With the market hitting all-time highs and the U.S. economy continuing to go strong, it’s not wrong to be worried about how much longer the good times can last. The recency bias of the Great Financial Crisis still affects us all. You might think that now is a good time to take some profits and move some of your portfolio’s equity exposure to cash. While this move might help you sleep a little bit better at night, especially if you are at the point in your life where you are living off the income and capital gains of your portfolio, but there are consequences to this decision.
Potential Future Returns
While the markets have produced spectacular returns over the last several years, investors are expecting lower future returns for stocks and bonds. Equities will generally be the highest returning part of an individual’s portfolio. Reallocating some of that capital to a less risky asset will lower expected returns for the overall portfolio.
What is the “job to be done” of your equity exposure
It’s important to understand the role your equity exposure is playing the portfolio. If you are simply trying to capture the highest possible capital gains, moving to cash or any other less risky asset will diminish the return potential. If you are trying to capture capital gains plus yield, that is tough to replicate. If you are worried about specific companies cutting their dividend during a recession, it’s important to look at the company’s current leverage and cash flow to understand how much financial flexibility the company has. And remember, a downturn in the market doesn’t necessarily mean the fundamentals of a business has changed. There are plenty of non-fundamental business (technical) reasons why the market can take a dip.
This is a slight digression about how companies allocate capital. There are three ways for a company to allocate capital. First, it can reinvest back into the company to build new products, stores, facilities, etc. Second, it can pay down debt. Third, it can return cash to shareholders through dividends or share repurchases. The decision should be based on which area will generate the highest return for shareholders. If the company is able to invest capital in new projects that will generate returns greater than the companies cost of capital, cash should be spent on those projects. But if the company’s stock price is trading significantly below its intrinsic value, share buybacks might be a better allocation of capital. Generally, utilities are limited in the amount of capital they can reinvest back into the company. That is why utilities pay out a higher percentage of their cash to shareholders as dividends than most industries. The conclusion is that it is important to understand a company’s capital allocation philosophy. For a deeper dive on this topic, read Michael Mauboussin’s paper on capital allocation.
If invested in an ETF, you should look at the underlying holdings to get a sense of the type of companies included in the fund. Just because an ETF pays out a high dividend right now does not mean that payout is permanent.
Time Period
This goes back to our earlier discussion on the “job to be done” of your equity exposure. If you don’t plan to touch the capital you have invested in equities for at least five years, it probably make sense to leave your portfolio alone. If you will be needing that capital sooner for living expenses, house down payment, college tuition, etc., then reducing your equity exposure makes sense.
Sleeping Well at Night
There is no one optimal portfolio. Each individual has different needs, biases, and concerns. At the end of the day, your portfolio should not be the reason you lie awake at night. Stuffing all of your cash under the mattress can cause just as much stress as investing all of your money in stocks (inflation and purchasing power erosion never sleeps). It is important to talk with a financial advisor who is a fiduciary to create a financial plan and helps you stick with that plan.
The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.
