Are you a rank amateur investor?

Investors still holding half of their funds in cash are making a big investment mistake.

Summary: Macquarie Bank is reaping the benefits of a huge cash wave being generated by financial planners across Australia, who are still directing their clients to allocate up to half of their funds into short-term bank deposits. It’s a strategy based on fear, and investors are missing out by not having a higher allocation to equities.
Key take-out: The big banks also are testing the pain threshold of depositors by seeing if they can manage their deposit rates even lower without triggering a mass cash withdrawal.
Key beneficiaries: General investors. Category: Asset allocation.

This week I want to write about a subject that we don’t like to refer to – fear.

Yet we see it as a driving force in a number strange and varied situations. It needs to be recognised in our investment strategies.

I want to illustrate fear in two situations in Australia, then in the international context. One of the remarkable features of the Australian capital scene is the fact that Macquarie Bank has an enormous cash deposit operation that comes from money placed via financial planners.

How they come to have these deposits is an excellent illustration of the way fear affects long-term investment decisions. I wrote about this fear factor in November in my article, Fear factor builds banks’ cash flows. It would seem that a great many financial planners allocate about half of many of their clients’ portfolios to cash, or near cash.

And Macquarie has an excellent account to manage that cash, so it is one of the main beneficiaries. One can understand a rank amateur having half in cash, but for financial planners to have so many portfolios that are almost perpetually half in cash is hard to fathom.

Bad advice from planners

It seems that many financial planners tell their clients, who are often self-managed superannuation funds (but are also often ordinary individuals), that the money is there for opportunities or, perhaps, that the market is uncertain. In theory, that is sound advice.

The trouble is that, in practice, the percentage of cash rarely changes. What so many financial planners are doing is in fact being careful not to expose their clients too far into equity, fearing a collapse.

But the planners should have made sure that other forms of low-risk investment were embraced, rather than simply Macquarie short term cash. And, of course, behind the strategy is fear. People still have not forgotten the enormous sharemarket crash that came with the global financial crisis and the effect that had on portfolios that had, say, 70 or 80% in equity.

But it means that in this sharemarket rise a large number of portfolios are only half equity, and therefore they haven’t benefitted to anywhere near the extent they should have. While everyone perhaps slept better, there were better returns available for long-term cash style investments.

As I have said many times, my view is that it is not at all sensible to have half your money in cash on a permanent basis. By all means, if you have a major investment coming up or you are genuinely frightened about the market then, on a short-term basis, you could have a high amount of cash. But longer term there are much better ways of investing low-risk money than simply in cash, which leaves you very vulnerable to lower interest rates.

For my own portfolio I have used longer-term bank deposits, which until recently have offered very good rates of return. Now you have to work harder to get adequate returns, but by taking a longer view you certainly get better returns than are available from cash.

Testing the depositors’ pain barrier

Now, the other side of the fear involved in cash hoarding is the game the large banks are playing with their term depositors.

I can remember writing that if term deposit rates fell much below 5% we were likely to see a big leakage into the sharemarket. But when the rates fell below 5% the bank deposits seemed to increase, even though many shifted to shares. I was wrong.

Then I thought that 4% might trigger an exodus, but like 5% it did not cause a massive withdrawal and the term deposit money stayed. Now banks are offering rates around 3%, and they are constantly testing the market to see if they can manage their deposit rates even lower without triggering a mass withdrawal.

This week’s fluctuations in the sharemarket will help that low deposit rate process, because the fear factor about the market has increased. Therefore banks will reason that people are likely to accept lower rates of return on term deposits.

My guess is that irrespective of what the Reserve Bank may do, banks will try to edge term deposits lower just to see how far they can take them down before they begin to see an exodus. And remember, with inflation above 2.5% many individual taxpayers are in negative return territory. But once again, it is the fear factor and banks are emerging as major beneficiaries.
Graph for Are you a rank amateur investor?

Economics and the fear factor

And, of course, as the US began to taper there were some surprising reactions. There was no surprise that the American sharemarket initially fell. The lessening of the amount of money being printed will mean that a number of investment banks will look to bring their money out of emerging countries and other places, and there will be some big losses. These potential losses create a clear fear factor that will emerge from time to time and cause big swings in the market – as we are now seeing.

In addition, the American middle class is still fearful about the future, and that sluggish middle class demand keeps a lid on the pace of American recovery. Nevertheless, in my view, recovery will still take place.

Meanwhile, over in China, it is busily pursuing their plan to lessen their dependence on exports and capital investment and are switching demand more into consumers. In addition, its banking system is stressed. China will proceed in a zigzag procession that produces periodically bad manufacturing data, which affects our mining shares. It should affect our dollar, but the dollar is holding up partly because our rates of interest remain higher than other countries and the rising inflation rate has lowered the risk of official interest rates being reduced.

At the same time, we are getting a lot of Chinese money being invested into our real estate. The Chinese are fearful of what might happen in China, and investment in Australia and other places is a reaction to that fear. And the Chinese money is joining our mining investment money and mining income to boost the dollar.

But longer term I don’t think the Australian dollar will hold at current levels. The swing of US dollars out of merging countries to the ‘safe haven’ of the US should lift the American dollar and depress ours. But, in my set of forecasts for 2014, I have so far have been proved wrong on the Australian currency. We all know the hazards involved in currency prediction.

Yet, wherever you go, you can see the fear factor below the surface.

* This article is part of the “It's Time” series in Eureka Report focussing on new opportunities for investors in 2014. Click here to see the entire series.