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Holding cash may mean risky business

Investors with too much cash could deplete their portfolios in times of negative real yields

The renewed decline in yields and cash rates across global markets in recent weeks leaves investors in a conundrum.

The safest assets, like cash and government bonds, now guarantee real (or inflation adjusted) wealth destruction if held to maturity. Non-dollar bonds in developed markets even have a negative nominal yield, on average.

Meanwhile, more volatile assets, like equities, seem vulnerable to a myriad of risks, ranging from global recession to the trade war.

So it is more important than ever to have a clear idea of how much money you really need to keep in safe assets, which means accepting negative real yields, and how much you can afford to invest for the long term in higher-return, but higher-volatility assets.

In most cases, holding five years' worth of net expenses (after deducting your regular income) in liquid cash and short-term bonds is more than sufficient to cover your near-term liquidity needs.

Since 1945, a diversified 60:40 portfolio of US stocks and bonds has never been underwater for more than four years. With five years' worth held in liquid assets, investors would never have been forced to sell their portfolio at a loss to fund their needs.


Yet we find that many investors continue to hold far more cash in their portfolios than this. And it's not because they think it's a good idea.

Our recent survey showed that 73 per cent of investors globally do not see cash as the safest investment for the long term, instead favouring options like stocks and bonds (48 per cent) or real estate (26 per cent). Yet average cash holdings among investors surveyed were 26 per cent.

Cash is an inefficient way of managing portfolio downside risk over the long term, according to the writer, who says it holds its value very well over the short term, but does not appreciate when markets fall.  PHOTO: AGENCE FRANCE-PRESSE

The only explanation is that investors are falling prey to "behavioural biases", such as loss aversion and decision paralysis, which, over a long-enough period, can do more harm than any stock market crash.

One of the biggest reasons investors hold a high amount of cash is "waiting for the right opportunity", cited by 48 per cent of investors in our survey.

But such drawdowns tend to be much less common than many investors think. Since 1945, investors in a simple balanced portfolio (60 per cent US large-cap equity, 40 per cent US government bonds) would have never seen their investment trade in the red from the original purchase price in 35 per cent of cases.

And they would have seen a greater-than-20 per cent portfolio loss in only about 5 per cent of cases.

The result is that investors waiting for the right opportunity often face the worst of both worlds: a high opportunity cost and being forced to eventually buy at even higher levels.

Another reason, cited by 42 per cent of investors, is "protection against a market downturn".

But cash is an inefficient way of managing portfolio downside risk over the long term.

Cash holds its value very well over the short term, but doesn't appreciate when markets fall.

Over a third of investors say that cash "helps them sleep at night". But in a negative-real yield world, depending on how much of their portfolios they spend each year, investors may be sleepwalking into depleting their portfolio.

The good news is that there are simple steps investors can take to overcome these biases.


The first is to acknowledge that ad hoc market timing is almost impossible, and to focus on disciplined, systematic strategies.

One strategy all investors can use is to rebalance equity holdings back to a target allocation within your portfolio on a regular basis. This ensures you are always "buying the dips" and "selling the rallies", without having to second-guess the next presidential tweet or central bank policy move.

Second, look to use diversification to insulate your portfolio against market shocks, rather than cash.

Diversified portfolios that hold longer-duration high-grade bonds alongside equities have historically provided much better portfolio protection than cash in the event of stock market declines.

Despite low yields, this is still the case - long-duration government bonds have been among the best-performing assets amid the recent market volatility.

Third, remember that volatility and risk are not the same thing. Volatility is how much an asset moves up and down from day to day. Risk is the probability that you fail to meet your objectives.

The least volatile assets, like cash, by failing to grow, may actually increase the risk that you may fail to meet a target you have, like buying a vacation home.

Meanwhile, the most volatile assets, like equities, may be the only investments that provide the growth needed to reduce the risk of running out of money in retirement.

Unorthodox monetary policy has turned much of traditional financial theory upside down. The idea that cash, the least volatile asset, may in fact be the most risky, could be just the latest instance.

• The writer is Asia-Pacific regional head of UBS Wealth Management's chief investment office.

This article was first published by the Straits Times. Read the original article here

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