Could cash be king after all?

It's tempting to switch into cash when volatility strikes - but timing the market correctly is a notoriously hazardous undertaking.

Ask any stockmarket old hand for a few words of wisdom that investors should abide by and it won’t be long before you hear the phrase “run a profit, cut a loss”. Intuitively, that makes sense – why would you not cash out of an underperforming investment before your losses spiral, or hold on to a winner for as long as it keeps delivering?

Yet this isn’t how financial advisers typically tell us to manage our money: instead they insist we will be better off investing for the long term by buying and then holding through thick and thin, rather than trying to second-guess the market.

Stick or twist?

Tom Stevenson, investment director for personal investing at Fidelity International, is convinced this is the best strategy. “Market volatility is the roller coaster that investors don’t want to ride, but like most roller coasters, the actual ride isn’t always as scary as you might think it would be,” he argues. “Many investors instinctively sell their stocks and stash their money in cash when the market hits choppy waters, but this can be a dangerous and costly move.”

Stevenson has the data to back this argument up. Fidelity’s analysis reveals that if you had put £1,000 into the UK stockmarket 30 years ago, your money would have been worth £10,799 by the end of January, a total gain of 980%, or an annual average gain of 8.25%. But if you had tried to be clever by moving into cash when you expected the market to fall, you would have risked losing a chunk of those gains. If you had messed up and found yourself out of the market on the 10 best days for returns during those 30 years, your final investment would only have been worth £5,777 – just over half as much.

But what if you didn’t mess up; what if you called the market right and missed the worst days rather than the best ones?

You’d have been far better off, that’s what. Imagine you had avoided the five worst times for investments during the 30-year period Fidelity analysed, by moving into cash at close to the top of the market and back into shares at close to the bottom. At the end of the period, your starting investment would have grown in value to £19,331, a total gain of 1,834% – almost twice as much as the buy and hold strategy delivered.

In other words, the conventional buy and hold advice you will get from most advisers isn’t the cast-iron strategy for optimal returns they would have you believe it is. The data shows that an investment strategy based on successfully timing the market will deliver substantially better returns than just sitting on your hands will.

Moreover, the performance of the stockmarket in recent times offers up another counterargument to the buy and hold mentality. It’s all very well arguing that a long-term approach to investing in the stockmarket tends to deliver attractive returns – and Fidelity’s 30-year 980% is hardly to be sniffed at – but there have been notable long periods of disappointment for investors in recent decades. For example, they would have not made a penny between 2000 and 2013 by simply staying invested – and 13 years feels like a long-term time frame to most people.

In truth, what advisers really mean when they tell you to buy and hold rather than try to time the market is that they don’t think you’re up to timing the market. Patrick Connolly, a chartered financial planner at Chase de Vere, says: “Some investors like to think they can time the market, but the reality is that very few people, if any, consistently call the market correctly, and those who try to often lose money. These investors will typically come out of markets when there are further gains to be made, and invest when markets still have further to fall.”

The evidence suggests Connolly’s scepticism is justified. Studies have repeatedly shown that private investors tend not to be great judges of the market. One recent study in the US found that investors in collective investment funds made an annual return of just 4% on average over the past 30 years, a period during which the US stockmarket has delivered 11% a year.

A table showing the cost of missing the market's strongest days


Merit in momentum

However, not everyone is quite as pessimistic as Connolly. In January’s Money Observer, Douglas Chadwick, founder of Saltydog Investor, penned a powerful defence of momentum investing – the use of trend analysis to adjust exposures to stockmarkets as they rise and fall.

“Yes, most investors aren’t good at timing the market,” Chadwick says. “But most investors don’t have a clear method or strategy that they apply.” His approach to momentum investing, by contrast, is strategic. He explains: “You look at some very specific numbers and charts every week – data that clearly shows what is happening in the market – and you make your decisions based on that.”

If this sounds too good to be true, Chadwick points to Saltydog’s demonstration portfolio, which delivered a return of around 30% over the five years to the end of 2018, a period during which the UK stockmarket was almost flat. That’s a relatively short period, of course, but the portfolio’s performance is impressive nonetheless.

How then to navigate a course between momentum investing, which appears to offer a holy grail of stockmarket upside without the down periods, and the conventional buy and hold strategy, which screens out human frailties to deliver solid, if unspectacular, returns?

The solution is to not see strategy selection as a binary choice. Even momentum investment extremists probably aren’t going to move entirely into cash when they think the market is heading for a fall. Equally, many advisers concede that investors may want to tinker with their stockmarket exposures during periods of market volatility.

Balanced approach

“Fundamental analysis on whether shares appear expensive, fair value or cheap can help guide decision-making and should be used to tilt a portfolio between more or less risk,” says Jason Hollands, managing director at wealth manager Tilney. However, he warns: “Major swings in markets invariably happen very rapidly and are typically triggered by unforeseen events. In my view, it’s a mug’s game to aggressively make a call on whether to be invested or not.”

In other words, there is a middle ground. If you’re determined to embrace the principles of momentum investing in the most full-blooded way possible, you run a real risk of coming a cropper – and all the more so if you don’t have the time and expertise to commit to the task of timing the market. Equally, your asset allocation doesn’t have to be set in stone. Don’t be afraid to adopt a more nuanced approach to investment at times, whether that means selling some equities and holding the proceeds as cash or increasing your exposure to more defensive markets and sectors.

Alternatively, if you really think timing the market is impossible, even for professionals, review your approach to investment. The implication of that belief is that there is little point in paying a fund manager fees to try to beat the stockmarket. If you deem timing the market impossible, stick to low-cost passive funds.

In the end, many investors will take a view informed by their attitude to risk. The buy and hold mentality carries fewer dangers than the momentum approach but offers less potential upside. Equally, momentum fans should remember the words of economist John Kenneth Galbraith. “There are two types of forecasters,” he observed. “Those who don’t know, and those who don’t know they don’t know.” If you’re in the market timing game, ask yourself honestly whether you’re in Galbraith’s second group.

Charges muddy the waters

Even if you were able to get market timing right more o­ften than not – meaning you would therefore be better off dipping in and out of the market than staying put – dealing costs potentially complicate matters. It’s significantly cheaper to buy an investment portfolio and then to simply hold on to it than to be an active investor – and the more o­ften you trade, the greater the expense you’ll incur.

The question then becomes whether you can get enough outperformance from active trading to compensate for the dealing costs involved. Consistently call the market well and there’s a good chance you’ll still end up ahead, but the issue of charges ups the ante. You’re effectively starting the race further back.

That said, you can take steps to mitigate this problem. Above all, you need to find the cheapest way to trade, in the hope of keeping your dealing costs as low as possible.

That means finding the most competitive platform or broker for your likely pattern of trades – based on what you’ll buy and sell, how o­ften you’ll trade and the size of your investment portfolio.

Candid Money’s calculator is a good option for working out where to go. Its three cheapest providers for active investors in the search we ran were Cavendish Online, Close Brothers and interactive investor, Money Observer’s parent company.

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