"The whole reason you get paid so much more to be in the stock market than in cash is that it fluctuates so much. You get paid to be scared. But do follow the good advice of my pal Ray Lucia, and keep plenty of cash on hand so you won't have to sell your stock (or at least not much of your stock) at a low price. Cash on the order of a year's living expenses is a sensible idea. It makes a lovely cushion."
~Ben Stein
Bueller? Bueller? Known more as the deadpan high school teacher in Ferris Bueller’s Day Off or for giving his money away in a quirky game show, Ben Stein is actually an accomplished lawyer, economist and author. Not to mention, he’s almost spot on in this quote. That is, if you can be “almost spot on.”
Ben nails the concept of risk premium simply and succinctly, “you get paid to be scared.” Bingo. It’s pretty much common knowledge these days that stocks, over the long term, deliver a higher expected return over cash or fixed income. And why is that? Precisely what Ben said, because “it fluctuates so much.” Markets, it turns out, are not hard to own. Not in the last thirty plus years, since index funds have been around. It’s even better in the last ten years since Dimensional Fund Advisors (DFA) has become somewhat accessible to the public. They are the firm that improved on index investing.
Yes, markets are rather easy to own. Buy an index fund, ETF or other low cost, low turnover passively managed portfolio, and stop looking at it. Ignore CNBC, ignore Kiplinger’s Personal Finance magazine, ignore the nightly news, and well, you should probably just turn your computer off entirely. If it’s so easy, why do people have a hard time in markets? It’s the fluctuation that gets people.
Few people open an 18 month CD and check online each day to see how much interest they earned. They already know the answer. However, there are hoards of people who check the value of their investment portfolio daily, even hourly. They don’t just look at the bottom line, they look at each position. “ABC is up 2%, XYZ is down 1.4%.” It’s the fluctuation that gets you. Most people have difficulty holding assets that have decreased in value. Something economists call Loss Aversion, but that’s a topic for another day. Those who stay the course are usually rewarded. It’s not that they are not scared, but they stay the course anyway. And as we learned from Mr. Stein, you get paid to be scared.
Where Ferris’ economics teacher is off the mark is in the amount of cash that you should hold. A year is too much for most people. Especially if you are not currently taking an income from your portfolio. But if you are, remember that a portion of your portfolio should be allocated to fixed income.
Example: You are living off of your portfolio to the tune of a 5% annual withdrawal ($2,000,000 portfolio, $100,000 withdrawal), and you keep 6 months living expenses in cash. Let's say that you have 30% of your portfolio in fixed income. If the stock market is down, you can sell fixed income positions in lieu of equities when the market is down. If there is a terrible, protracted market downturn, 30% of your portfolio at a 5% withdrawal rate, ignoring dividends and interest, (and some really crude math) will last you 6 years before having to sell your stocks when they are down. Factoring in dividends and capital gains will probably buy you another year.
It’s not selling stocks that hurts. At some point, you have to sell. It is being forced to sell when you are down that really blows your portfolio up. In a bad bear market one year of cash won’t protect you, but as a general rule, it’s too much. Some portion (like 15% or 30%) allocated to fixed income provides greater protection for your portfolio through a market downturn.
A year is too much for most people. Especially if you are not currently taking an income from your portfolio. But if you are, remember that a portion of your portfolio should be allocated to fixed income.
Posted by: James Morgan - Puritan Financial Advisor | September 10, 2010 at 12:28 AM