The Problem with Too Much Cash

Dollar Bills

According to a survey by MFS Investment Management, investors on average have 24% of their portfolio in cash. Is having so much cash a good idea?

Cash is a unique investment: unlike stocks or bonds, you can use it to buy goods or pay your bills. And most cash-like investments (such as savings accounts at banks or money market funds) have very little risk since they promise to at least maintain the value of the investment. In some cases, such as with cash in US bank accounts below $250,000, this guarantee is explicitly backed by the US government.

The downside of cash is that because it is low-risk, it also tends to offer lower potential returns. After all, if other investments didn’t offer the possibility of better returns, everyone would simply keep their money in cash.

Therefore, for investors with longer time horizons, having a large allocation to cash can substantially reduce how much their portfolio is able to grow. According to data compiled by New York University professor Aswath Damodaran, $100 invested in 1928 in the S&P 500 index of large US stocks would have grown to over $250,000 by the end of 2013, compared with less than $2,000 for an investment in cash. The difference is even more dramatic after taking into account inflation, which would have eaten up two-thirds of the growth of the cash investment. And there wasn’t a single 20-year period during that span where cash outperformed the US stocks, let alone a more diversified portfolio of multiple asset classes.

That doesn’t mean investors should never hold any cash. If you have sizable near-term expenses, keeping a portion of your portfolio in a very low-risk investment such as cash can help ensure you’ll have enough money when the expenses come due. And if you’re worried that many other asset classes are going to perform poorly in the near future, temporarily increasing your allocation to cash is one way to reduce the amount of risk you’re taking. Maintaining a large allocation to cash for an extended period of time, however, it likely to limit the growth of your portfolio.

Which Countries Are Your Funds Invested In?

Globe

In a recent post we discussed the weak performance of Brazilian stocks over the past few years. But how do you know what your exposure is to Brazil (or any other country)? Unfortunately having only a general idea about the types of investments you own doesn’t answer that question.

Obviously if you own individual stocks in Brazilian companies, or a fund that invests solely in Brazilian stocks, those holdings will give you exposure to Brazil. But many other types of funds have Brazil exposure as well. Brazil makes up over half of the market value of Latin American stocks overall, so a fund designed to invest in Latin America will likely have a large exposure to Brazil. The same is true for broader emerging market funds: based on market value Brazilian stocks account for about 13% of emerging markets overall. More general international and global funds often have a small exposure to Brazil as well.

Yet even within these categories, the exposure to a specific country can vary dramatically. For example, the Invesco Developing Markets Fund and the iShares Emerging Markets Minimum Volatility ETF are both funds that invest in emerging market stocks. Yet Brazilian stocks make up almost 20% of the former and only about 6% of the latter. Furthermore, these numbers will change over time as markets move and as the fund managers change their views about which stocks they should be invested in.

There are even more dramatic differences for other countries. The two largest emerging markets funds by assets, the Vanguard Emerging Markets ETF and the iShares Emerging Markets ETF, are both “passive” funds that simply try to mimic a benchmark index of stocks. But they’re far from identical. Because they have different definitions of which countries qualify as emerging markets, South Korea is the largest country in the iShares fund and has a 0% weighting in the Vanguard fund.

For most investors, taking the time to investigate these details for every holding isn’t a reasonable option. Instead, having tools that allow you to easily understand your geographic exposure and let you know when it gets out of alignment can be a better alternative.

Brazil’s Stock Market Struggles

Brazil Stock Returns

Emerging market stocks haven’t done particularly well in recent years, but Brazilian stocks have done especially poorly. From 2010 through 2013, Brazilian stocks substantially underperformed emerging markets as a whole in each calendar year. So far this year, however, Brazilian stocks have outpaced their emerging market peers. Does this reversal herald a comeback for Brazil’s stock market?

The struggles of Brazilian companies have a number of causes. The country has been battling persistently high inflation, currently above 6% per year. Worker productivity in Brazil has been weak due to factors such as poor infrastructure, a low-quality education system, and inefficient regulations. And declining commodity prices in recent years have hurt the country’s commodity producers.

Often times when a country’s stock market dramatically underperforms over a number of years, stock prices fall so far that they subsequently look cheap. By conventional valuation metrics such as price-to-earnings ratio and price-to-book ratio, however, the valuation of Brazil’s stocks isn’t much different from emerging markets overall. Other valuation measures, such as the ratio of the size of the country’s economy to the size of its stock market, suggest that Brazilian stocks may indeed be undervalued, but less so than other emerging markets such as China.

Since Brazilian valuations don’t seem especially attractive, the country’s stock market will likely need something else to provide a boost if it’s going to build on the gains achieved so far this year. Perhaps elections in October will provide the impetus for pro-growth economic reforms, or a stronger global economy will lead to higher commodity prices. If not, the stock market gains so far this year may be an aberration rather than the start of a trend.

Why Dividends Matter

In a recent post we discussed how taking a total return approach to investing can have benefits relative to focusing on dividends when trying to generate income from your portfolio. Does that mean dividends (and the numerous funds and commentators who focus on them) are irrelevant? Not exactly.

Historically, stocks that pay higher dividends have outperformed stocks that pay low dividends or no dividends at all. And contrary to the investing principle that higher returns should go along with higher risk, higher-dividend stocks on average have actually been less risky investments. They’ve historically outperformed lower-dividend stocks in both bull markets and bear markets.

Dividends
Source: BlackRock, via Business Insider

There are a number of possible explanations for this phenomenon. One hypothesis is that investors tend to overestimate that potential of high-growth companies, which also tend to be the companies that pay lower dividends (since the companies are choosing to use their money to try to grow their businesses rather than returning it to shareholders). As a result, the stocks of lower-dividend companies are often overvalued, so the subsequent returns are lower than for higher-dividend stocks.

Other possible explanations relate to how paying dividends affects companies’ decision-making. For example, it’s possible that having to consistently pay a dividend to shareholders keeps companies’ management more focused on only investing in profitable ventures.

That’s not to say that higher-dividend stocks always do better: there have been extended periods of time when they’ve underperformed lower-dividend stocks. And while some investors consider the collapse of internet stocks in the early 2000’s to be a warning against investing in high-flying stocks that don’t pay dividends, higher-dividend stocks are not immune from big declines of their own: banks were among the highest-dividend stocks in the US prior to the financial crisis in 2008.

So what’s the verdict? There’s no definitive explanation for why higher-dividend stocks have done well in the past, and there’s no guarantee that they’ll continue to outperform in the future. But there is compelling historical evidence that dividends do matter.