Cash not king for the risk averse

CHICAGO (Reuters): Market volatility has terrified investors to such an extent that they are avoiding stocks like the bubonic plague. But as cash becomes king, it bears a leaden crown.

There’s significant evidence to show that there are better places to grow diversified portfolios. However, instead of focusing on overall portfolio performance based on risk-adjusted returns, most people think monolithically. Should I be in or out of the stock market? Should I be completely out of big stocks and into bonds and cash? This risk on/risk off approach is not only disconcerting, it leaves you open to bad market-timing decisions.

Fear rules

Fear is currently ruling mass investor behaviour. Cash inflows into checking and savings accounts – which are posting negative returns after inflation and taxes – outpaced all other investments in the first half of the year, according to TrimTabs Investment Research. More than one-third of a trillion dollars went into these safe-but-sorry vehicles, compared to a $26 billion exodus from US stock exchange-traded funds.

Mega-manager Bill Gross, co-founder of PIMCO, has declared “the cult of equity is dying,” and the 6.6-per cent return of stocks over the last 100 years is “a historical freak, a mutation likely never to be seen again.” Millions have already taken that to heart, beating a steady retreat from stocks since 2008.

While Gross is probably right that stock returns will be less than half of the historical performance, there’s little reason to abandon stocks completely for cash or bonds. It seems reasonable that a new average performance for US stocks will be around 4 per cent. That’s a 2 per cent for dividends and 2 per cent for capital gains, according to Peng Chen, who wrote a paper on expected returns earlier this year for Ibbotson Associates.

Chen may be on the low side if robust growth returns to the US and abroad. Adds Seth Masters, chief investment officer for Bernstein Global Wealth Management, “with reasonable assumptions, we can get returns in the 6 per cent to 7 per cent range.”

Part of the “stocks are not quite dead yet” argument rests on looking at smaller stock sectors and not just the largest, most popular US stocks. In a paper to be published in the Journal of Indexes, Craig Israelsen, who teaches finance at the University of Utah, found higher historical returns when examining indexes of non-blue chips.

True, the much-followed S&P 500 stock index, he found, returned a lacklustre 2.92 per cent from 2002-2011 and lost 0.25 per cent in the last three years. Projecting those returns forward, which is always dangerous, gets you into Gross’s “dying equity” zone.

Yet when you look at other sectors, the picture brightens considerably. The MSCI US Mid-Cap Value Index returned almost 8 per cent in the near decade. The Dow Jones US Small Cap Value Index was up 7.7 per cent. The S&P SmallCap 600 Index rose 7.5 per cent.

Well-rounded portfolio

The monolithic view dominated by only looking at brand-name US stocks suffers in a finer analysis. You need to consider a well-rounded portfolio of all sizes of growth and bargain-priced value stocks - and more. Nothing is guaranteed going forward, of course. The point is to take a more global view of different asset classes.

“What is important is how the overall portfolio performs,” Israelsen notes, “rather than over-focusing on how an individual ‘single-asset-class’ behaves…the sum is more important than the parts.” By covering all sizes and styles of US stocks; non-US developed and emerging stocks; real estate investment trusts (REITs); natural resources/commodities; US and international bonds; inflation-protected bonds and cash, Israelsen figures you could have achieved a 7.73-per cent return over the past 14 years (through 2011), compared to 3.55 per cent for an all-US stock mix or 5.12 per cent for a 60-per cent stocks/40-per cent bonds portfolio. What about 100-per cent cash? A sure loser at 2.9 per cent. That’s before you subtract inflation. This “7-12” strategy places 8.33 per cent in each of 12 asset classes.

Instead of beating a hasty retreat to cash every time a sour headline emerges on the US, European or Chinese economy, if you’re a long-term investor focused on inflation-beating growth, you could avoid the opportunity risk trap. Then you wouldn’t have to worry whether the current rally or sell-off will last or how to best time your move. You’d be strategically situated to capture some growth and income throughout the world no matter how much stocks were gyrating.