Should you hold cash in your portfolio?

Ben Carlson, Director of Institutional Asset Management at Ritholtz Wealth Management, points to the psychological impact of holding cash while waiting for a correction to enter the market.
By Morningstar |  21-11-18 | 
 

In 2015, Ben Carlson wrote a post titled The Psychology of Sitting in Cash. He begins the post with a query from a reader who feared that the market was too high and was waiting on the sidelines with cash to enter at the next correction: How do I proceed from the position I have of feet embedded in concrete?

Here are some of his observations:

The problem is not just sitting in cash per say. It’s really the mind-games that come about as a result of making a binary decision to go all-in or all-out.

Tadas Viskanta from Abnormal Returns put it best when he wrote: Market timing is a gateway to cash addiction.

And that’s one of the biggest issues when you pull the trigger and go to all cash. It turns psychological warfare in your own head because there are always going to be good reasons to wait for a better buying opportunity. When stocks go up, you tell yourself you’ll wait for a correction and when stocks fall, you tell yourself you’ll wait for them to drop just a little further.

It’s easy to look back on it now and say how much of a lay-up it was to invest at the depths of the market crash in early 2009, but there weren’t too many people saying things were all clear at the time. Investors were scared and constantly waiting for the next shoe to drop. Ever since the recovery started people have been doubting its legitimacy. Pundits have been scaring people away with predictions of double dip recessions, hyperinflation and the collapse of the U.S. dollar.

Don’t let anyone tell you investing in this bull market has been easy. It hasn’t, but really, it never is.

Sitting on a pile of cash has nothing to do with the financial markets and everything to do with human psychology.

Readers told me that they had rules in place based on technicals or moving averages that would give them a signal that would tell them when to get back into the market. But when those thresholds were hit, the fear of coming off the sidelines was too much to handle.

When readers ask me what they should do when they’re in this position I can never fully answer their question because everyone’s situation and risk tolerance is different. My response is always that whatever you choose to do — dollar cost average over time, wait for a market correction, put it all back in at once, hire a professional — try to have a plan of attack that you can follow. It’s no good to create a plan that you have no chance of actually seeing through because you become paralyzed by fear or greed.

This dilemma has nothing to do with cash as an investment option. Or the current stock market valuations. Or the opportunities cash can bring about in a market crash or correction. Those things can be important to understand, but they don’t really matter if thinking about them causes you mental anguish and leaves your feet stuck in the concrete.

It’s about having the ability to get over the fear of allowing market forces stop you from implementing an investment plan.

In October 2018, Ben Carlson revisited the subject in a post titled The Psychology of Sitting in Cash, Part Deux. He noted that there were plenty of opportunities over these past few years to enter the market at dips. And if the concerned individuals never took advantage of those corrections and are in cash, things have gotten even more painful as the S&P 500 was up a little more than 40% in total or just shy of 10% annually since he wrote that piece.

Here he points to some considerations of those who are sitting on a big pile of cash or are thinking about raising cash now that we’re in the midst of another correction:

Corrections and bear markets don’t make it any easier to pull the trigger. 

You would assume it becomes easier to buy stocks when they’re falling but cash is a comfortable place to be during a correction. It’s like you’re tucked in under your warm comforter on a freezing Saturday morning in the winter and you never want to get out of bed. When stocks begin to fall, that comfort can lead to a cash addiction where you keep telling yourself you’ll buy when stocks fall a little further or the dust settles. And each time they fall you move that hurdle to buy just a little higher until you’re never able to pull the trigger.

When you consistently hold a large majority of your entire portfolio in cash all it does is add pressure to the timing of your buy and sell decisions.

Let’s say you sold out of your stocks after the lights out year in 2013 that saw the S&P 500 rise more than 30%. “Too far, too fast,” you may have thought to yourself. Since 2014 the S&P is up around 60% or so. Just to get back to those levels where you got out, stocks would have to drop 35%. Waiting for this type of pullback can wreak havoc on your psyche when it doesn’t come right away.

Let’s say you did sell out and plan to wait so you can break even on this timing trade. Making your buy decision strictly based on when you sold will likely only compound the issue. Make your investment decisions based on the present, and more importantly the future, not the past. Anchoring to previous market levels is a good way to compound previous mistakes.

Timing the market requires being right twice. 

It’s hard enough to nail one correct call about the markets in terms of magnitude and direction. A handful of people seemingly nailed the call to sell risk assets leading up to the financial crisis. You could probably count the people on one hand who correctly made that sell call who also made a buy call on the other side.

Most simply clung to their bunker mentality and couldn’t bring themselves to see a light at the end of the tunnel. The worst part about going all-in or all-out is you have to get both of those decisions right to succeed. This is not easy to say the least.

Extreme positions in the markets can be addicting. 

There’s nothing in the investor’s handbook that says you need to be all-in or all-out to succeed. Investing is a game which is won by those who think using probabilities, not certainty. No one is smart enough do the red light/green light thing where you’re consistently trying to figure out when to go all-in and when to fold. Markets are rarely black or white and the ability to stay in the game often requires a delicate balance between many competing forces.

There are no perfect allocations or times to invest in risk assets. These things only get known with the benefit of hindsight.

The greatest investors in the world have a difficult time predicting the direction of the markets and the timing of those moves. The fact that so many professional investors are wrong on a consistent basis should be a clear signal that humility should be your default position when thinking about trying to outsmart the markets.

Figure out an allocation that works for you and avoid guessing what will happen based on your feelings.

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