Footsie’s recent sharp sell-off has left equities looking cheap and hastened the Bank of England’s interest rate cut to 0.25 per cent. It’s tempting therefore to get out of cash completely because this currently ensures that we will lose money after inflation. Such a temptation should be resisted, as there is actually a strong case for all investors to hold onto at least some cash.
The obvious reason for this is simply that we face equity risk. Yes, it is likely that equities will bounce back. But we don’t know when. The coronavirus has genuinely increased risks to the world economy. And history warns us that low interest rates often lead to low returns on equities and to the risk of big losses.
Even if you are reasonably confident that equities will recover, there is still significant risk. If you expect shares to rise 10 per cent in the next 12 months, then applying reasonable volatility (let alone current volatility) around this forecast implies a 30 per cent chance of them falling.
Yes, being fully invested now might well pay off handsomely. But this isn’t assured.
What’s more, even if you are brave enough to dump cash and become fully invested now, you shouldn’t have that position permanently, because there are several longer-term risks that justify us holding cash.
Equity risk is not merely near-term volatility. We also face a bigger but unquantifiable danger – of what Richard Bookstaber in The End of Theory calls radical uncertainty. This is the possibility that the past will cease to be a decent guide to the future.
For example, recent history tells us that the dividend yield on the All-Share index is a superb predictor of longer-term returns on the index: since 1985 the correlation between it and five-year price changes has been 0.8. With the yield now well above average this points to good returns. But can we trust history? There’s a chance that the high yield is telling us not that shares are cheap, but that we really are heading for trouble – be it either recession or just continued weak growth, perhaps because measures to tackle the coronavirus will cause a permanent reversal of globalisation. This chance justifies holding some cash.
So too does another danger – liquidity risk. There are some assets we cannot sell quickly at a decent price in bad times. The most obvious of these is property, where we also must spend money on repairs and maintenance. But it is also true of private equity and collectibles such as classic cars or art. In theory, we should be rewarded over the long term for taking on liquidity risk. But this requires that we stay invested for the long term. Which requires that we have enough cash to avoid having to sell assets at a bad time. One of the basic and most important rules of investing is: never, ever be a forced seller. Having cash means we don’t need to be.
The converse of this is that cash can allow us to take advantage of others’ misfortune. Economists at the Bank of England show that companies that had high cash holdings before the 2008-09 recession invested more and grew faster than their rivals because they were better able to invest in profitable projects. The same applies to retail investors. If you have ready cash you can buy up the bargains we occasionally get from the forced selling of distressed investors. You might think the sell-off has left shares looking very cheap. But you can only exploit this fact if you have cash to put into the market.
There’s another risk cash protects us from – correlation risk, the danger that assets will drop in price at the same time.
One way in which this might happen would be if investors were to fear that monetary policy will be tighter than they currently expect it to be. The anticipation of higher interest rates might then cause losses on bonds and equities.
Granted, this seems a slim chance now. But we shouldn’t rule it out later. The coronavirus is not just a cause of weak demand. It’s also a supply shock: if, as the government fears, a fifth of workers might be off sick or in self-quarantine, we could see shortages of goods and services and rising prices. Investors might fear that this would warrant higher interest rates after the current panic has diminished and so dump equities (albeit from a higher price than currently) as well as bonds. In such an environment, cash would hold up well.
Most of these thoughts apply especially strongly if you are retired. People in work have an alternative to cash. We can respond to losses by working longer or saving more – although this might be more painful than you think. Retired people lack this margin of adjustment and so need the flexibility that cash offers.
My point here is essentially a trivial one. We cannot know the future with any confidence: the only certainty is that things will change. Our portfolios must be resilient to such changes. And for several of these changes, cash offers us such resilience. It is a simple and proven way of future-proofing our portfolios.
