In 1976, Ibbotson and Sinquefield first published their seminal study Stocks, bonds, bills and inflation: year-by-year historical returns (1926-1974). It has been renewed every year since. Stocks, bonds, bills demonstrated that cash merely keeps even with inflation in the long run, while stocks and bonds provide much greater positive returns. Since then, fund managers have been loth to hold cash. Large cash positions are now seen as signs of uncertainty and indecision. Cash is not macho. Real men do not eat quiche. Or hold much cash.
It is axiomatic in the mutual fund industry that what are considered normal cash positions should be between 3% and 5%. This affords liquidity to meet redemptions from fund shareholders, which commonly run at about 25% of assets annually, and for the opportunistic purchase of long-term assets. Today, however, the equity markets are at or approaching all-time highs in the US and Europe and interest rates are at extraordinarily low levels and rising.
The Shiller 10-year inflation-adjusted PE ratio is 24, well above the historical mean since 1880 of 16.5, and Shiller predicts an average real return of only 3% annualized over the next 10 years. This analysis suggests that the risk of negative future returns for risky long-term assets is higher than normal. However, above-average valuation and interest-rate risk do not appear to be reflected in today’s mutual fund cash positions.
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The Investment Company Institute reports that as of September 30, equity mutual funds held 3.7% cash, about the same as their long-term average. Fidelity Magellan (assets of $13 billion) reported cash of 0.78% of assets, while American Funds’ Growth Fund of America ($68 billion) reported 0.71%. Although I fancy myself an independent thinker, I do occasionally seek advice from the best minds. I remember once hearing my parents and some of their friends discussing André Malraux’s 1951 essay Le musée imaginaire, which postulated a museum of reproductions unconstrained by time or place. This has inspired me to create a highly expert albeit imaginary investment committee, Le comité imaginaire, peopled by admired strategic thinkers.
This cross-temporal brains trust comprises: Sun-tzu (6th century BC Chinese general and philosopher), Fabius Maximus Cunctator (the Roman general who confounded Hannibal in the Second Punic War), and Marshal Joseph Joffre (the French generalissimo who repelled the German advance at the beginning of the First World War using the famous ‘taxis of the Marne’).
Scheduling was of course a problem, but our last meeting provided useful insights. Sun-tzu decried the recklessness of most investors. He does not believe in luck or good fortune, but only in careful preparation, superior intelligence-gathering, secrecy and the avoidance of risk.
Unerring victories
The minutes of the meeting make his advice clear: “He whom the ancients called an expert in battle gained victory where victory was easily gained. Thus the battle of the expert is never an exceptional victory, nor does it win him reputation for wisdom or credit for courage. His victories in battle are unerring. Unerring means that he acts where victory is certain, and conquers an enemy that has already lost.” Sun-tzu does not, for the record, endorse insider trading; rather he argues for committing cash reserves only to exploit compelling opportunities.
Fabius Maximus had earned the sobriquet ‘Cunctator’ (delayer) for wearing down Hannibal by harassing and retreating before Hannibal’s army, until the latter was obliged to return to his home base in Carthage after a few years. To our committee, Fabius understandably argued that cash should be hoarded until the odds of investment success are overwhelmingly favourable.
In the First World War, Joffre had the supreme sang froid to hold back his 75 millimetre cannons, their precious store of munitions and the reserve divisions until the Germans, advancing too rapidly, exhausted, and perilously ahead of their supply lines, were within cannon-shot of Paris. He then launched a furious counter-attack that drove his adversaries back almost to the German border. Joffre, like Sun-tzu and Fabius, argued for maintaining large cash reserves until an overwhelmingly favourable opportunity presented itself.
Save for the fact that I feared his cigar smoke would give Sun-tzu a headache, I would have included Winston Churchill in the committee because of this incident: in mid-1940, as the Germans were advancing into France, Churchill had gone to the French headquarters in Paris and watched as the moving positions of the various forces were being indicated on a table map.
As the Germans broke through the Allied defences, Churchill said: “Now you must commit the reserves.” A French general replied: “There are none.” Plan B did not exist. The battle was lost.
Particularly when stock and bond valuations are extended, cash is an important strategic asset. The clear sense of the committee was that cash should be husbanded. By doing so, the investor will be able to profit from what might otherwise be long-lasting or permanent reverses. The committee concluded that 30% was an appropriate cash position today.
* Roger G. Ibbotson and Rex A. Sinquefield, The Journal of Business, Vol. 49, No. 1 (Jan., 1976), pp. 11-47