Portfolio Management: Should You Switch to Cash?

I’m sure the thought has crossed your mind, especially with the roller coaster stock market we are currently experiencing. “Why not just put all of my investments in cash, just until the market stabilizes?” Many investors are acting on that thought. Through the first six days of October, $19 billion was pulled out of mutual funds that invest in United States stocks. That’s equal to the ENTIRE MONTH of September 2008 according to TrimTabs Investment Research.

At first it seems like a good idea, cut your losses and get back in when things are better. But if your investment horizon is beyond a few years you may be doing significant damage to long-term finances. If you moved all of your investments to cash you are attempting to “time the market.” The problem with “market timing” is there is no evidence of it working… in fact there is evidence that it doesn’t work. Take right now for example. If you were a successful “market timer” you would have moved out of the market about a year ago before various stock indexes through out the world fell by 33% or more. Chances are you didn’t get that memo though… nobody did.

There is no way to know what is going to happen in the future. But, if you decide to sell now, your losses will be locked in, and historically, cash doesn’t grow in value. You will most likely lose in the end due to inflation eating up the after-tax returns you earn from a savings or money-market account. This may sound like a fair trade, but if you are planning on returning to the stock market, how will you know when to get back in? Chances are the “market timing” strategy failed to warn you of the current market conditions. How will it tell you when the market will recover?

Consider this, in 2005, H. Nejat Seyhun, a professor at the Ross School of Business at the University of Michigan tested the damage investors incurred if they missed out on a small number of days when the market had strong gains. From 1963 to 2004 the index of American stocks he studied gained almost 10.84% annually in a geometric average. If you were invested in that index, and missed the 90 biggest-gaining days in that period by trying to time the market, your return would be a mere 3.2%. This means that 96% of the market gains occurred on less than 1% of the trading days available.

If you need cash for the short term you may have no choice but to convert some of your portfolio to cash. If you subscribe to the Modern Portfolio Theory (and you should), you already have a percentage of cash in your portfolio, and therefore may not need to sell.

Selling now and moving to cash could mean guaranteeing a lower standard of living for the rest of your life, because you’d be locking in your losses.

Think of your portfolio in the same way you value your home… if you wouldn’t sell your house when the housing market is down, why would you sell your portfolio when the stock market is down.