When investors "go to cash," they can mean actual cash - money-market funds, savings accounts, CDs - or they can mean a diversified fixed-income bucket. To find out which approach works better, consider the performance of two different fixed-income portfolios following four recent crashes in the U.S. equity market. The first is a true all-cash portfolio and the other is a diversified fixed-income portfolio that includes three types of bonds as well as cash.
Let's begin by analyzing the U.S. equity crash in 2000. The S&P 500 lost 9.7% (as measured by exchange-traded fund SPY). An investor who reacted to that loss by going entirely to cash at the start of 2001 would have incurred a three-year annualized return of 2.2% over the subsequent three years (2001-03) as shown in "Cash Comparison" below.
Next, assume the investor fled stocks (following the bear market of 2000) and repositioned those investments at the start of 2001 into a diversified fixed-income portfolio of 40% cash, 20% aggregate bonds, 20% TIPS and 20% in non-U.S. bonds. The diversified fixed-income portfolio was rebalanced at the beginning of each year to bring each asset to its predetermined percentage allocation.
All these fixed-income asset classes are easily accessed through mutual funds or ETFs. The three-year annualized return of this diversified fixed-income portfolio was 6.8%, more than three times higher than an all-cash portfolio.
What if an investor went to cash at the start of 2002 after a dismal equity year in 2001, in which the S&P 500 lost 11.8%? Over the next three years (2002-04), the all-cash portfolio produced an annualized return of 1.2%. The same investor would have enjoyed a much higher three-year annualized return of 7.2% with a diversified fixed-income portfolio.
Fast forward to the next time frame. After a third year of equity losses, the investor shifts entirely to cash at the start of 2003 (after a deflating loss of 22.6% in the S&P 500 in 2002). After three years in cash (2003-05), he or she experienced an annualized return of 1.7%. Alternatively, a diversified fixed-income portfolio consisting of cash, U.S. bonds, TIPS and non-U.S. bonds generated a three-year annualized return of 3.9%.
Now consider a more recent memory. After being gutted by equity investments in 2008, the investor runs, not walks, to cash at the start of 2009. Over the subsequent 2.6 years (through July of this year) the all-cash portfolio generated a paltry 0.2% annualized return, while the diversified fixed-income portfolio produced an annualized return of 3.6%.
Clearly, diversification is key when investing money. Diversification is needed on the equity side of a portfolio as well as on the fixed-income side. Perhaps some investors may assume that diversification primarily applies to equity investments.
Not so. The fixed-income portion of a portfolio clearly benefits from diversification. Rather than hiding in cash, a diversified fixed-income position has demonstrated consistently positive annual returns that materially outperform cash.
Was the diversified fixed-income portfolio riskier than an all-cash portfolio? No. The annual returns of both portfolios were always positive, as shown in the chart below, "In the Black." In fact, since 1998, the average annualized return of the diversified fixed-income portfolio has outperformed an all-cash portfolio by 194 basis points with only a slight increase in the standard deviation of annual returns (2.77 vs. 2.20).
So, is it wrong for an investor to move entirely to cash? Certainly not. However, staying there too long can hinder investors who need safety combined with performance that stays ahead of inflation.
The return of the six-month Treasury bill (a common measure of the performance of cash) has averaged an annual return of 4.7% over the past 25 years, whereas the annual rate of inflation (as measured by the Consumer Price Index) has averaged 2.8%. The margin of cash outperformance over inflation is about 190 basis points, much of which will be wiped out by taxation.
Having a diversified fixed-income bucket is particularly important right now given the dismal performance of cash in recent years: 0.5% in 2009, 0.06% in 2010 and 0.05% through July 31, according to Vanguard Prime Money Market. On the other hand, an all-cash portfolio had better returns in four of the 13 years (1999, 2001, 2005 and 2006).
For particularly cautious investors, another asset allocation option is to have an all-cash bucket that's teamed with a diversified fixed- income bucket. We don't live in an either-or world. Investors can have a cash bucket and a diversified fixed-income bucket in their portfolios if they wish.
LOOKING FOR BALANCE
This analysis should not be construed to mean investors should abandon their asset allocation strategy (for example, fleeing to a different model) after equity market meltdowns. Rather, prudence would suggest that investors should always have portfolios that have both growth and preservation elements.
For younger or more aggressive investors, the investment portfolio would likely emphasize the growth elements by assigning larger allocations to a wide variety of equity and diversifying assets. Nevertheless, the younger investor also should have some exposure to preservation assets - and a diversified fixed-income approach is better than simply allocating the preservation component of the portfolio to cash.
For older and/or more conservative investors, the preservation elements of the portfolio will likely have larger allocations. Conventional wisdom often suggests that cash would be the predominant preservation asset.
However, this analysis clearly demonstrates that a diversified fixed-income bucket is a better choice than an all-cash position. If you must flee equity market mayhem, flee it well.
Another point: the need to flee at all (to cash, to a diversified fixed-income portfolio, to equities, etc.) is minimized by building risk-appropriate portfolios that have a diversified fixed-income component and a diversified equity component. Doing so stabilizes our portfolios while creating safe havens. No need to flee - safety is already built in.
Craig L. Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio With a Plan.