Flatlining

 By Guest Blogger Doug Rowat

One of my first blog posts back in August spoke of the pointlessness of holding excessive amounts of cash. So, let’s spend some time examining perhaps the world’s most boring asset class.

For some investors, holding large amounts of cash is a prudent response to volatile and down-trending markets: after all, holding cash during the credit crisis, to provide an extreme example, would have saved most investors a considerable amount of money. However, it’s important not to overlook the consequences of remaining in cash.

First, there’s the loss of purchasing power. Over the past 30 years, the average annual inflation rate in Canada has been about 2.2%. This can also be viewed as the annual percentage decline in the value of money. Simply put, because of inflation, we’re losing money each year. An investment in cash will never overcome this “loss”. To see for yourself, try the Bank of Canada’s inflation calculator at http://www.bankofcanada.ca/rates/related/inflation-calculator/. Having an excessive weighting to an investment that’s guaranteed to lose is, of course, a waste of capital.

Secondly, there’s the impossibility of market timing, which I also spoke of in my August post. Ryan also mentioned this last week by highlighting the Dalbar report and how badly average US retail investors underperform a simple buy-and-hold-the-benchmark approach. Some investors fashion themselves brilliant short-term tactical market timers. Some may be, but most aren’t. The chart below indicates how holdings in Canadian money market funds align with Canadian equity market direction.

Canadian Cash Levels Peak At the Wrong Times

Investment Funds Institute of Cda, Bloomberg, Turner Investments

Looking at the past two major market meltdowns (2000–02 and 2008–09) Canadians’ cash levels peaked at or near both market bottoms (i.e., the worst timing) and it took months, if not years, as the market rallied off these bottoms, before cash levels dipped below the long-term average (red line). Holding 30%, 40% or even 50% cash with the intent of putting it to work at the exact right moment is actually pointless on several levels: 1) you probably won’t do this (again, see chart) and 2) holding cash means you’ve failed to identify any other asset class likely to outperform.

Which brings me to my final point.

In virtually any market and economy there is an asset class doing better than cash. For instance, if you’re a portfolio manager who believes equity markets will come under pressure you should probably direct funds to bonds not cash. During the worst of the credit crisis, as a simple example, cash had a zero correlation to equities, but bonds had a negative correlation. In other words, bonds controlled volatility better.

And, indeed, they performed better. To use the plain-vanilla iShares Canadian Government Bond Index ETF (XGB) as a bond-market proxy, while the Canadian equity market was plunging roughly 50% from mid-June 2008 to early March 2009, XGB actually managed a 6% positive total return. Cash? It returned, once again, less than inflation.

Holding a bit of cash (a 5–10% portfolio weighting) makes sense as a portfolio shock absorber for those rare instances when all other asset classes decline simultaneously. And certainly having some cash on hand makes sense to cover unexpected expenses, but to hold excessive amounts of cash, particularly for any length of time, only implies paralysis.

Show me a portfolio manager who holds lots of cash and I’ll show you a portfolio manager who probably doesn’t know what they’re doing.

Doug Rowat,FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.