An Action Plan For Investors Holding Too Much Cash

One of the greatest benefits of being a public speaker is getting to meet different people and hear various experiences and stories within the financial and investment realm. This year I am very busy traveling the country speaking to both financial advisors and retail investors about the influences of investor behavior and how to improve our decisions. One of the greatest frustrations I hear is that investors have found themselves sitting heavily in cash and waiting for a market correction to get back in. The problem is that many of these investors have been waiting a very long time. Let’s discuss how investors got here, things that should be considered, and an action plan to get them back on track.

 
How Did We Get Here?

GoodIntentionsMany investors begin with very good intentions, but lack a specific investment plan to help them reach their goals. There are many distractions and illusions that influence investors to become speculators, without even realizing it.

The Distraction of Noise
Most news is not relevant to your long-term investment plan. In fact, seldom is there news that is pertinent to your long-term portfolio. The daily news stories are just noise, which distract you from your long-term goals and entice you to speculate on short-term outcomes. Viewer beware.

The Illusion of Certainty
Because our brain craves certainty we are subconsciously influenced to believe forecasts of market experts, and act upon those forecasts – despite expert forecasts being correct less than half the time. After all, why would any investor choose to remain in a market that is expected/due to go down? (That is the thinking)

Add volatility to the mix, and it is easy to see where a well-intentioned investor could get distracted and change the strategy from a deliberate, thoughtful process to a speculative game of timing the market…resulting in greater stress, reliance on luck and a suboptimal portfolio.

 
“It’s Too High To Get Back In Now”

For investors that find themselves in a greater cash position than they want to be in, the common response is that they want to get back to a diversified portfolio, but the market is too high to do it right now. And there is data to support that view.

The bull market is now going on 6 years, making it the sixth longest dating back to 1850. The Fed has ceased their quantitative easing programs. The S&P 500 is up over 250% from the lows. And it has been 3 1/2 years since the S&P 500 had a correction of 10% or more. Historically the market experiences a correction, on average, every 12 months. So we are overdue. With this information, investors may conclude that the market is too high to invest in today.

 
Or is It?

When you compare stocks to bonds, the same stock market is now relatively inexpensive. We are no where near the relative valuation that occurred during the expansion of the 1990’s, and the health of corporate balance sheets is much better than in prior economic expansions. Assets heavily outweigh debt in the corporate world. While the Fed may have stopped quantitative easing, they have signaled that interest rates are not likely to increase much in the near future.

1While the market expansion has lasted a long time, its growth has been tepid. On average, in prior expansionary phases, once bear market losses have been recouped the market went on to rally an additional 160%. Once we account for recouping market losses from the financial crisis, this market has only rallied 35%.(Source: Gluskin Scheff)

There are many times through a market cycle when there are both good reasons to invest in stocks and good reasons to not invest in stocks; today is no different. No one knows for sure how the market will perform over the next 6, 12 or 60 months. It is important to know when it comes to investing that just because something hasn’t happened before doesn’t mean it won’t. If you think about it, everything that has ever happened, at one time had never happened. We are still writing the history of the stock market.

 
What to Do

Let’s say an investor that we will call Bob has too much in cash. He recognizes the cash position puts him in a precarious position, and he would like to improve his portfolio allocation but doesn’t know the best way to get there. His major concern is that soon after he purchases stocks, the market will experience a correction and put him in a hole. So how does Bob transition to a robust long-term portfolio while accounting for his concerns?

The key is to create a specific action plan to get to the targeted allocation. Step one would be for Bob to define his risk preference, which includes specifying how much, in dollar terms, he could lose without losing sleep at night. I call that the threshold of pain. Once that is identified, then an investment allocation should be constructed that would help Bob achieve his financial goals while minimizing the probability of breaching the threshold of pain. Once those two are defined, then the action plan can be implemented.

mf_sip_picA systematic investment plan may be a good solution. For simplicity sake, let’s assume Bob is currently in 100% cash and has defined a target allocation of 60% stocks, 30% bonds and 10% cash. He is concerned the market may experience a significant correction over the 15 months. In this case, a systematic plan over a 15 month time period may be reasonable. Each month Bob would systematically (and automatically) invest 4% of his portfolio value into stocks and 2% in bonds. After 15 months, the target allocation would be reached. While it would not happen overnight, it would eventually get there, which is the main goal.

Bob would benefit in any market condition during that time period. If the market experiences a correction, Bob is still investing and would be taking advantage of the correction to purchase stocks at a lower price. If the market continues higher, at least he has some assets gaining value. It takes the guess work out of the market (less speculation) and focuses Bob back to an investment strategy. We have no control over what the market does, but we have complete control over our investment choices and strategy.

The key is to focus on what we can control.

 

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