This is a story many of you will be familiar with.
You have money to invest that’s been sitting in cash. This is money you don’t expect to need or access for more than 20 years, if ever.
You know that cash is likely to significantly underperform a diversified investment portfolio over the next 20+ years, but you just can’t pull the trigger.
You know you can’t time the market, but…
- “Valuations are high.”
- “Stocks have had an incredible run, how much higher can they go?”
- “I’m just waiting for a correction to get in.”
- “We haven’t had a recession in more than 10 years. Aren’t we due?”
- “Interest rates are at historic lows. What happens when they rise?”
These are all reasonable things to think about when allocating a lump sum of money that has been sitting on the sidelines.
But what does the data suggest?
- What is the opportunity cost of sitting in cash?
- What are the odds that you will have a chance to buy in at a lower price than today?
- What are the odds that waiting for a bear market will allow you to buy in at a better price than today?
- If you could have predicted the start and end of all prior recessions with perfect precision, how helpful would that have been in terms of returns?
- What are the odds that dollar-cost averaging into the market will beat a lump today?
- Should you time new money allocations based on valuation?
- Should interest rates play a role in timing the market?
Let’s take a look at each of these questions…
1) The Opportunity Cost of Sitting in Cash
Most studies on market timing compare stock returns with a 0% return on cash, assuming it is held in a no-interest checking account or stuffed under your mattress.
The reality is with minimal effort cash can indeed have a positive return over time, and it is more accurate to use this return in determining the true cost of “sitting on the sidelines.”
The average yield on cash since 1928 has been 3.4%, but as you can see, the rates have fluctuated considerably over time.
Going back to 1928, the odds of beating the S&P 500 while sitting in cash were 30.6% over rolling 1-year periods. The longer you sit in cash, the lower your the odds of beating the market. An investor in the S&P 500 has beaten cash in every 25-year period, including those who bought at the peak in 1929.
What does sitting in cash cost you? Sometimes nothing, if markets are down and there’s a long bear market.
But much more often, it is costing you something, with that something increasing as the years go by. Over 1-year periods the average cost of holding cash has been around 8%. Over 25-year periods, this grows to over 1,300%.
2) What are the odds that you will have a chance to buy in at a lower price than today?
Many investors will tell you they’re just waiting for a correction to get in. This a fine thought, and buying stocks on sale is generally a good idea.
The only problem is that correction may not come for some time, and when it does, it may never take stocks below today’s levels. You could very well be waiting forever to get invested.
Let me explain.
Historically, stocks have a 74% probability of closing lower at some point in the future (note: monthly total return data going back to 1928). Those are pretty good odds, but it means that 26% of time, stocks just keep on running, and you don’t ever have an opportunity to buy in at a lower point than today.
My favorite example of this is 1995. Stocks ran higher out of the gate, and by the end of February, the S&P 500 was up over 6% on the year. Let’s say you were an investor at that time with cash on the sidelines, and you wanted to wait for a measly 5% pullback to get back in.
Well, you would’ve had to wait until July 1996 before that pullback would come. And when it did, the S&P 500 was still more than 25% higher than where it closed in February 1995.
Would you have deployed your sideline cash then? It’s doubtful. Which is why waiting for a correction can be a difficult game to play.
3) What are the odds that waiting for a bear market will allow you to buy in at a better price than today?
Some investors want more than a correction or lower price point to get invested. They want a significant decline.
Let’s say you want to see a minimum of -20% on a monthly closing basis. How often would waiting for such a drawdown allow you to buy in at a lower level than today?
Going back to 1928: only 21% of the time.
And I’m being generous here in allowing for a larger than 20% drawdown to hit your lower level target (I’m taking the lowest monthly close of each bear market to compare to prior prices).
That means 79% of the time, even if you have the discipline to wait for a 20+% decline before investing (no easy task), when it finally comes it will be at a higher level than today.
Following the Bear Market low in March 2009, stocks went vertical, rallying 7 months in a row and 9 out of the next 10 months into year-end. At the time, many thought it would be prudent to wait for another 20% pullback before getting back in.
Fast forward to 2020 and that 20% decline on a monthly closing basis has yet to occur. If it were to happen today, it would only bring the S&P 500 back to last year’s levels.
Another 50% drop like we saw in 2007-09 would take stocks back to 2014 levels, but that would still be 88% higher than where stocks ended 2009.
The lesson here is clear. If you’re waiting for a large decline to get invested, you have to be prepared to wait a very long time with the understanding that when the decline eventually comes, it could very well leave stocks at a higher level than today.
4) What are the odds that dollar-cost averaging into the market will beat a lump sum today?
Up until now, we’ve assumed that you are investing all of that sideline cash at once, otherwise known as a “lump sum” investment.
There is an alternative to this approach known as dollar-cost averaging.
Let’s say you have $100,000 of sideline cash to invest. You could put all of it into the market today or you could invest x$ per month over y years.
Let’s assume you invest that $100,000 in equal installments over a period of 12 months, or $8,333.33 per month while keeping the balance in cash (3-month Treasury Bills).
How often would such a strategy beat a lump sum investment ($100,000 all at once)?
33% of the time.
Here’s a chart illustrating the 12-month returns of a lump sum investment minus the 12-month returns from dollar-cost averaging. 67% of the time, the lump sum is outperforming.
The longer the period you dollar-cost average over, the lower your odds of beating a lump sum investment. If you spread the same $100,000 over 36 months, your odds of beating a lump sum move down to 27%.
Importantly, the 27% odds are not distributed evenly over time. The last 36-month period in which dollar-cost averaging beat lump sum was October 2008 through September 2011. Starting in November 2008, a lump sum has beaten a 36-month dollar-cost-averaging strategy every single time.
Yes, this is a function of being in one of the most unrelenting bull markets in history, but it illustrates just how long the odds of timing via dollar-cost averaging can be out of favor.
5) Should you time new money allocations based on valuation? What are the odds that such a strategy will be successful?
US equity valuations are high.
At 31, the S&P 500’s CAPE Ratio (aka “Shiller P/E”) is above 96% of historical readings.
As valuations tend to be inversely correlated with future long-term returns, this is a concern for many investors.
Going back in time, how would a market-timing system based on valuation fared?
Let’s take a look.
First, we need to come up with a system.
Starting in 1928 (assuming CAPE data was available then), let’s say you moved from stocks to cash every time the CAPE ratio moved above the 90th percentile and only got back into stocks when it moved back below the 90th percentile. (Note: using a rolling percentile as you wouldn’t have had the full historical data set at that time).
How would such a strategy have fared? Not terrible, but at 8.5% annualized, still a full percentage point lower than the S&P 500’s buy-and-hold return of 9.5%.
Importantly, though, you would’ve had to sit in cash through some incredible runs in stocks. The most memorable of these would be the 1990’s, when the CAPE ratio first moved above the 90th percentile in February 1995. Over the next five years, the S&P 500 would more than triple as valuations went to heights never seen before.
It would come crashing down thereafter (2000-02 bear market), but how many investors could sit in cash for five years during such a run? Even after the crash, stocks weren’t exactly cheap, with a low CAPE of 21 in February 2003 still in the 86th percentile. Would that have been cheap enough for a value-conscious investor? Not likely.
More recently the CAPE ratio moved above the 90th percentile in October 2013. Stocks have more than doubled since.
This system assumes that investors who are concerned about valuations will buy back in once valuations are no longer above the 90th percentile. But for someone that has sat out of stocks for years on end, this is probably not a realistic assumption.
What if we change the system to say that an investor who went to cash after stocks moved above the 90th percentile only got back into stocks when they were below the 75th percentile? How would such a system have fared?
Pretty much the same: 8.6% annualized versus 9.5% for buy-and-hold.
But is the 75th percentile “cheap”? It doesn’t sound like it, but lowering the threshold from there will leave you out of the market for even longer stretches of time. The last time the S&P 500 had a CAPE ratio below the 50th percentile was in April 2009. A month later, they were no longer “cheap” and haven’t been since. Stocks are up 5.5x since then.
That’s not to say valuations don’t matter. At extremes, they most certainly do as they tend to lead to below-average future returns. We should expect that today from US equities. But we have no way of knowing the path of those lower returns, making it quite difficult to time. A long bear market could start tomorrow, stocks could continue to run for years before a larger decline, or stocks could simply trade sideways for years working off that higher valuation.
Additionally, over the long run, returns from high valuations are often still positive (ex: with dividends, the S&P 500 has more than tripled since the March 2000 valuation extreme), making cash a less attractive option.
An alternative approach to trying to time high valuations is to increase your diversification into asset classes that aren’t at similar extremes. Japanese investors in the late 1980s would have benefited greatly from this principle after the historic bubble they experienced.
6) What if you knew exactly when the next recession would start and end?
At 127 months and counting, this is the longest expansion in US history. The 2010s were the first decade ever without a recession.
Many investors are asking: aren’t we overdue for a recession, which tends to take stocks down with it? Should we wait for recession before investing?
Let’s take a look.
Historically, bear markets associated with recessions have indeed been steeper, averaging 42% vs. a 29% decline for stock downturns not accompanied by a downturn in the economy.
Have all recessions led to bear markets?
No. In 1945 there was an 8-month recession without any stock market decline of note. The 1953-54 and 1960-61 recessions had declines of only 14% in stocks, while the 1980 recession saw stocks decline 17%.
So while a recession is likely to lead to a sharp decline in stocks, it is by no means guaranteed.
But getting back to the question of timing.
Let’s say you are the best economist that ever lived. You know exactly when recessions start and end in advance, and allocate to cash during recessions and stocks only during expansions.
What would your returns look like since 1928? 10.7% per year versus 9.5% for buy-and-hold.
Not bad, until you dig into the data and see that all of this outperformance came from avoiding the bulk of the losses during the Great Depression (when stocks declined 86%). Since the Depression, if you were able to time every single recession perfectly, you would have had underperformed with a 10.5% return versus 11.5% for buy-and hold.
In reality, no one could’ve predicted every recession with such precision. Let’s say you were early in getting out and moved to cash a year before the recession, and you got back into stocks a year after it ended. Or more likely, let’s say you were a little late and moved to cash six months after a recession started and moved back into stocks a year after it ended.
That would still be pretty remarkable timing. How would these have fared?
a) Move to cash a year before recession starts, move to stocks a year after recession ends….
Including the Depression: 9.2% vs. 9.5% for buy-and-hold. Excluding the Depression: 9.4% vs. 11.5% for buy-and-hold.
b) Move to cash six months after recession starts, move to stocks a year after recession ends…
Including the Depression: 8.1% vs. 9.5% for buy-and-hold. Excluding the Depression: 8.1% vs. 11.5% for buy-and-hold.
So your timing has to be almost perfect when it comes to recessions, and even then, higher returns are no guarantee.
How can that be?
The stock market is not the economy. It often starts going down before the economy turns south and starts turning back up before the downturn ends. Getting that timing right on both ends is nearly impossible.
Complicating matters is the fact that stocks can go down without a recession (though many will assume we are in one when it happens – see 2011 & 2018 for recent examples) and there can be a recession with only a small or short-lived decline in stocks (1990 is a great example – 3-month bear of only 20%), making timing such a move that much more difficult.
7) Should interest rates play a role in timing the market?
Interest rates are low.
At 1.91%, the 30-Year US Treasury yield has never been lower.
That scares a lot of people because of the widespread belief that low interest rates are “propping up” the market. When interest rates finally rise, it is said, stocks will come crashing down.
While that’s certainly possible, what does the evidence suggest? Are rising interest rates bad for stocks?
As it turns out, not exactly.
There’s almost a 0% correlation between changes in interest rates and changes in stock prices. In plain English that means even if you could predict the direction of interest rates (no easy task), it would tell you nothing about the direction of stock prices.
Since 1928, the 1-year average returns for the S&P 500 are almost exactly the same (11.4%/11.5% respectively) during periods of rising/falling 10-year Treasury yields.
That’s not to say that higher rates cannot act as an impediment to economic growth or stock market returns at times. They most certainly can. But they are just one variable in a highly complex system that is the stock market.
Still not convinced? Let’s go back in time.
From the start of 1949 to the end of 1968, a 20-year period, the 10-Year Treasury yield rose from 2.32% to 6.03%.
How did stocks fare? They were up over 1,500%, or 14.9% annualized.
Summary: How to Think About Investing Cash on the Sidelines…
When it comes to deploying cash on the sidelines, there are no easy answers.
Investing is just a game of odds and the historical probabilities up until now suggest the following:
- If you sit in cash over a 1-year period, you have a 30% chance of outperforming the market. If you sit in cash for 10 years those odds fall to 16%. Over 25-year periods, cash has yet to beat the US stock market.
- Sitting in cash has an opportunity cost on average, and that opportunity cost increases with time (8% over 1-year periods, 1,300% over 25-year periods).
- If you are waiting for lower prices to get in, chances are you will get them (74% of the time), but you also have to be prepared to wait forever (26% of the time there’s no lower low).
- If you are waiting for a bear market (-20%) or more to get in at lower prices, you may never get that chance (only happens 21% of the time).
- Slowly wading into the market via dollar-cost averaging has beaten a lump-sum only 33% of the time over 1-year periods and 27% of the time over 3-year periods. The longer the time period you spread that initial investment over, the lower your odds are of outperforming a lump sum today.
- Timing the market based on valuation is not an easy task, and you have to be prepared to sit in cash for many years or even decades depending on your methodology. Had such a strategy been applied historically, it would have lagged buy-and-hold because equities with high valuations can still have positive (and cash-beating) returns over time.
- Predicting recessions with precision on both ends is nearly impossible, and even if you could’ve done so historically, there’s no guarantee you would have earned a higher return (since the Depression ended in 1933, you would have actually earned a lower return than buy-and-hold even if you were able to predict the exact start and end date of the next 13 recessions).
- Timing the market based on interest rates is not a strategy supported by the data which shows almost no correlation between the two variables. The notion that rising rates are “bad” for equities is a myth.
Does that mean everyone should just close their eyes and invest all their cash on the sidelines today in a lump sum? Most certainly not.
Successful investing is about psychology more than anything else and if putting everything in today via a lump sum causes you to lose sleep at night, you will not be able to stick with that portfolio for a week, never mind the next 20+ years.
The portfolio with the highest expected return is completely irrelevant if you can’t handle its higher level of risk. Far better to be in a portfolio with lower returns that you can compound over 20+ years than one with a higher return that you are likely to abandon at the first sign of trouble.
We started this post by posing a hypothetical where an investor did not need the cash for more than 20 years, if ever. Under that scenario, there should be a pathway to investing at least some of that money to earn a higher long-term return. Not for everyone (if you can’t handle any volatility, cash is the only option), but for most people.
For simplicity, I assumed a 100% allocation to US equities in this post, but in reality most investors would be better served with a more diversified portfolio and a lower risk profile. This is particularly true for investors who have been sitting out of the market in fear of getting in at the top. The last thing they need is confirmation of that view if a steep market decline were to occur shortly after investing. A lower initial risk profile than necessary would cushion the blow if that were to occur, and provide an opportunity to increase equity exposure into the decline.
The goal for all investors should be to remain invested long enough to reap the enormous benefits of long-term compounding. That starts with finding a portfolio and a plan that is best suited to you.
If you’re thinking about your own portfolio and wondering how to allocate cash on the sidelines, reach out. We’re here to help.
Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.