Holding too much cash: the peril of playing it safe

Cash is hard to get right. If the market crashes, you wish you had more of it; if it goes up, you regret holding so much.

July’s rally was a fine example of this dilemma. US stocks rose by 9% – one of the all-time best months – yet just 28% of large-cap fund managers beat their benchmarks, according to Bank of America. Growth, value and core (ie, neither growth nor value) managers all underperformed, seemingly because they had too much squirrelled away in cash and deployed too little as the market rose.

The fundamental problem is that holding cash has been a losing game in the past few decades. Global stocks have risen strongly over time – even if individual markets such as UK large caps have sometimes trod water – so keeping money out of the market has been a drag on returns.

Yes, a few bear markets presented great buying opportunities for those who had cash to deploy – but to take advantage of them, you needed to get two calls right: you must sell close(ish) to the top and buy close(ish) to the bottom. Few of us can consistently do so. I was fortunate enough to lighten up on stocks at the start of 2020 and start adding back in the summer, but that may have been more luck than judgement. I certainly didn’t repeat the trick so well in the latest crash.

Staying invested

Thus the advice is to remain invested at all times. Private investors will want to hold some cash to cover expected or unexpected expenses and to have dry powder for opportunistic investments – but we’ve talking maybe 5%-10% of a portfolio at most (depending on portfolio size).

But these rules of thumb have evolved in a 40-year uptrend. In a side-to-side ranging market such as the 1970s where stocks get steadily cheaper, the potential gain from holding a lot more cash for longer and eventually picking up bargains is much higher. So in a true 1970s scenario, our assumptions about how long to hold cash might change.

However, for most of the 1970s, interest rates were high enough that cash could match inflation. Today, they are still near record lows.

Inflation of 10% in the UK means cash loses 8%-9% per year in real terms. If stocks do a bit better than that – and as real assets, you would expect them to do so – they still look less awful. This suggests that interest rates need to go much higher than central banks are currently implying to wallop stocks 1970s-style by creating a mass flight into cash. That could happen, but I wouldn’t bank on it yet.

The most attractive compromise looks like stocks with steady dividends (not very high-yield ones with insecure payouts or zero-growth), which should at least keep throwing off cash that can be reinvested at lower valuations if the market ranges up and down for years. It won’t protect you from short-term sell-offs – but it’s easier than trying to time the market.

SEE ALSO:

The ten highest dividend yields in the FTSE 100
The ten highest dividend yields in the FTSE 250
The ten investment trusts with the highest dividend yields