Cash is a bad habit most investors need to kick

With the stock market pushing through to new all-time highs the idea of holding cash is coming under a great deal of scrutiny. Indeed one could argue that any “great rotation” into equities will come not from bonds but from the mountain of liquidity that has been built up over the past five years. Josh Brown at The Reformed Broker writes:

To just refer to bonds vs stocks instead of cash and bonds vs stocks is to miss the entire premise of the rotation debate to begin with. Everyone who manages and allocates portfolios in real life understands this even as many journos and analysts do not.

In my book I try to make the distinction between “cash as an investment” and “cash as an asset.” Cash has over certain time periods provided investors with real, after-tax returns. However those times are in the minority. By and large holding cash generates negative real returns. Therefore a strategic allocation to cash, above and beyond what one would need in case of an emergency, represents a large opportunity cost.

Some professional investors embrace the optionality of cash. If you view cash as simply as a residual. That is one’s cash holdings represent what is left after making positive, real investments then it makes sense to hold cash from time to time. Jay at Market Folly notes how recent Fed policy has changed how some investors view cash. Cash can play a number of roles but in the end they all bump up against the hard math of low returns. Again from my book I write:

In an ideal world, we could meet our future financial needs by investing in safe, liquid, short-term assets. Unfortunately we don’t live in that world. To generate real returns, an investor needs to take on some risk. Treating cash as a long-term investment has been historically a money-losing proposition. We can offset some of those costs by pushing out the yield curve a little bit, but this only pushes the needle so far. Cash is at best a place for nimble investors to park assets, and avoid risk, while waiting for more attractive opportunities to present themselves.

However most investors do not have the discipline to have a fully thought out strategy for employing cash on an opportunistic basis. For many cash becomes a bad habit. There is always a reasonable claim for another correction or bear market. That is the nature of markets that climb a “wall of worry.” There is ALWAYS something to worry about. The desire to flee to cash to avoid the next 5% downdraft is a gateway to a cash addiction.

We may or may not be entering a new secular bull market for stocks. Only time will tell. However those clinging to cash for the past five years will likely kick their habit at the very worst possible time. The only cure to a cash addiction is not to start in the first place. As Josh Brown notes the chances of you getting your market timing right is slim (to none):

Can you nail every 5 to 7 percent upside and downside correction in the market on a continuous basis?

You are to be congratulated if so.

But it is more likely that you cannot.

Market timing is a gateway to cash addiction. One need only look at fund return statistics to see that individual investors have a horrible tendency to buy high and sell low. Have a strategic (or even tactical) asset allocation and stick to it. Let the “professionals” wield cash in an option-like fashion. You have better things to do with your time.

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