Investors stay in cash at their own peril: Report

Nervous Canadian investors are pulling out of investments and sitting on record amounts of cash, a new CIBC World Markets Consumer Watch report says. While they think they may be playing it safe, many of these investors face a scenario of actually losing money.

The report finds that Canadians are holding onto a record $45 billion in extra cash they normally would invest in the markets, which represents 10% of the total personal liquid assets in Canada.

Benjamin Tal, senior economist at CIBC World Markets, says $35 billion worth of equity funds have been cashed out in the last six months alone. The cash holdings of Canadian households are now rising at a year-over-year rate of 15% — the fastest pace in more than six years.

“Despite the recent recovery in the stock market, Canadians are still sitting on cash positions which in real terms are 15% higher than the already elevated level seen in 2001,” Tal says. “The October 1987 stock market correction lasted two months, but investors sat on their newly created mountain of cash for a lengthy 16 months, during which time the stock market gained more than 20%. Ditto for the 2001 flight to safety.”

According to his calculations, investors who waited too long to re-enter the stock market 2001 market correction lost more than $30 billion.

The losses could be more substantial this time, due to risk aversion of younger investors. Tal says back in 2001, many of these investors moved money from the stock market into real estate — an option less attractive or affordable today.

“As risk aversion rises with age, it is hardly a surprise that older Canadians are the first to make a beeline to the safety of cash. However, what is surprising is the near 40% contribution of Canadians aged 25-49 to the current liquidity reserve. This amount is twice as large as what we saw in 2001.”

If investors do invest their money, it seems to be in money market funds. Sales of money market funds hit a record $10.7 billion during the first three months of 2008. The share of money market funds as a percentage of total mutual funds has shot up from 7% in September 2007 to 10% today.

“Clearly, safety is in these days. The most popular destination is by far money market mutual funds, which have seen cumulative net sales over the past six months rising eight times faster than during the same period last year,” Tal says. “The rush into cash during periods of increased volatility is understandable. But in all recent instances, Canadians sat on their cash for far too long after the markets rebounded.”

Investors who move to cash aren’t just missing out on potential gains; in today’s environment they face a real prospect of losing money, period. This is a low-rate environment right now, but many indicators point to a steep rise in inflation. One has only to look at the astronomical gains in energy and food prices to see this.

Therefore, investors who park in money market funds or stay in cash will not be realizing much of a yield on their investments while at the same time will be facing an increase in living costs.

“There are two major risks to being in cash. One is that you stay in cash too long and miss the market recovery or the early stages of the recovery,” says Liz Lunney, senior vice-president and director of portfolio management for Fiduciary Trust Company, a division of Franklin Templeton Investments. “The second risk is that cash returns are typically low, especially in this low-rate environment, so investors face a big inflation risk.”

To add insult to injury, the tax rate on money market funds and interest income are much higher than on capital gains. Lunney notes that, after tax and inflation, there is high risk of a negative return on cash balances overall.

Still, there are going to be clients who simply do not have the risk tolerance for today’s volatility and are more comfortable having inflation and taxes subtly eat away at their holdings. For this type of investor, Lunney suggests advisors look to at least park their client money in a conservative portfolio investment.

For instance, Franklin Templeton offers the Quotential Diversified Income Portfolio.

“It’s designed exactly for investors that are looking for a steady income stream, have lower risk profile but at the same time addresses the need to earn returns over time that match inflation,” Lunney says. “We diversify across both the Canadian and the global bond market. There is also exposure and income trust securities and equity income, a higher percentage of which are in bank stocks, utilities and have a higher dividend yield.”

If clients are insistent on a low-risk money market fund, Lunney suggest they at least put the money in a tax-efficient one that converts the income payout to capital gains. At a minimum, this will at least reduce the tax hit on the investment.

Ultimately, Lunney believes there is no substitute for staying invested. If possible, investors should look to set up an instalment investment plan that will dollar-cost average their contributions and minimize the effect of volatility.

“The true long-term objective of investing is to save for retirement during periods of anxiety about the market council an “average in” strategy. Take the emotion out of it. Make a decision to invest over a three- or six-month period and simply divide the contributions into equal instalments. It takes the emotion out of it, but gets you invested for the long term,” she says. “The difficultly with trying to time the market is investors have a tendency to sell after the market is corrected, realizing those losses. Then they are forcing a second loss decision when to buy back in. Unfortunately, financial markets tend to move in advance of the fundamental economic indicators.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(05/07/08)

Mark Noble