There are a couple of reasons why I think some investors may be contemplating selling some of their stocks and holding more cash.
First, the S&P 500 has gained over 40% since reaching a three-year low in March. Investor sentiment has improved dramatically due to factors such as the Federal Reserve’s unlimited quantitative easing program and the prospect of the economy gradually reopening. Further gains of this magnitude in the long run may appear unlikely to some investors.
Second, the economy’s future is highly uncertain. Cash is a lower-risk investment over the short run that could mean investors avoid a potentially volatile outlook for the stock market.
One investor who holds substantial amounts of cash at all times is Berkshire Hathaway BRK.A BRK.B Chairman and CEO Warren Buffett (Trades, Portfolio). Despite this, the Oracle of Omaha concedes that cash has major limitations for long-term investors.
Cash appeal
One of the most appealing traits of cash savings in times of market volatility is its capacity to provide you with peace of mind. Unforeseen events can occur at any time that wipe out overly optimistic market gains.
At the moment, having sufficient cash to pay for unexpected events may be more valuable than it has been in the past few years. The economy’s future is highly unclear. Unemployment has risen rapidly and a prolonged recession may be ahead.
In addition, holding cash may provide liquidity should the stock market experience a pullback after its recent rally. Investor sentiment has been highly changeable over the past few months, and could lead to a volatile performance from stocks. Keeping part of your portfolio in cash may allow you to capitalize on short-term mispricings.
As Buffett once said, “Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity.”
Return profile
The main drawback of holding cash is its poor return prospects. Interest rates have been reduced to zero in response to the challenging economic outlook. This means that cash savings accounts offer returns that will likely be below increasing inflation levels.
Over time, a return that is less than inflation causes an asset’s value to fall in real terms. Since nobody knows how interest rates will change in future, the prospects for returns on cash holdings could be relatively unattractive for a protracted time period.
Investing in stocks over the long run is most likely a more efficient use of your capital. The S&P 500 has recorded a compounded return of 11% since World War II in spite of it experiencing 14 bear markets occurring on average once every five years. Therefore, even if you invest just ahead of a fall in stock prices, holding for the long run is likely to still yield a higher return than that of cash.
As Buffett once said, “The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time.”
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Mohnish Pabrai on Investing in These Precarious Times
- Peter Lynch on Investing During an Uncertain Economic Period
- Does the S&P 500 Have Investment Appeal After Its 40% Rise?
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