EVOacademy

Let’s take an investor who, for the past four years, has been invested in a portfolio holding 80% in stocks, and 20% in bonds. What if that investor sold their stocks just before an election and waited for a year before buying them back. That individual had 4 years of an 80/20 portfolio and 1 year of a 0/20/80 portfolio (where 80% was now held in cash). Over the course of those 5 years the average allocation of the portfolio was not an 80/20, but rather a 64/20/16, with only 64% of the portfolio being in equities on average and 16% being in cash when averaging over five years. This may indicate that a portfolio holding only 60% stocks and 40% bonds would be more suitable for the individual than their current target allocation of 80/20. Even though the investor may prefer to have long-term returns that track with a 80/20 portfolio, in reality their portfolio has likely performed worse than a 60/40 since for a period of 1 year they were in cash likely earning less than the 60/40 would earn during the same period. History shows how much damage can be done to a portfolio by missing the best days. https://www.visualcapitalist.com/chart-timing-the-market/

Why would this investor go to cash in the first place? Perhaps they believed that the U.S. presidential election would trigger a major market event that would result in stock prices falling, and by going to cash they would be better off than staying the course. Historically speaking, in most scenarios they would be worse off by going to cash, not better off. Contrary to what many people may believe, the stock market has performed better on average during election years. This is a disconnect between perception and reality. Since the 1928 election, markets have had a positive return during an election year 83% of the time. The average return in those election years was 11.28%, a higher return than the average performance for all years between 1928 to 2023 of 9.9%. Vanguard research dating to 1860 shows there is no statistical relationship between a 60/40 portfolio’s performance and election years — elections have had no significant impact. Fears around elections, and the affects they will have on financial markets have been a psychological impediment to investing success long before the 21st century, but they have not come to fruition when looking at the statistical relationship elections have on markets.

In the case of the investor who went to cash for one year out of five, their actual return and average allocation over five years look starkly different than their target return – the return of an 80/20 portfolio. Not only can going to cash influence portfolio returns, but it will likely have a tax impact too. “Go to cash” stock sales that would take place in a taxable account may incur capital gains tax, assuming the assets are being sold for a gain and not a loss. Liquidating a $500,000 taxable account which triggers $100,000 in capital gains means that 20% of the portfolio is subject to taxes. If these are long term gains, they will be taxed at the capital gains tax rate, but if the assets were held for under a year, they will be taxed as ordinary income. Liquidating this $500,000 portfolio will generally result in the investor keeping less than $500,000, because taxes are owed.

Going to cash also introduces the question of “when do you reinvest?”

Reinvesting once you have gone to cash can be equated to “catching a falling knife” when markets are falling, and “holding out for ‘the big one’” when markets continue to rise despite the decision to liquidate. In an event where the market does decline and an investor goes all to cash, they may be fearful to invest in the market that has been declining, the thought of “how low can it go?” starts to creep in, and hesitation can result in being on the sidelines until the market already has rebounded, leaving the investor worse off than had they done nothing.

In the other scenario, the investor goes to cash and watches the market continue to rise but may believe (or hope) that there is a downturn just around the corner. This can create emotional resistance to reinvest and force them to admit they jumped the gun and went to cash when they should have stayed the course. This event can leave an investor in cash for a long period of time as they wait for the market to decline below its value at the time they went to cash – a day that may never come. Despite the market declines of 2020 and 2022, neither came close to declining back to the values during 2007-2009, meaning an investor waiting around for the market to crash back to great recession valuations would still be waiting for “the big one” that may never come. And who wants to live in such a pessimistic condition, anyway?