I Like Cash Because I Like Stocks

I Like Cash Because I Like Stocks
<a href=”https://pixabay.com/users/SharonMcCutcheon/”>SharonMcCutcheon</a> / Pixabay

Cash is at one side of the risk/reward spectrum of investment possibilities. Stocks are at the other end of the spectrum. Stocks are risky but offer great returns. Cash is safe but offers poor returns.

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Q4 2020 hedge fund letters, conferences and more

Right?

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Stocks vs Cash: Returns And Risks

I don’t think that’s quite right. I of course understand that there is a general truth in thinking of stocks as riskier than cash and in thinking of stocks as offering greater returns than cash. But, as is so of every other strategic question in stock investing, Shiller’s Nobel-prize-winning research showing that irrational exuberance is a real thing should change our thinking on this matter.

In 1982, the most likely 10-year annualized return on stocks was 15 percent real. The worst possible return (assuming that stocks continued to perform at least somewhat as they always have in the historical record) was 12 percent real. The best possible return was 18 percent real. Where’s the risk? Investors who purchased stocks in 1982, when the CAPE was 8, stood a chance of seeing a very good 10-year return and also a chance of seeing an extraordinary 10-year return and also a chance of seeing a flat-out amazing 10-year return. When there are no bad outcomes, there’s not much risk.

In 2000, there were no possible good outcomes. The CAPE was 44. The most likely 10-year return was a negative 1 percent real, the worst possible return was a negative 4 percent real and the best possible return was a positive 2 percent real. There are two ways to look at those numbers. You could say that investing in stocks was extremely risky at that time since all of the possible outcomes were poor. Or you could say that again there was not much risk. All of the possible outcomes were poor. But you weren’t taking much of a chance. You knew at the time you made the purchase that you were going to obtain one poor long-term return or another.

Treasury Inflation-Protected Securities (TIPS) were paying a guaranteed return of 4 percent real at the time when the most likely 10-year return for stocks was a negative 1 percent real. TIPS are certainly safe; they come with a government guarantee. So the conventional thinking works to that extent. But I wouldn’t describe a return of 4 percent real as poor. I certainly would not describe it as that at a time when the most likely long-term return on stocks was a negative number.

Stocks Are Far More Risky Than Cash

These are extreme scenarios. I chose extreme scenarios to make the point. The usual reality is that stocks are far more risky than cash and pay far greater returns. The conventional thinking is based on something real. But the conventional thinking can be very misleading in some circumstances and at least a little misleading in many more circumstances. Shiller’s finding that stock investment risk is not stable but variable requires a reexamination of the conventional thinking on a multitude of strategic matters.

The return today on cash-like investment classes is nothing close to 4 percent real. Today’s return is trivial. So, when I make these sorts of points, lots of people respond by saying that the year 2000 is ancient history and that it simply is not realistic to consider cash as an investment option in today’s world. I do not agree. An argument can be made that cash offers a better deal today than it did in 2000.

You won’t get a good return on cash, that’s for sure. But going by what the 150 years of historical return data available to us teaches us, stocks are even more risky today than they were in 2000. Today’s CAPE level is 35, not 44. On that score, stocks are a little less risky today. But the point of Shiller’s work is that, to the extent stocks are overvalued, the market value reflects only irrational exuberance and not anything of lasting economic significance. The great power of cash is that it permits you to protect the value of your portfolio at a time when the stock market is priced to obliterate it. Put 70 percent of your assets in cash and a 50 percent price cash deletes only 15 percent of your life savings. That’s a trick that will pay off in higher compounding returns for many years to come.

Irrational Exuberance Is A Psychological Phenomenon

We never know when a crash will arrive. But irrational exuberance is a psychological phenomenon. Investors bid prices up for a long, long time and then they lose confidence in what they have done and prices come tumbling down. It takes decades for a bull/bear cycle to complete itself. I would not dare to say that a price crash is coming this year or next. But I think it would be fair to observe that this bull market is closer to exhaustion today than it was in the year 2000. So the risk of investing in stocks — and thus the merit of investing in cash — is arguably greater today.

I don’t like the returns offered by cash any better than most other investors. But I like the returns offered by stocks purchased at reasonable prices a great deal indeed. If accepting the poor returns offered by cash today for a few years permits me to avoid a stock price crash of 50 percent or more and then enjoy the amazing returns offered by stocks in the days following a crash for many years afterwards, I feel that I have engaged in a rewarding trade-off.

Investing in cash when stocks are insanely overpriced permits me to own more stocks over the course of an investing lifetime. And stocks purchased at reasonable or super-reasonable prices are the best investment class out there. I don’t invest in cash because I like the direct return provided. I invest in cash because doing so permits me to buy more stocks when they are priced to offer a solid return. I love cash because I love stocks.

Rob’s bio is here.

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