Life is not linear, nor is it symmetrical. Life is full of hidden asymmetries, and they dictate much of the world as we know it. Over recent months, inflation, rising interest rates and a cost-of-living crisis has cast fear, uncertainty and doubt (FUD) over capital markets. In just a few months, some assets have fallen to valuations not seen for years. Find out the importance of hidden asymmetries and why holding onto some cash may be a good idea when considering investing.
Risks in the investment market
There is a brilliant phrase within the investing community; “Stock markets take the stairs up, and the [lift] down”. This is an empirical fact of investing.
At Acumen, we always tell our clients that investing is a long-term thing. Veterans of the capital markets have seen the recent events play out time and time again with the knowledge that, over the long-term, temporary down turns are just temporary.
When you enter the world of investing, there are very few “risk-free” assets in existence. Over the short-term, an investment portfolio is exposed to volatility often described as “risk”.
Over the long-term, the real value of cash is eroded by inflation, which in itself is a risk.
If the benchmark for average returns is, for example, 6% per annum, and investing for three years, we would expect to yield a return of 19.1% on a compounded basis. However, in order to achieve that return, the portfolio is potentially exposed to risk up to 100% of its value.
Now, thanks to diversification – and investing in uncorrelated assets – the likelihood of a 100% loss to a high-quality portfolio would require the complete collapse of financial markets, governments and businesses from a global perspective. At which point, money would be the least of our concerns.
Short-term vs long-term investment
Over the short-term, the risks associated with investment are asymmetrical with the rewards. Without time on an investor’s side, the odds are stacked against them. However, over the long-term, the asymmetries involved in the markets are some of the most powerful wealth creation tools imaginable.
For instance, if you achieved that 6% per annum return for 15 years, it would equate to a growth of 139.5%. In this example, the investor will have more than doubled their initial investment.
In modern times, a person might begin work when they turn 18 years of age, and not draw their state pension until they reach their 70s. Over a 45-year career, the fairly balanced and achievable 6% per annum return would equate to 1276.46% in growth. Therefore, investing over 40 years yields a total return over nine times larger than investing over 15 years, despite the time frame being only three times the length. For the average person, 25 years may be manageable to visualise, and a 6% return over this period would equate to an increase of 329.19%.
Should you hold onto your cash?
So, why is holding some cash important? Compound interest is what drives the astounding figures mentioned above. Warren Buffett’s right-hand man, Charlie Munger has stated that, “the first rule of compounding is never to interrupt it unnecessarily”.
During a downturn, holding some cash in a portfolio gives an investor flexibility to choose. If they need income, they can draw it from the cash, and they can leave their portfolio to grow. If they don’t need the cash, then perhaps it can be used to snap up investments at discounted prices.
Either way, holding some cash allows the compounding to do its magic. It allows the portfolio to weather the storm and continue to grow uninterrupted over the long-term.
Finally, Nassim Nicholas Taleb – the author of The Black Swan – once said: “when markets go up, they go up a little. When markets go down, they go down a lot”.
Over the short-term, volatility is inevitable and part of the journey. Over the long-term, the asymmetries of the market produce outsized returns practically beyond comprehension. The important thing is to stick with the process, understand the quality of the portfolio and try to ignore the sensationalist doomsaying media outlets.
If any of the above has prompted any questions, please feel free to get in touch with the team at Acumen. Additionally, feel free to send your queries to [email protected] where we will pick them up and answer any questions you may have.
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