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Is now the time investors should move to cash?

Long gone are the days when most companies looked cheap and buying equities was a no-brainer. Now stock markets are at all-time highs and index valuations are closing in on their historical norms.

Many investors are, understandably, nervous about where stocks are headed. Thanks to several wars overseas, as well as Argentina's recent debt default and just general nervousness about markets and the economy, the S&P 500 has dropped nearly 2 percent over the last month.

Moves like that have caused some people to ask themselves whether or not they should put more of their money in cash. Even Friday's market rally is not affording any peace of mind.


Max Oppernheim | Stone | Getty Images
"Thirteen percent of U.S. funds have increased their cash holdings by more than 2 percent over the last year." -Lipper

It's a question that Irwin Michael, a deep-value portfolio manager with Toronto's ABC Funds, has been pondering lately, too. In the past, finding bargains was easy; it's getting harder today. "A year ago we would look at five stocks and buy two. Now we're looking at 10 to buy one," he said.

While he said that there are still places to deploy capital—mining and oil and gas, for instance—he's also not afraid to hang on to cash and wait for an opportunity to arise.

At the moment, Michael has only 2 percent of his portfolio in cash, but he said that he's not afraid to hold up to 10 percent of the asset class.

In fact, his cash allocation may rise in the near future. He's considering selling a couple of stocks, he said, and while he has his eye on some other buys, he's not quite ready to pull the trigger.

"Cash gives us time to think, so we'll hold it as long as necessary," he said.

To stay or not to stay invested

There's one big danger with moving money out of stocks and into cash: If the market continues to rise, your portfolio won't benefit from those gains.

Of course, no one has any idea where stocks are going, and just because the experts are nervous about a hot market, it doesn't mean things will go south.

In 1996 Alan Greenspan, the then Federal Reserve chairman, talked about the "irrational exuberance" of the market and told people to be careful about stocks. Whoever sold out that day would have lost out on nearly four years of stellar returns.

"It's a very slippery slope for people," said Larry Swedroe, director of research for St. Louis-based Buckingham Asset Management. "There's plenty of evidence that shows that investors shouldn't time the market."

At the moment, just 3 percent of America's 7,500 equity funds have more than 10 percent of their assets in cash, said Todd Rosenbluth, S&P Capital IQ's director of ETF and mutual fund research, and many of those funds have underperformed the market over the last year.

The Intrepid Small Cap Fund, for example, has about 73 percent of its assets in cash. If you invested $10,000 in the fund a year ago and the same amount in the S&P 500, you'd have $730 more if you stuck with the broader index, according to Morningstar.

The same thing goes for the larger-cap Invesco Charter fund, which has had between 10 percent and 17 percent of its money in cash over the last year. Investors who put $10,000 in the fund a year ago would have made $165 more if they put that money in an S&P 500 ETF.

Of course, these and other funds that hold significant amounts of cash—13 percent of U.S. funds have increased their cash holdings by more then 2 percent over the last year, according to Lipper—could have the last laugh if markets do fall.

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"This strategy will pay off if the market pulls back and managers can get in at lower prices," said Rosenbluth. "However, if we see the market move higher, then cash is going to be an anchor for performance."

For Irwin, holding cash is less about stock market fears and more about having money to jump on new opportunities. He agrees that the market timing is risky, and he thinks that without a recession on the horizon and continued low interest rates, the market will continue to climb.

However, that doesn't mean people should just buy and hold.

Right time to rebalance

It's always a good idea to rebalance a portfolio at least annually, and in today's market, where stocks keep climbing, that's even more important.

Paul Harris, a partner and portfolio manager with Toronto's Avenue Investment Management, has been trimming more expensive parts of his portfolio and redeploying that capital in bonds to keep his portfolio's balance in check. However, he's also holding some of that money in cash. He's finding it harder to buy good high-yield bonds, which he uses to reduce volatility in his portfolio, yet still get equity-like returns.

Typically, 10 percent to 12 percent of his equity portfolio's assets are in bonds, while 5 percent to 8 percent are in cash. He's still within that range, but he may have to hold more if it gets more difficult to find opportunities.

"When we rebalance, we keep that money in a cash position, but we want to redeploy it to another security we like," he said. "We try and do that as quickly as we can."

Rebalancing is a much better way to play a hot market than selling off all your equities in the hopes that stocks fall, said Swedroe.

Between the time Greenspan made his exuberance comment in 1996 and the day the market peaked in 2000, the S&P 500 climbed by about 100 percent. What investors should have done during that time is sell some equity when the market moved higher rather than selling out completely.

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"If you had a 60/40 portfolio, the smart thing to do would have been to sell some stocks in 1998, sell some more in 1999, and then maybe you'd be so far ahead that you could be 50 percent in bonds and 50 percent in equities," Swedroe said.

Value investing

Whether or not to hold cash ultimately comes down to what kind of investor you are or what kind of fund manager you want to own.

Cash can lower volatility in a portfolio, which is one reason why Harris likes to hang on to more than 5 percent, but he also likes to hold cash because it allows him to pounce on undervalued opportunities.

Value managers like Irwin and Harris tend to sell stocks that run up in value and then buy undervalued companies with the cash from the sale.

Sometimes that requires holding more cash than usual.

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"You'd probably be more comfortable seeing a value manager take this [cash] approach," said S&P Capital IQ's Rosenbluth. If you're worried about stock market valuations, then you may want to consider buying a value fund with a manager who is actively selling winners, buying cheap equities and has a higher percentage in cash. However, be sure that person has a history of deploying those dollars when good buys pop up.

If you want to hold cash yourself? Then remember to do it carefully, ABC Funds' Irwin explained.

Patience is key

For him patience is key. You don't want to make rash decision and go all into cash, because overvalued markets can continue to climb for years. As well, if you do have money to spend, you don't want to jump into just anything.

Irwin wants to generate at least a 50 percent return over 12 to 18 months on his buys, and if it can't deliver that, then it may be too risky a bet.

For now, he's taking that careful approach. He'll hold cash if he needs to, but he'll keep buying stocks, too.

"There are periods of time where the market will test our nerves," he said. "Ask yourself, Is this the start of a trend or will the market come back? We think there's support for going long, but everyone has to make the decision to hold bonds, equities or cash for themselves."

—By Bryan Borzykowski, special to CNBC.com

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