice, the vast majority of investors who try to time the market will sell based on fear and wait until they feel less fearful to buy back in. This strategy most often results in buying in for a higher price than they sold for.
It is not obvious on the surface, however, when you stop to think about it, when an investor moves to an all cash position, the investor takes on an additional new risk, namely, the risk that the investor will earn a significantly lower return. The more often the investor switches to cash, the greater this risk becomes.
For example, if an investor moves into cash and avoids a 20% drop in value, but then does not move back into investments before there is a 25% increase in value, the investor has not realized any benefit.
It may surprise you to realize during periods of maximum uncertainty about the future, stocks are priced to offer investors higher returns. When there is less uncertainty, stocks are priced to offer investors lower returns because investors perceive there is less risk.
The net effect is that when movements into cash are caused by feelings of uncertainty, and movements back into investments occur when the uncertainty has dissipated, the investor is “out of the market” when returns are most likely to be high, and “in the market” when returns are most likely to be low. This situation applies to investors who are spending their assets just as it does to those who are building them.
When you factor human emotions in the equation it is ironic that oftentimes the market bottom — the “best time to buy” — is the time when people are the most fearful and things look the absolute worst.
Also consider, if your money is in a portfolio that is based on your risk tolerance — generally a combination of how well you sleep at night during market volatility and how long you will need the money — your exposure to stocks may not be as high as you assume. Generally speaking, the longer you need your money to last, the more likely you will need to earn returns better than cash to meet your goals over time.
You may have found yourself thinking the following:
“I see the market has dropped 30%. That means I have lost X amount” (where X is equal to your portfolio times 30%).
The situation above is rarely, if ever the case. As long as you, as an investor, have the proper allocation (right mix of stocks, bonds and cash), then you do not own the market – only a portion of it. So those figures quoted in the media should be less extreme in its impact on your portfolio.
Finally, most investors have this impression that once they retire, they are done investing. That is definitely not the case. You may be done adding to your investments, but your investing time horizon is still very long. It could be anywhere from 25-30 years during retirement, which is more than ample time to earn the return you need to make your money last as long as you weather the storms along the way and you monitor your portfolio spending.
In fact, what do think has a bigger impact on your financial success during retirement? The rate of return you earn or how much you spend? It is your spending, which is significantly more impactful rather than your returns. And here is the good news. You can control your spending.
Perhaps it is helpful to think of the following. If the recent market movements have you feeling as though you must move to all cash, maybe it is a signal that you might want to reevaluate your risk tolerance and asset allocation. If you move to cash, the statistics are dramatically against you.