There is an old investment adage that cash is king. At the recent Berkshire Hathaway annual meeting, a money manager said that he had his clients "30% in cash" and was contemplating moving that percentage to as much as 50% in anticipation of what he sees as the inevitable correction in equity values.
Now, there is little doubt that in the coming years that there will be a significant correction, defined as a 20% or more drop in equity prices. This isn't because stocks are wildly overvalued but simply because corrections are a normal part of stock market cycles, and from an historical perspective, we are overdue for a major correction.
By some people's definition, this year we have already experienced a correction. In mid-January most major U.S. stock indices were down by about 10% from their highs.
For some, 10% seems to be some sort of magic number, as losing a double-digit percentage of portfolio value registers on investors' pain thresholds.
This is despite the fact that 10% corrections are quite common. Since 1950, the S&P 500 has had a 10% correction in more than half the calendar years.
In fact, one in six years witnessed corrections in excess of 20%.
Having a significant amount of cash on hand when valuations are cheap is definitely a luxury. But, like many luxury goods, it comes at a very high price.
The opportunity cost of holding cash over long periods of time is simply too high for the typical investor. Since 1926, cash has an average real return (after inflation) of just 0.5%.
And, it gets worse. After taxes, cash has actually had a negative real return.
This has prompted Warren E. Buffett to declare, "The one thing I can tell you is the worst investment you can have is cash. Cash is going to become worth less over time."
That money manager at the Berkshire Hathaway annual meeting proudly touted that he had a large portion of his clients' portfolios in cash prior to the financial crisis. And, by the way, these clients pay the manager a handsome fee for him to hold cash.
What he didn't say, however, is that he didn't put the majority of that cash to work prior to the dramatic rebound in values.
Unfortunately, as the old Wall Street proverb states "nobody rings a bell at the top or bottom of a market."
And, nobody rings a bell when a correction begins or ends.
This article is commentary by an independent contributor. Robert R. Johnson is president and chief executive of the American College of Financial Services.
At the time of publication, the author held a position in Berkshire Hathaway.