The most dangerous asset class may just surprise you….

Investors flee to cash during times of trouble.  However, far from being a safe haven, cash is potentially the most dangerous asset class for investors, luring investors into bigger psychological bubbles than even tech stocks and housing have historically.

We recently wrote about why investors might want to consider holding bonds rather than cash, even at current low and negative yields (see Why on earth would you hold a bond with a negative yield?).  A recent article (see Journey of Cash by Alex Gurevich) and further investor questions have inspired us to think a bit more specifically about cash and its merit (or not!) as an asset class in a well diversified portfolio.

Hold cash for known near-term purchases and an emergency fund

First of all, before we start thinking about cash’s merits as an asset class, let’s be clear about something.  Holding a certain amount of cash is prudent – it should be held in safe, liquid instruments and for two purposes:

  1. To fund known near-term purchases (mortgage down-payment, next year’s college tuition, etc) and;
  2. To be set aside as a reserve to be used in the case of an emergency (house repairs, surprise periods of unemployment, other unplanned expenses, need to help a family member, etc)  We usually recommend an emergency fund somewhere between 3-6 months of fixed and discretionary living expenses depending on your specific situation.

Beyond for personal consumption, cash is not useful as an asset class 

Beyond the two purposes stated above, investors should consider the merits of cash as an asset class alongside the other asset classes in their portfolio like stocks, bonds, real estate, commodities, etc.  As an asset class, rather than as a means to fund personal consumption, cash leaves a lot to be desired.  Some of the specific shortcomings are well understood while others less so:

  1. Holding cash leaves you susceptible to inflation risk – when inflation exists, the nominal value of your money loses purchasing power over time – who remembers when a chocolate bar cost a quarter and taking the bus cost a dime?  People generally get this point.
  2. Cash offers poor investment returns – cash equivalent investment vehicles like GICs and money market funds offer returns that hardly keep pace with inflation.  This is also broadly understood.
  3. The opportunity cost and risk of holding cash is high, especially if held in one currency – when investors use cash as an asset class, not only do they miss out on other potentially more productive investment opportunities, they often hold it in their home currency,  If this isn’t money we need to spend in our home currency, why hold it in only our home currency?   As Canadians have witnessed recently, currencies can be quite volatile/risky even though they don’t offer a high expected return over the long run.  Holding cash increases opportunity cost and exposes investors to specific currency risks.  This point is less well understood.
  4. Using cash as an asset class is usually done in conjunction with trying to time the ups and downs of the market and market timing is extremely difficult.  People are terrible at market timing yet investor funds-flow data suggests they try time and time again unsuccessfully to pick market tops and bottoms.

Cash is used for market timing and market timing doesn’t work

This last point is worth expanding.  Investors remember well the stock market highs around the tech bubble in the early 2000’s and in 2008 just before the financial crisis cut stock markets in half, causing investors enormous short-term pain.  But who remembers these crashes in terms of the “cash bubble” that followed immediately afterwards?  While the climb-downs from the peaks were painful, in many cases they weren’t nearly as painful as the damage caused to investors who fled to cash near the bottom of the equity market and remained in cash through the subsequent recovery.  Holding cash is an active investment decision and these “reverse bubbles” (missing out on the upswings) do just as much or more damage to long-term investor returns.  Investors went to high levels of cash in 2008/2009 and many investors have stayed out of the market since then even though many stock indices are once again near all time highs.  Furthermore,  investors that cashed out at the bottom never actually benefited from being in the market during the peaks (except for an unrealized gain on paper) but they did realize actual poor investment returns when they sold at the bottom.  Unfortunately this cycle repeats itself every time fear starts to creep into the market.

Canadians no exception

While not exactly the bursting of a bubble, at the end of January this year Canadian stocks hit their lowest point since mid-2013.  And sure enough, many investors panicked and Canadian cash held by investors hit a record (see CBC’s report at the time: Canadians hold record $75B in cash as they wait out volatile markets).  Unfortunately for many investors, these record cash levels coincided with the market bottom.  Since then the recovery has been swift, Canadian stocks have jumped back up approximately 20% leaving many cash laden investors wondering what happened and hesitant to come back into the market at these levels.

The reason cash is so appealing as an asset class is exactly the reason it is so dangerous.  Investors flock to it en masse when it’s too late and cling to it as a safe haven during times of heightened fear.  The problem is investors remain anchored to the traumatic feelings that forced them to flee the market in the first place.  There they remain frozen, unable to act and as a result miss out on any subsequent recovery as the market shakes off the correction and adjusts back to its long-term job of earning return on capital for risk takers.  Market timing is so dangerous because it requires that you make not just one good call on the market (when to get out) but a second, even more difficult call (when to get back in).  People, even institutional investors, are just not hard-wired to make those calls effectively.

To reiterate, it is prudent to keep enough cash on hand to fund near-term known purchases and your emergency fund, otherwise, keep this dangerous asset class to a minimum.