Fear of Equities Drives More Investors to Cash

If a lot of your portfolio is still sitting in cash after a five-year bull market in equities, you're not alone. Investors at all wealth levels around the world are holding substantial amounts of cash that have increased since 2012. What this means for investors and the markets that depend on their money is intriguing.

According to new research on investors in 16 countries by State Street's Center for Applied Research, retail investors globally were holding an average of 40 percent of their assets in cash, up from 31 percent two years ago. That's a compounded annual growth rate of a whopping 13 percent.

The lowest levels of cash holdings were in India, at 26 percent, and China, at 30 percent; the highest was 57 percent in Japan. The United States was in the middle at 36 percent, but that was an increase of 10 percentage points in just two years. The survey, done by State Street, one of the world's largest asset managers and custodians, was conducted in the first quarter of this year. It considered cash to be money held in savings and checking accounts as well as cash equivalents like money market funds.

Despite the run-up in equity markets, people have resisted rushing into stocks and have instead added to cash. They've done this regardless of their age or amount of wealth. The study found that millennials who are younger than 33 and have the longest time to invest their money were increasing their cash positions at the same rate as baby boomers, who will need to draw on their investments soon.

Why is this happening? Suzanne Duncan, global head of research at State Street's Center for Applied Research, chalked it all up to fear - even though it has been more than five years since the Standard & Poor's 500 stock-index hit its low.

"If it wasn't fear, there'd be a much different variation by age," Duncan said. "Certain cohorts need more liquidity than others. When you find consensus across age cohorts, you realize it's not for liquidity needs but lack of trust across all age and wealth levels."

She said her own client meetings confirmed this deep-seated worry about the markets, like the one with the 90-year-old woman who had most of her money in cash. "She said she was afraid of high-frequency trading and dark pools," Duncan said. "Then she said, 'I don't know what those are, but I don't want to put my money with them.'"

That meeting, she said, was before Michael Lewis' "Flash Boys" came out about the rigging of the stock market by big financial firms and the impact of high-speed trading.

While fear is propelling people to hoard cash on one end of the spectrum, overconfidence is driving the investments people are making on the other end, the State Street study found. Two-thirds of the investors polled said their best investment was "entirely" their decision, and the investment that topped the list was "buying land or property."

Yet 45 percent of investors didn't know what the annual returns on their investments were and 64 percent said they didn't know what fees they paid.

"They're disenchanted with what the markets returned, and they're comparing a physical property to this abstract market return," she said. "They remember significant pain going through the downturn. But they don't even know what their returns are on their investments."

With results like these, the study's least surprising finding may be just how poor financial literacy is around the world. It asked 13 fairly specific questions about how compound interest, fees and active or passive management affect returns. Singapore came in first, with a C-minus. Citizens of five countries, including Germany, Japan and France, failed. Americans barely passed, with a score of 60 percent.

So what does this mean for investors? It depends on whom you ask. Duncan noted that cash hoarding decreased at higher wealth levels. Investors with less than $250,000 have 50 percent of their wealth in cash, while those with $250,000 to $1 million have 38 percent. People with more than $1 million have 32 percent. (This was the one data point where the study did not have a comparative figure from 2012.)

The money not held in cash, the State Street study found, generally went into equities and alternatives, like real estate and hedge funds.

This phenomenon has led some analysts to argue that high cash positions will buoy the stock market. Bill Stone, chief investment strategist at PNC Wealth Management, said he had been doing his own cash calculations, comparing the average level of cash investors had to invest with the market capitalization - the value of the outstanding stock - of the companies in the broad Standard & Poor's Composite 1500-stock index.

Right now, he said, that cash available for investment relative to market capitalization is just about average. In December 1999, on the eve of the technology bubble's bursting, that level hit a low, he said. It hit a high in February 2009, but that, he said, was a function of the market capitalization being so low.

"What I was trying to get to was to decide if there was firepower out there," Stone said. "Some function of the stock market still going up is the next guy to buy. Valuation is in there, of course. But if the last person has just bought, you have a problem."

He said he believed there was still money to drive stocks higher but that investors were only slowly becoming less hesitant. "People saw the value of having some cash," he said. "It was the only thing that could save you if you've gotten out over your skis too far."

Jose A. Rasco, head of investment strategy at HSBC Private Bank, took a different view in support of the same thesis that the stock market was not overvalued and that investors would continue to support it. He said that while the S&P 500 was up 30 percent last year, economic growth in the United States and the developed world was still below historical averages.

If that growth picks up and company earnings begin to improve, Rasco said the bank's clients, who are extremely wealthy but still have large cash positions, would see that as a signal to invest more of their cash.

Of course, there is no guarantee that those large pots of cash will flow into equities and support a continued rally. "I'm not as compelled or convinced that cash will propel the market," said G. Scott Clemons, chief investment strategist at Brown Brothers Harriman. "Behaviorally, it makes sense, but empirically it doesn't. Large cash positions are not necessarily dry powder waiting to be deployed."

He suggested cash could be a safety net for some. For others it could be money held in reserve for a future market decline.

Still, Clemons sees continued value in holding cash, even though it neither grows nor offers a return like other assets. "If you believe future volatility will increase, the option value of cash increases and outpaces the return on a money market fund," he said. "It's a little theoretical, but it represents potential buying power."

Yet he drew a line at 50 percent of a portfolio in cash because of the impact that even moderate inflation would have on that money. At 2 percent inflation, for example, $1 million would be the equivalent of $615,000 in 25 years.

Whatever the outcome, for Duncan, investors clinging to cash around the world confirmed her belief about the magnitude of the psychological effect of the financial crisis.

"We are accustomed to thinking about other crises like the dot-com crash," she said. "In this case investors haven't come back because they were painfully affected by the financial crisis. It's interesting to see if the buy high/sell low pattern comes into play in a couple of years."

Until then, the mattresses may stay stuffed.

© 2014, The New York Times News Service