Negative returns. Cash is one of the three major asset classes and it serves several legitimate purposes in a portfolio: it dampens volatility and provides liquidity. The cost is that cash typically produces much lower returns than stocks or bonds. Once you adjust for both inflation and taxes, average returns have been negative.
Equity market is richly valued at the moment
Robert Shiller’s cyclically adjusted price-to-earnings ratio (or CAPE ratio) for the S&P 500 (SPY) (IVV) was measured at 27.8x in February, which is significantly above the historical average of 16.5x. The CAPE ratio is defined as the price of a share divided by the ten-year moving average of its earnings. It’s used to assess valuations in markets and can be seen in the previous graph. The six-year bull run has left equities expensive and hence, investors are choosing to stay on the sidelines instead of jumping into US equity markets.
Cash provides liquidity and flexibility to take advantage of opportunities
Cash is the most liquid asset. Holding cash gives investors psychological comfort, as they have a safety net available for emergencies. Given the increasing volatility (VXX) in the markets, it makes sense to hold on to some amount of cash in your portfolio. Also, government bonds (TLT), which are considered to be a safer asset class, are giving very low yields. Government bonds in Europe (EZU) and Japan (EWJ) are offering near-zero yields. Hence, the opportunity cost of holding cash against investing in bond markets is not as high.
Holding cash also gives opportunities to investors to stay flexible and enter the markets when prices are depressed. The previous graph shows the results of the BlackRock Investor Pulse survey conducted in 2014 as to why investors prefer to hold cash.
Now that we know why it is worth holding on to cash, read the next part of the series to understand why cash may need some support.