Investors need to invest in cash, hopefully with a better yield than what banks offer. They may use ultra-short term bonds as a substitute for cash but they should remember they are not a true substitute for cash since even investment grade bonds with a one year maturity can lose a small amount of money during a credit crisis or during a rapid increase in rates.
Part of successful investing is to have a significant allocation to cash or to "near-cash" assets or to short term bonds so that these can be used to buy "risk" assets like stocks, real estate, etc. during a crash. To succeed one needs inspiration that it is OK to hold cash while waiting for a crash.
People have asked me if both stocks and bonds are overpriced then what to invest in? If the only investment available for sale is overpriced and all of your assets are in cash you should not buy a “risk-on” investment just to diversify out of cash. There are times in history like the great dotcom bubble of 2000 when it was better to sit in cash. Of course at that time you were well paid to sit in cash with the two year Treasury yielding 6%.
But what about now when cash or near cash equivalents like high quality short term bond funds that pay about 0.75% or the two year Treasury is had a 0.33% yield in August, 2013.
During an era when Central Banks attempt to reflate bubbles one must ponder the question if both stocks and bonds are overpriced then what to invest in? One answer is to continue to own a modest allocation in bonds but only if the portfolio duration is kept short. In addition one could invest in mutual funds that use “strategies” to invest in fixed income instruments such as “opportunistic” investing in distressed debt. If defaulted debt is purchased at 60% of face value and later sold for 70% of face value then the investor gets a capital gain of 16.7% plus interest.
Investors can invest in mutual funds that employ hedge-like long-short strategies in a bond portfolio. The duration is kept short, the assets may be “B” paper, the risk may be partly reduced with Put options in some cases. Other alternative investments would be long-short hedge-like mutual funds that invest in stocks, traditional bonds with short term duration, bank loan funds.
Buffett views cash as an option on the future. If a crash comes and you have cash then you can take advantage of deep discount sales of assets. Also if you have lots of cash you feel better during crashes, which is important because it enables you to function better as an investor. I wrote an article "What's a secret type of call option?". The discounted future value of cash is more than simply the cash flow from the interest it earns. It is also the utility value of having resources ready to spring into action to buy things at a discount when the time is right. And during recessions and crashes just when you want to buy something it may become harder to borrow against assets or to qualify for a loan, so cash has more value to it than it would appear to have, just like lifeboats on the Titanic had more value than anticipated.
Investors should seek independent financial advice which is best gotten from a fee-only financial advisor.
In a bubble the most daring and courageous thing may be to avoid owning excessively risky securities as they may go down a lot and stay down in a crash. I remember the 1998-2001 tech stock bubble where many companies dropped 90% and stayed down. People ask me “if both stocks and bonds are overpriced then what to invest in?”
Many bank stocks crashed 90% during the 2008-09 crash and are still down. B of A (BAC) went from 52 in 2007 to 14 now, a 73% drop, and had to suspend or cut the dividend for a long time. Citicorp (C) went from $478 in 2007 to $48 now (August, 2013), a 90% drop.
Recuperating from losses is an asymmetric experience. For example if you lose 50% then you need to make 100% to breakeven. If you lose 90% then you need to make 1000% to breakeven. How many people do you know who made 1000% on an investment? The research problem “if both stocks and bonds are overpriced then what to invest in” should be dealt with by remembering the negative consequences of a bubble crash and how difficult it is to rebuild from a zero net worth after a crash. This means having courage to break away from the masses and think independently.
The first order is to avoid excessive loss or at least take steps to reduce the probability of an excessive loss, since there is no guaranteed way to invest. This means diversifying into an asset that is not correlated with stocks. Real estate and commodities are too correlated with stocks, as they are all risk assets that usually go up when things go better for the economy. The assets that are not correlated with stocks are basically investment grade bonds or cash. (Hedge funds are “sort of” but not really an asset class). Since long term bonds have excessive duration risk then short term investment grade bonds and cash are the two main assets to use to diversify from stocks.
During the bubble phase of a bull market there is tremendous peer pressure, news media pressure to participate in the bubble. There is a tremendous myth that the bubble will grow forever. It takes courage to boycott a bubble since the masses are in favor of a bubble when it is occurring.
Just when everything is going well for an asset class is when it is probably overpriced and thus time to sell. It takes courage to be a contrarian. The ironic thing is that the real world economy will continue to get better with more jobs and higher pay, but that will actually hurt stocks and bonds, and increase inflation. Stocks are overpriced using PE10 and even more overpriced if current profit margins were reduced to normal margins. Stocks are overpriced according to Tobin’s Q which uses cost basis to reconstruct the value of stocks. Assuming the 10 year Treasury will go to 5% in the next two years then stock investors who bit on the bait of high dividend yields may bail out of stocks and go into bonds, making stocks go down. Higher interest rates will not help real estate.
It takes contrarian courage to hold a large cash allocation, a large short term bond allocation, along with hedge funds, etc., especially during a time when small cap stocks went up 35% in 12 months. But such a dramatic parabolic price increase in stocks is a tip off of a potential bubble crash.
I wrote an article “How to invest in an era of high correlations”.