When stock markets become volatile, investors get nervous. In many cases, this prompts them to take money out of the market and keep it in cash. Cash can be seen, felt and spent at will and having money on hand makes many people feel more secure. But how safe is it really? Read on to find out whether your money is safer in the market or under your mattress.
All hail cash?
There are definitely some benefits to holding cash. When the stock market is in free fall, holding cash helps you avoid further losses. Cash is also psychologically soothing. During troubled times, you can see and touch cash. However, while moving to cash might feel good mentally and help you avoid short-term stock market volatility, it is unlikely to be a wise move over the long term.
A loss is not a loss
When your money is in the stock market and the market is down, you may feel like you’ve lost money, but you really haven’t. At this point, it’s a paper loss. A turnaround in the market can put you right back to breakeven and maybe even put a profit in your pocket. If you sell your holdings and move to cash, you lock in your losses. They go from being paper losses to being real losses with no hope of recovery.
While paper losses don’t feel good, long-term investors accept that the stock market rises and falls. Maintaining your positions when the market is down is the only way that your portfolio will have a chance to benefit when the market rebounds.
When buying and selling assets for profit, it is important for investors to differentiate between realized profits and gains and unrealized or so-called ‘paper profits’.
Simply put, realized profits are gains that have been converted into cash. In other words, for you to realize profits from an investment you’ve made, you must receive cash and not simply witness the market price of your asset increase without selling.
For example, if you owned 1,000 shares of XYZ Company and the firm issued a cash dividend of Rs.0.50 per share, you would realize a profit of Rs.500 from your investment. This is a realized profit because you have received the actual cash, which cannot be lost due to changes in the marketplace.
Similarly, let’s say you purchased your 1,000 XYZ shares at Rs.10 per share, for a total investment of Rs.10,000. If XYZ Company were presently trading on the market for Rs15 per share and you sold all of your 1,000 shares on the open market at Rs.15, you would realize a gain of Rs.5,000 on your investment (Rs.15,000 – Rs.10,000).
Inflation is a cash killer
While having cash in your hand seems like a great way to stem your losses, cash is no defence against inflation. You think your money is safe when it’s in cash, but over time, its value erodes. Inflation is less dramatic than a crash, but in some cases it can be more devastating to your portfolio in the long term.
Opportunity costs add up
Opportunity cost is the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, opportunity cost refers to the benefits you could have received by taking an alternative action.
In the case of cash, taking your money out of the stock market requires that you compare the growth of your cash portfolio, which will be negative over the long term as inflation erodes your purchasing power, against the potential gains in the stock market. Historically, the stock market has been the better bet.
Time is money
When you sell your stocks and put your money in cash, odds are that you will eventually reinvest in the stock market. The question then becomes, “When should you make this move?” Trying to choose the right time to get in or out of the stock market is referred to as market timing. If you were unable to successfully predict the market’s peak and sell, it is highly unlikely that you’ll be any better at predicting its bottom and buying in just before it rises.
Markets move in cycles and there are undoubtedly indicators of various kinds that at least potentially reflect the particular market phase at a given time. Smart investors who recognize the different parts of a market cycle are more able to take advantage of them to profit. They are also less likely to get fooled into buying at the worst possible time.
Common sense is king
Common sense may be the best argument against moving to cash and selling your stocks after the market tanks means that you bought high and are selling low. That would be the exact opposite of a good investing strategy.
While your instincts may be telling you to save what you have left, your instincts are in direct opposition with the most basic tenet of investing. The time to sell was back when your investments were in the black - not when you are deep in the red.
Buy and hold on tight
You were happy to buy when the price was high because you expected it to go higher. Now that it is low, you expect it to fall forever. Look at the markets over time. They have historically gone up. Companies are in business to make money. They have a vested interest in profitability. Investing in equities should be a long-term endeavour and the long-term favours those who stay invested.
Short-term market performance is unpredictable. Daily price swings occur, sometimes for seemingly irrational reasons, which is why long-term investors ignore short-term distractions. To get a better sense of the long term, look at the performance of any major market index over a 20-year period. The trend is for the numbers to move upward. Sure, there are peaks and valleys, but overall, the direction of the movement is up.
Take advantage of the long-term trend when planning your investment strategy. Accept the fact that your portfolio won’t always be in the ‘right’ place at the ‘right’ time and that you won’t always own the ‘hot’ investment. Instead of acting like an amateur and chasing short-term performance, plan your investments like a professional.
Set a long-term goal and then choose a strategy that has a high likelihood of achieving that goal. Make logical decisions, not emotional reactions. Think about inflation and don’t count on cash to appreciate at a greater rate. Rely on the time-tested theories of diversification and low-cost investing to help you over the long term.
Nerve wracking, but necessary
Serious investors understand that the markets are no place for the faint of heart. On the other hand, since social security schemes may not be sufficient to finance retirement years, individuals must look for avenues to ensure financial security during retirement.
Generally speaking, investors have a few factors to consider when looking for the right place to park their money. Safety of capital, current income and capital appreciation are factors that should influence an investment decision and will depend on a person’s age, stage/position in life and personal circumstances.
Once you’ve faced the facts, you need to have a plan. Figure out how much money you need to amass to meet your future needs and develop a plan to help your portfolio get there. Find an asset allocation strategy that meets your needs. There is no simple formula that can find the right asset allocation for every individual.
However, the consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make.
In other words, your selection of individual securities is secondary to the way you allocate your investment in stocks, bonds and cash and equivalents, which will be the principal determinants of your investment results.
Monitor your investments. Rebalance your portfolio to correspond with market conditions, making sure to maintain your desired mix of investments. Once you reach your goal, move your assets out of equities and into less volatile investments. While the process can be nerve-wracking, approaching it strategically can help you keep your savings plan on track, despite market volatility.