Cash vs Diversified portfolio

Investors usually have mixed feelings about cash. In bull markets, cash is shunned whereas in volatile bear markets, when equities and bond prices are falling, it can be looked on as a safe heaven and ready liquidity.

Attempting to successfully time your re-entry into markets can be challenging even for professional fund managers. Fund managers recognise the difficulty of consistently getting this decision right and will typically maintain a diversified exposure to a range of investments, rather than swing their portfolios between different asset classes.

Investors who are approaching retirement and are focused on preserving their savings, may adopt a more conservative asset allocation but that doesn’t necessarily mean holding 100% cash. Doing so may jeopardise their likelihood of achieving their goals given cash holdings can be particularly vulnerable during times of deflation and inflation.

While cash provides liquidity and is a ‘safe’ investment, it’s not intended to be the primary holding in your portfolio due to its low returns. Currently the returns on cash and short-dated term deposits range between 0% and 1% which is below inflation.

Graph1

We can simulate the various ways of investing to assess how these strategies might have performed historically. The above table highlights the historical annual performance of a range of asset classes going as far back as 1990. The three columns to the right highlight three different investment strategies:

The Chaser – invests all their money in best performing asset class from the previous year, effectively chasing last year’s winners.

The Contrarian – invests in the worst performing asset class of the previous year expecting that it will turn around.

The Balanced investor – decides that trying to time their entry into different asset classes is too difficult so they maintain a diversified exposure across all the asset classes.

The Results

Table2

As you can see, the strategy that would have provided the best returns is the Balanced investor. What is also interesting is that the Balanced approach also had, by far, the most protection against negative returns, with the annual drawdown the smallest compared to the other strategies.

The lessons from this analysis reinforce important principles for investing, namely:

  • Avoid the temptation to chase the best returns;
  • Some asset classes can take years to return to normal following poor performance, don’t expect this to happen quickly;
  • Diversification is still the best strategy to maximise the probability of achieving your goals.

 

Current advantages / disadvantages of each approach

Portfolio with Significant cash holdingsWell Diversified Portfolio
Advantages
  • Capital stability
  • Ability to purchase assets in the future at lower prices if a significant market correction occurs
  • Low cost
  • Potential for higher total returns over the medium and long-term.
  • Income is significantly higher than cash.
  • Still maintain some ability to purchase assets in the future at a lower price if a significant market correction occurs
Disadvantages
  • Current returns may be below inflation
  • Low income
  • Opportunity cost – markets may not experience a significant correction for a long-time
  • Higher costs
  • Portfolio may experience more volatility in the short-term due to market fluctuations.

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