Possible Perils of Switching to Money Market

October 25-26, 2008. Is the money market beckoning you? In volatile times like these we often get calls from readers asking us what they should do with their investments. Many feel they would like to switch their share investments to money market funds to avoid the volatility that they are currently experiencing in the stock market. Most have read articles warning of long-term depressed markets or have spoken to friends and colleagues and begun to panic in the face of such uncertainty.

While it is human nature to try to avoid losses, we usually do more harm than good when deciding to switch from equities to cash/money market in volatile times. This is because while shares are expected to recover over time, cash (including the money market) is expected to under perform inflation over time, taking tax in to account.

There are a few fundamental emotions that financial planners need to deal with that cause investors to act irrationally and often to their detriment; greed and fear are the most common amongst these.

With greed, as we enjoy good times across all the asset classes, investor confidence grows and we forget the difficult times. We start to believe that our investments will always go up in value and forget about the downside risk that we are taking when investing in volatile investments. This causes some to buy blindly without paying attention to the fact that the good times will not continue forever. Market cycles have always, and will always, play a vital role in our financial affairs. This was displayed recently in the property market where many individuals bought investment properties, often off-plan, with the intention to sell the property at a tidy profit a few months later. Many of these investors are now unable to sell these properties, or may have been forced to take significant losses on disposal.

To contrast this, the concept of fear arises when we have lost some of our investment value and are faced with further uncertainty. We tend to feel the pain of a loss far more than we feel the joy of an equivalent gain. This means that while the stock market may creep up for 3 years in a row, there will be little joy felt by us. However, if an equivalent loss is made, we tend to quickly forget about the prior years’ profits as the loss feels far worse than it really may be.

The most common result of the above fear and greed is that investors tend to buy at the top of the market and sell at the bottom. This is because they are not cautious enough in good market conditions and over cautious when market conditions are difficult. Some investors try to time the market with a view to getting a better return. What makes timing the market so difficult is that the investor is making decisions based on historical data, which is often irrelevant. By the time the investor notices the volatility which they are trying to avoid, there has already been a significant decrease in the value of their portfolio. Switching to the money market at that point only locks in the loss and does not allow for recovery over time.

Warren Buffet once said that in times of market uncertainty, money moves from weak hands to strong hands.
Those “weak” investors who choose to sell when prices are depressed in the short term will lose out to those “strong” investors who buy into the market when it is low and offering significant long term value.

We all need to remember that long term asset allocation is the most significant driver of returns. Asset allocation is how your investment is split between shares, bonds, property and cash (money market). Balanced funds have a mixture of shares, bonds, properties and cash and we should invest in the appropriate fund based on our financial plan. As share values fall, the overall asset allocation of the fund changes, allowing the manager to buy shares at lower prices, at the same time rebalancing the portfolio. This means that if we remain in the strategy for the appropriate time frame, we would effectively be buying into shares at reduced prices and effectively acting as the “strong” investor to whom Warren Buffet refers. If we were to panic and switch their funds to cash, we would effectively be acting in line with the “weak” investor and would be locking in losses and not giving their investments time to recover. This is supported by research conducted by Brinson, Hood and Beebower. They were able to prove during two different testing periods that most of the difference in portfolio performance was due to asset allocation, and not clever stock picking and market timing.

We also find that some unit trust investors switch between unit trust funds from year to year in an attempt to follow the most successful funds in the short term. These investors usually find that it is impossible to pick the best fund for the short term consistently based on historical performance. A fund that outperforms its peers in one year will not necessarily do the same the following year. In fact it is fairly uncommon for one fund to consistently outperform others in short term periods. Investors are better off looking for a fund with a long term track record and one that is appropriate to the investor’s specific financial plan. Besides the difficulty of trying to identify the best short term performing fund, there may also be switching costs and / or capital gains tax effects of implementing such a strategy. This would further reduce the return on the investors’ funds.

Over time, it is best to determine a long term investment strategy based on your specific requirements and to stick to this plan. A financial planner will assist in setting up and implementing a personalized investment plan that provides good resilience.

Ian Beere, CA(SA) CFP was Financial Planner of the Year in 2007. His business partner Debbie Netto-Jonker CFP, founder of Netto Financial Services, was Financial Planner of the Year in 2001.