Andrew Lill is Chief Investment Officer at Morningstar Investment Management, Australia, does concede that holding too much cash is not a good idea over the long term, but it has its role as a defensive option.
Cash as an asset class has a bit of a bad reputation when it comes to investing. Thanks to inflation, cash offers a negative real rate of return. As an investor, is there a good time to hold cash?
That's right. Clearly, cash is not an asset that a long-term professional investor wants to have in their portfolio forever. However, cash does have two great advantages going for it.
The first is liquidity and optionality to invest quickly when markets become dislocated and there's a great opportunity to invest overnight.
The second, even though most investors chase those returns of the equity markets in general, the reward that you get for taking investment risk is much lower than it has been for the last decade. Therefore, in that regard, you are better off taking lower risk and getting that reward that you do for cash right now.
It basically all boils down to valuations. As a contrarian, valuation-driven investor, what you are basically saying is that equity markets look pretty overvalued and cash might be even a safer place to be?
That's right.
So, a valuation-based investor focuses on the future rather than the past, thinks about what are the asset classes that are going to be able to pay off the best from this day given the valuations we have today going forward.
Particularly in the U.S. where cash rates are rising quite quickly, there's a much better opportunity right now than investing in U.S. equities even though for most investors they think that U.S. equities are the place to be right now. That's what I mean by contrarian; thinking about the future and not the past and being prepared to be different.
I suppose what you are waiting for is for those markets to correct, be it because of a macroeconomic event or a central bank policy or even just markets overinflating and collapsing, and then you are going to put that cash to work?
That's certainly Plan A.
Plan B will also involve – well, let's say that other markets compared to the U.S. become a lot more attractive, then actually even though the U.S. doesn't correct, we can put that cash to work in other markets. And we find that while generally around developed markets, they move in unison within markets, particularly in sectors, there tends to be quite a large dispersion between the best-performing sector and the worst-performing sector in any period. And if you are investing in sometimes the worst-performing sector, but it has good fundamental strength going forward, it offers the best return. It's actually better to invest in poorer-quality investments when they are priced to be very poor than it is to invest in good-quality investments when they are priced to be very, very good.
As a professional investor, it's easy for you to say be nimble, have cash ready, invest on the dips, because you are sitting waiting for those dips. For the individual investor, timing the market is near impossible.
Could you argue that it would be better to drip feed over a long period of time on a regular basis, so you almost accidentally catch those dips?
That's certainly one way of doing it. And you know, all we would say is that if you watch kind of the most successful investors over time, the likes of Warren Buffett and others, they tend to be following that mantra of buy when the fear is highest and effectively sell when things look a lot more kind of comfortable.
And so, if you start to sell when the market looks very strong and comfortable, you are effectively doing the same thing as a Warren Buffett.
Dan Kemp, the chief investment officer for Morningstar Investment Management - EMEA, too has a view on cash in the portfolio.
We're not constrained to some sort of benchmark. We look for opportunities to invest people's capital to deliver a return that’s better than the risk they are taking. When stock prices are so elevated that there are very few opportunities, in that situation it's good to have some cash to keep your powder dry and look for better opportunities.
We have to remember that although cash is quite a safe investment in the short term. It's very, very dangerous in the long term. So people shouldn’t be complacent about holding it. But it’s a great way of holding your money once you've used all the opportunities that you see that were available, then to hold back and wait for new opportunities to appear.
The cash is king adage reflects our behavioral biases.
Loss aversion: we hate losing money much more than we enjoy making it. And value protection probably more than we should. Hence money is kept in the bank.
Temporal myopia: we tend to focus on the short term rather than the long term. So, we much rather as humans surety in the short term than the possibility of much more gain in the long term. And that's a bias that we need to overcome, as investors we constantly need rethinking about the long term rather than just the short term.
Cash has a role, but focus on the long term and remember that we have these biases that lead us in the wrong directions.
The above interactions took place with Emma Wall, senior international editor for Morningstar.
They have been played up on Morningstar.co.uk, Morningstar.com.au and Morningstar.com
