Why cash is king for a day

One of the natural reactions to periods of strong sharemarket volatility is for investors to rush for the security of cash. 

 

"Cash is king" is the cry that goes out through the broking community when individual share prices seem to be in a state of free fall. 

 

Seeking shelter in a storm is a perfectly rational thing to do. But rushing to cash when markets have already shed 10% to 20% in value may make you feel safer but could well be the opposite of sensible investing. 

 

Take a look back over market returns for the past 30 years. If you had $10,000 invested in three portfolios - the first in the Australian sharemarket index, the second in cash and the third portfolio in the consumer price index - where would you have ended up? 

 

Our safety first investor who stayed in cash saw the $10,000 grow to $159,270 at the March 2008. That is an annual return of 9.8%. More impressively the cash investor comfortably outperformed the CPI index which had a growth rate of 4.9% per annum. To get the real rate of return - that is after inflation - we should subtract $41,590 from our cash portfolio's return which leaves our conservative investor a real return of $117,680 after the rising cost of living is taken into account. 

 

Now let us look at the result for an investor who put their $10,000 into the Australian sharemarket - as measured by the S&P/ASX all ordinaries accumulation index. At the end of March 2008 that $10,000 had grown to $589,794 which is an annual return of 14.7%. Take off the CPI adjustment and we are left with $548,204. 

 

For someone 30 years old in 1978 with the ambition of retiring when they turn 60 the difference between investing in cash and in the growth of the sharemarket is a staggering $430,524.* 

 

That was the result for the past 30 years. There is no certainty that will be the outcome for today's 30-year-old when March 2038 comes around but it does highlight one of the fundamental principles of investing - risk and reward. The investor in the more volatile sharemarket took more risk and was rewarded with the higher return. The risk needs to be well understood but portfolios can be constructed to manage it using diversification to lower specific stock - a portfolio based on the broad market index gives you diversification within an asset class but you need to also consider diversifying across asset classes. 

 

Over the past 30 years the sharemarket has had seven falls greater than 10% - with the average fall 21.2% which took about eight months to occur and just over 15 months to recover from. 

 

The portfolio return differences are stark but the important aspect is that it is being looked at through the lens of 30 years of market returns. The long-term view makes a compelling case for investing in growth assets. The short-term volatility can make us overly conservative out of fear of losing money. 

 

There is a behavioural finance theory known as loss aversion - essentially it means that the emotional impact of losing $1 hurts 2.5 times more than the satisfaction we get from making $1. 

 

So at times when the media is full of negative market returns and fear of losing is the dominant emotion in the financial media it is not surprising that people seek refuge in the safety of cash. 

 

Cash may well be king ahead of a market meltdown but over the long-term its reign tends to be short-lived. 

 

* Month-end index values have been used. Index prior to 1980 is the MSCI Australia Gross Total Return Index. From 1980 the index is the S&P/ASX All Ordinaries Accumulation Index. The growth of $10,000 calculation begins 30 June 1978.