INVESTING IN TIMES OF UNCERTAINTY AND VOLATILITY - Part 2 THE INVESTMENT DECISION AND CONSEQUENCES
Should I switch my investment selection to cash?
People who have existing investments in retirement or non-retirement investments may have the facility to switch investment options. Typically they are in a balanced or growth fund which have a high exposure to growth assets such as domestic and international shares and property.
A balanced fund typically has 60% to 75% exposure to growth assets while a growth or high growth fund may have up to 100% in growth assets with a typical asset allocation of say 50% domestic shares, 40% international shares and 10% property.
The greater the exposure to growth assets, the greater the long-term investment return however the greater is the volatility. When we talk about the risk of an asset allocation we generally do not mean that you will lose your money, but rather that the investment returns are more volatile. You will have a wider range of investment returns and a greater incidence of negative returns.
The more defensive assets that you have, such as cash and fixed interest, the lower the long-term investment return, however the lower the volatility. This is known as the risk/return trade off. As much as we would like it, you cannot have both high investment returns and low volatility.
By switching from a balanced fund or growth fund into a defensive asset such as cash you will reduce volatility which does limit the further downside if the market continues to deteriorate. You must however realise the consequences of your action.
Consequence One - You crystallised what has been a paper loss.
Let us assume that you are invested in growth assets. There has been a 20% fall in the share markets. You are scared that you could "lose" more money and so switch into cash. Yes, the share market could fall further and you would limit the downside risk, but have you really "lost" any money at this stage?
If you are invested in a well diversified managed investment which holds quality assets you have not lost any money until you decide to sell. The managed investment may well hold the same assets each day such as the same commercial office buildings, the same share of airports and other infrastructure and the same shares in blue chip companies, however the market prices these assets higher or lower each day for various reasons. It does not mean that the long-term investment value or earning capacity of these assets has changed.
A good example is your home. Each day your home is worth more or less for various reasons such as a change in interest rates, employment or a change in housing supply, however you do not see this change in value until you sell your house or your neighbour sells theirs. Note that your house has not changed. It has the same number of bathrooms, bedrooms, kitchen fixtures and landscaping.
Now suppose that you have decided to sell your house but there is no urgency. If there was a sudden downturn in the market would you sell your house then or would you wait for the market to recover and then sell? Most people would wait for the housing market to recover however it is amazing how these same people take the opposite view to their other investmentsand sell at the bottom of the market.
Consequence Two - You miss the upside when the markets come back.
People who make the switch from a balanced or growth fund into cash say that they will get back into the market, "when things settle down." But what does this mean in reality? When do they go back into their higher growth option? After the market has already gone up 20%?
There is no bell that goes off when the share market has reached a low point and a bull market returns. Typically most of the investment returns after the end of a bear market happens within a relatively short period of time after the low point. If you "cash out" once the market has already fallen 20% and then wait until the share market has "settled down" and has recovered 20% you have lost a significant portion of the value of your investment which could have been avoided if you had stayed in the same investment option throughout the market downturn.
Many people make the classic mistake of looking in the rear view mirror and follow past investment returns. They buy high and sell low.
Yes, by switching from a balanced fund or growth fund into a defensive asset such as cash you will reduce volatility which does limit the further downside if the share market continues to deteriorate. You must however realise the consequences of your action.
This is a reprinted summary from an article on my web site. The complete article contains diagrams ommitted in this summary.