Over long enough time periods, the stock market has always performed well. There are plenty of bumps and bruises along the way, but the overall trend has always been up and to the right. In fact, the worst total return in history over a 20-year period was +54%. The worst 30-year return was +854%. We’ve all seen images like the one below that show this never-ending march up.
Even when markets are high, as many people believe them to be now, the future expected returns from the stock market are still positive. I think this is an important distinction because I’ve talked to many people who think that because the market is high a crash must be inevitable and thus future returns will be negative. If the market is in fact too high right now (which we won’t know for another 5-10 years when we can look back), that means that future returns will be lower than historical averages—but not negative. Though I don’t put much value in people’s opinions who try to estimate future stock market returns, almost all of the estimates I’ve seen are in the low to mid-single digits—call it 4%. 4% isn’t great, but it’s a hell of a lot better than earning 0% in cash.
If the above is true and the stock market always has a positive expected value, shouldn’t we always be 100% invested? The usual reasons given from investors (myself included) to hold cash are:
- Cash is optionality. If the market tanks, holding cash allows us to be nimble and quickly take advantage of cheap stocks.
- There is nothing cheap to invest in (definitely been here before, like, right now for example).
- Behavioral / psychological reasons (peace of mind, etc).
The third one is very personal to each person’s situation and mindset, but I’m not sure the first two hold up to scrutiny. If the broad market is a bet that wins more often than not and it’s a bet we can always make, then anytime we want to own cash, shouldn’t we just own a broad stock market index fund like SPY instead (SPY is an index fund that tracks the S&P 500)? On the first point from above, SPY might as well have the same optionality as cash because I can buy and sell it instantly (SPY’s average daily volume the past three months is over $20 billion dollars). On the second point, even if there are no good individual stocks to invest in, a broad stock market index fund that has a positive expected value is better than cash at 0%.
Whether conscious or subconscious, I feel like a lot of investors (again, myself included) actually hold cash as a way to time the market (even though none of us claim to do it, maybe some cognitive dissonance here) or because we manage other people’s money and are embarrassed to invest in an index fund (which makes sense, paying someone to invest in an index fund does sound pretty stupid). But market timing and/or pressure from outside investors aren’t great reasons. I believe very, very few people can time the stock market consistently and thus the rest of us should probably just be 100% invested and benefit from the market’s inevitable march upwards over the long-term.
If an investor averages a 10% cash position per year (which is low for a lot of investors) and the stock market returns 8% per year over the long-term, that investor is costing themselves 0.8% per year by not putting their cash into a broad market index fund. If the starting account value was $100,000 and 10% was in cash, that’d be $10,000 in cash to start. If the $10,000 is always invested in broad market index funds earning 8% on average, that $10,000 would grow to over $43,000 by year 20. If put in cash, that $10,000 would grow to exactly $10,000 by year 20. Ok, you’d probably get a little interest on the cash. If the cash was able to somehow earn 1% per year, it would grow to just over $12,000 by year 20. $43,000 vs $12,000 is a big difference! Missing out on 0.8% per year doesn’t sound like a big deal, but it can add up to a lot of money.
I asked several money managers I talk to about their views on holding cash and got some quality input. I thought Fred Liu did a great job of describing the trade-off mathematically:
“The other way to think about it is yes, you’re giving up say 8% a year, with the trade-off that a recession / bear-market should bring it down (call it) 40%. With the assumption you can call a bottom (a big assumption), you’re basically assuming a bear market will come in the next 4.5 years, if you’re holding cash today. But note at the core, this is a market timing call.”
My take away is that for it to be mathematically correct to hold a meaningful cash position, one has to believe the market is going to have frequent and/or very deep downturns. The above also generously assumes the person invests their cash position near the market bottom, which we know isn’t usually the case. A lot of investors would actually have a bigger cash position at the bottom because the 40% drop they just experienced scared the shit out of them. I think an attitude of always being 100% invested can protect a lot of investors from these kinds of behaviors and cognitive biases that can hurt their long-term results.
Of the money managers I talked to about this, every single one cited some sort of behavioral or psychological reason for wanting to hold cash. Samir Patel brought up an interesting point that I hadn’t considered myself:
“In theory you always want to swap the apparent 17% IRR for the apparent 21.6% IRR, but in practice I find that it’s usually hard to value things that precisely or anticipate when that value will be realized. As such, I find it hard to rob Peter to pay Paul – it’s easier for me to manage the portfolio when the decision to buy/sell one stock is mostly discrete from another (assuming no overlapping exposure, i.e., if I own FOGO, I don’t also want to buy a bunch of some other restaurant.).”
I think that makes a lot of sense. I’ve gone through that process many times where I’m 100% invested and want to add a new position. Then, I have to figure out what holdings to trim or sell completely to make room for that new position. That decision making process may very well be improved if those buy and sell decisions are completely discrete and not influenced by each other.
Two other investors I talked to about this brought up holding Berkshire Hathaway as a placeholder for cash, but they also mentioned that selling Berkshire may be difficult to replace with another company (that isn’t run by arguably the best investor of all-time). Thus, Berkshire in theory sounds like a good placeholder for cash, but it could easily turn into a normal position. My hunch is that owning SPY would not have that same psychological commitment, but maybe not. SPY is still a distinct position you have to sell to make room for something new. And if your SPY position it down, it may be difficult to sell thanks to how averse humans are to taking losses (loss aversion).
As I’ve been thinking about this concept the past few weeks, I went back and looked at some of my own purchases from the past year and three stood out. First, the big addition I made to my Franklin Covey (FC) position in mid-2017 that took my sizing from the low teens to the high-20s was when I had a big cash position. I wonder if I would have made that same addition if I was 100% invested and buying more Franklin Covey required me to sell other positions. I sure hope I would have if all I had to do was sell SPY, but I don’t know.
The other two purchases that stood out were almost identical—Calloway’s Nursery (CLWY) put out great earnings after market close, so I put in buy orders immediately (because I had cash sitting around) and was able to get a small number of shares at the market open. I’ve made similar small additions to positions several times over the past couple years, but it’s only possible in micro-caps (where new information isn’t immediately reflected in the stock price) and when cash is sitting in the account. If I had all my “cash” invested in SPY, by the time I sold SPY and tried to buy CLWY at the market open I may not have gotten my shares—who knows. So if you invest in micro-caps, I think this is a very legitimate reason to have a small amount of cash sitting around (3-10% maybe?), but those opportunities are never available in larger companies.
Despite what the above sounds like, always being 100% invested isn’t yet an investment philosophy of mine (though I think the logic is sound so far). I’ve held plenty of cash over the years, but whether or not that’s a smart thing to do is something I’ve been challenging myself on recently. “Cash is optionality” is one of those market truisms that almost everyone believes, but I’m not convinced it’s right in the long-term. I think “liquidity is optionality” is closer to the truth—and a lot of things other than cash are extremely liquid. My current thinking is: if the market always has a positive expected value, there’s no reason to ever hold a meaningful amount of cash (vs a broad, liquid index fund).
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch