Am I Really Safer In Cash?

At this point in the market cycle, many investors are trying to decide whether to change their asset allocation.  The argument runs thus: cash has outperformed equities over the past 1, 3 and now 5-year periods; it’s time to lock in returns because the risk of remaining invested in equities is beginning to outweigh possible further upside.

Methodical politely disagrees with this analysis.  Yes, cash has been out-performing equities.  However, it is a jump from that to disinvestment.  Are the risks greater than the benefits?  It all depends on your frame of reference – in this case, the investment period.

Let’s define risk within equity markets to be the possibility of capital loss.  Note it’s not permanent capital loss because, so long as one doesn’t actually sell out, the positions themselves have the potential to rise again.

Methodical examined historic data using the S&P 500 index, a leading index of US equities, going back to Dec 1927.  We looked at rolling returns on a 1, 2, 3… up to 15-year basis, starting at each month-end and continuing up until end-Jan 2019.   The results are tabulated below:

 

For each time horizon, whether one invested for 2 years or 10 years etc., the number of rolling periods that delivered positive returns exceeded those with negative returns.

The risk of capital loss is therefore highest for short-term investors.  The longer the investment horizon, the lower the probability of losing some of the initial capital.  To make this point graphically:

With a 15-year horizon, only 4% of rolling 15-year periods showed any loss at all.  This compares with 22% at 5-years and 32% at 1-year horizons.  Interestingly, if we were to look at global numbers, using the MSCI Index, the risk of loss using historic data falls to 0% – that’s zero – by the time any rolling period reaches 14 years.

It’s worth emphasising that this holds true regardless of the initial investment date, with one exception.  Anyone who had the misfortune to begin their investments between 1927-1930 would have faced high losses, even on a 15-year basis.  This is attributed to the huge losses incurred during the Great Depression 1929-1934.  However, if they had held on for another 5-10 years, those losses would have been recovered.

What is also interesting from the S&P 500 data is the asymmetric skew on returns versus losses.  The average increase in value greatly exceeds the average capital loss.   At 10 years, for example, average gains over the period were 121% whereas the losses (which happened only 12% of the time) were an average 25%.  Neither of these are annualised but the nominal numbers speak for themselves.

Critically, these calculations also ignore the effect of inflation because all investment asset classes have to battle against that constant flood of financial erosion.  Cash faces this problem more than any other asset class.  Interest on cash almost never pays out as much as inflation.  This means holding cash is a function of loss avoidance rather than gain.  As mentioned before, stocks have the capacity to regain paper losses; cash does not.

Of course, no one likes to lose money at any time or in any place.  We tend to forget, though, that losses are a normal part of investment activity.   Give the average investor a product which has an 88% chance of delivering returns of 121% (against 12% odds of losing 25%) and most would undoubtedly take the investment.    If that means holding on to investments during periods of paper losses, a clear-headed investor would choose to do exactly that.

The big caveat is whether we have the necessary time horizon to absorb downward fluctuations.   Some investors, due to their own circumstances, have shorter time frames and lower risk tolerance.   But for most, the time is there but the patience might not be.   Tempering ourselves to invest through cycles is an important skill.  Timing the market is also important but has more to do with luck.  Over the long run, it is sensible and continuous investing that pays the highest dividends.

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