Investor distrust drives rise in cash holdings

It is an immutable truth of investing that you should sell at the top and buy at the bottom. And it is almost as immutable a truth that most of us do exactly the opposite, buying at the top and selling at the bottom.

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Professional investors are prone to this. But nobody suffers it worse than retail investors. Over history, they tend to be sucked in at the top of a bull market, turning optimism into euphoria; and to give up just when all hope has been lost and the foundations for a fresh rally have thus been built.

In the US, mutual funds took in $259.5 billion in 2000, when the market peaked and crashed. In 2002, a great time to buy on the verge of a strong recovery, investors removed $24.7 billion.

These basic facts are well known. They do not necessarily suggest that retail investors are stupid. At market bottoms, families tend to be cash-strapped. It is harder to put money away in long-term stock plans. Stock markets, in which only the affluent can participate, become an engine to drive inequality even further.

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One new survey suggests the problem is even worse in this post-crisis environment. This bull market has endured for more than five years but has not made people happier.

The reason, it appears, is that many stayed out of the market. Indeed, as the rally has continued, the proportion of savings that investors park in cash has significantly increased.

That is the core finding of a survey of retail investors in 16 countries by State Street. Globally, retail investors have raised their cash allocations from 31 per cent in 2012 to 40 per cent in 2014. In the US, where rising share prices should directly reduce the share of cash in portfolios, cash allocations jumped from 26 to 36 per cent.

This cannot be attributed to retiring baby boomers. Millennials, under the age of 33, increased their allocations to cash just as fast as boomers, aged 49-67.

Japan had the highest cash allocation at 57 per cent, so a jaded public failed to enjoy the stock market boom sparked by Abenomics. This also implies that the rise in asset prices will not have the hoped-for "wealth effect" and prompt consumers to spend more.

So not only do investors distrust the market, but their distrust has also grown as the rally has continued. Why? To quote State Street, "the crisis of 2008 is burnt into their memories." After two sell-offs in 15 years, younger investors simply do not trust financial companies.

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When asked their best investment to date, easily the most popular was "land or property." It outstripped equities, bonds, commodities and mutual funds. And two-thirds said their best investment had been "entirely" their own decision, speaking volumes of their distrust of financial advisers.

To be clear: there were good reasons to distrust this rally, which has been driven by the aggressive monetary policy of the US Federal Reserve. But a prudent strategy would keep putting some cash into the stock market, just for diversification. As stocks have risen far faster than bank deposits, it is hard to see any good reason for cash reserves to rise in this way.

Other results speak badly both of consumers and of their advisers. Some two-thirds of investors globally said they did not know the fees they paid for their investment because it was too difficult to find out.

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Most spent more time reading free catalogues than reading investment statements. Almost two decades after Arthur Levitt, then head of the US Securities and Exchange Commission, attacked the prose in mutual fund prospectuses for "flowing like peanut butter," basic communications to retail investors are no better.

There are two powerful implications for people in financial services. The first is that nobody trusts them. Trust, even more than credit, is the essential lubricant for capitalism, so this is a serious problem. Governments and regulators might help bankers and fund managers regain trust by staging a genuine reckoning for the crisis and punishing those financiers who deserve it. That could leave the industry with a cleaner slate than it has now.

The second implication is rosier. If retail investors are still in cash, and do not believe this rally, then the bull market has longer to run, even though stocks are already expensive. For years now, the greatest reason for optimism has been that so many remain dubious. If so much has stayed in cash, then greed has not yet swamped fear and an overpriced stock market has not yet turned into an exuberant bubble.

That could yet happen if, as in 1999 and 2000, retail investors at last decide to flock into stocks.

It is not inevitable. The Bank of England's warning that the UK could see rate rises earlier than expected is a reminder that the Fed could do the same and suck life out of the stock market. What appears to be turning into an outright war in Iraq, not at all on investors' radar screens even weeks ago, could also change the calculus.

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But if retail investors still have so much in cash, then the conditions for a future stock market "melt-up" are in place.

—By John Authers for the Financial Times