Is Cash Valuable?

One way of understanding risk is to calculate expected returns. This is done simply by looking at the dividend yield and the capital gain. You can set these out quite easily and ask yourself if you are comfortable holding risk assets given their expected return. 

For example:

Cash/term deposit - approximately 3.5-4 percent

10 year Government Bonds - 4.19 percent. 

ASX 300 dividend index (VAS) - 3.3 percent 

Sydney 2 Bedroom Unit - 5.2 gross (1.5 percent net)

Gold and alternative assets - no yield. 

Now select a timeframe. 

The question is are you comfortable holding any of those assets are the expected rate of return. This is generally ignoring the valuation of those asset and the timeframe as these will vary between each investor.

Will there be opportunities for higher returns in the future and therefore holding cash is a good idea even though some asset classes will outperform over some future time frame? 

Will you be able to add additional funds if the market declines and offers higher yields in the future?

Importantly, will you be able to stomach a large drawdown which potentially reduces previous returns and may eventuate in negative returns? 

Let’s address the questions one at a time:

1. Future opportunities. Select your timeframe and see what the range of returns were over equivalent periods given the same valuation. With a CAPE of 40, looking back at previous times when the same CAPE, you see that forward returns are negative over a 10 year timeframe. Hmmm….
2. Additional funds - most investors have a job that pays a regular wage or salary. This can be a source of funds, but if the market experiences a large decline, we would want a large pool of additional funds in order to take advantage of the decline. You must also consider the potential for unemployment if companies start laying off staff given weaker economic conditions. 
3. Drawdowns & Emotional Investing - this is probably the main one as higher volatility leads to lower returns. Will you be able to manage your portfolio through periods of higher volatility? Do you have a plan or strategy to implement in the face of higher volatility? 

Looking back at history when markets are seriously overvalued after a 16 year bull market it has shown that prudent investors who understand cycles and risk reward measures, are more likely to generate higher long term returns largely to avoiding losses and accepting that for short periods of time, they will suffer from FOMO but in reality know that these returns will vanish and be comfortable looking wrong.