Client's Corner: The Terrible Temptation to Hold Cash
[This essay is typical of the pieces I make available to newsletter subscribers most months, in pdf format, for direct transmittal to clients, though not in newsletters or any websites, which would open these essays up to the non-subscribing world. I retain the copyright, which must be cited. PLEASE NOTE THAT THE INCLUSION OF THIS ESSAY IN THIS SAMPLE ISSUE IS FOR ILLUSTRATIVE PURPOSES ONLY; NON-SUBSCRIBERS MAY NOT SEND IT ON TO ANYONE, WHICH WOULD CONSTITUTE COPYRIGHT INFRINGEMENT.]
May 2021
As I write, less than 13 months after the S&P 500 made its panic low around 2,200, it has closed above 4,100. It has nearly doubled. In just a bit more than a year. Something like that doesn't happen very often.
When it does, however—when equity prices go on a terrific tear, often following a big decline—a dark and very powerful human instinct leaps to the fore. It's the impulse that says:
“The market's too high.”
“It's come too far, too fast.”
“There's bound to be a significant pullback.”
“Let's wait for that.”
I cannot overstate how normal and even fundamental this impulse is. It is every bit as basic as the instinct to flee the market when stock prices are declining sharply: you almost wouldn't be human if you didn't feel it. So my first bit of advice in this little essay is: go ahead and feel it. (What choice do you have? You're human.) Just, for heaven's sake, don't give in to it.
Because it's bound to be wrong. Even when, for some little while, the market acts like it was the right impulse. Hold that thought for a moment, if you will, while I engage in a digression.
There is a much larger truth at work here—one that is at the root of all the unforced errors that go into a lifetime of investment failure. It is that there is a whole suite of basic, normal impulses—indeed, human nature itself—that feel so right, and turn out to be so deeply wrong.
We just noted another one: flying out of equities in falling markets, instead of shopping opportunistically before the sale ends. Here is yet another: buying whatever has been the hottest performer in the last block of time. That is, buying the thing that went up the most before you bought it. (“But my brother-in-law bought it last October, and he's way dumber than I am, and he's making a fortune!”)
Let me spell this larger truth out for you, so you can't miss it. Basic human nature is antithetical to lasting investment success. As Warren Buffett's teacher Benjamin Graham famously put it, “The investor's chief problem—and even his worst enemy—is likely to be himself.”
This, incidentally, is why your financial advisor was sent into the world. Not to forecast the economy nor time the market, but to save you from yourself. To dissuade you, as gently as possible, from running away from great values when they're on sale, and running toward overhyped fads. Again: these powerful impulses do not make us unintelligent. They make us human.
That concludes the digression. We now return to the specific destructive impulse under discussion: “market's too high/wait for the pullback.” Herewith, a suggested methodology for beating back this demon of a misguided idea.
- Call on that first and most important quality of the lastingly successful equity investor: humility. If I say the market's too high, and must set back significantly before it resumes its long-term advance, I am in effect claiming to be smarter than all the global owners of some $34 trillion in equities—the current market capitalization of the S&P 500. I've decided that I see something those institutions and wealthy individuals do not. They have all stampeded heedlessly into mispricing the whole market, and I alone have perceived this. Possible? Certainly. Probable? I think not—and neither will you, when you view the issue through the lens of humility.
- Remember your plan, and continue to work it. The next most powerful antidote to impulse is a financial plan and/or a formal investment policy. If, for instance, you are accumulating capital for retirement, your plan almost certainly calls for you to invest steadily toward a date-specific, dollar-specific goal. See that you do so. That is: act on your plan, not on any impulse and/or current event. In the fullness of time, you will discover what all successful equity investors eventually learn. To wit: in the long run, the best time to buy more quality equities was when you had the money, regardless of what the market was doing at the time.
- Realize that to successfully execute your “strategy”—wait for significantly lower prices and buy then—you'll need to be right twice. Not only do you have to be right that the market is just about to set back, but then you have to be right again regarding your eventual entry point. Hear this from a friend: you won't be. Human nature again: if the market now proceeds to reward you with its average annual decline approaching 15%, a dozen “expert” pundits will begin caterwauling in unison that much lower prices are coming. You'll hold on to the cash, delighting in how right you've been. And you'll miss the turn. It's inevitable. More than that, it's human nature.
- Accept that the historical odds of catching a significant decline in the next year are three to one against you. Since 1926, equity returns (with dividends reinvested) have been positive roughly three rolling 12-month periods out of four. (Sources: Morningstar, YCharts.) By holding cash, you're asserting that the historical one negative year in four will be along just about any minute now. Indeed, you may effectively be betting your retirement on it. Are you pretty sure that's what you want to do?
© May 2021 Nick Murray. All rights reserved. Used by permission.