The perils of not questioning everything

Yesterday, Fidelity Investments sent information to me and perhaps millions (or at least hundreds of thousands) of other people like me who have retirement accounts with their firm in what was clearly an attempt to compel squeamish stock investors to get back in the market while the gettin's good.

In a piece titled The Perils of Herding to Cash, they make the case that a high percentage of money market holdings to overall fund holdings is an indication that it's a good time to buy stocks, presenting the blurry chart you see further below as prime evidence.

The stock market tumbled more than 50% since its peak in 2007, causing many investors to flee to cash. At the end of 2008, the percentage of all mutual fund assets invested in money market funds (37%) stood at its highest level on record, surpassing the previous peak during the bear market of 2002 (34%).

Now, the first thing that should come to mind when you hear about a percentage change such as this, where there are two moving parts - cash and non-cash holdings - is that statistics can be very misleading.

A change in one can dramatically affect the composition of the whole and, given the magnitude of the change we've seen over the last year in the bread-and-butter offerings from big retirement companies like Fidelity - big U.S. stock funds - a rapidly changing percentage of assets held as cash may not be what it appears.

[Note: If you already know where this is heading, you probably also already understand that this is akin to having forgotten to rebalance your investment portfolio and letting last years market crash take care of that job for you.]

Here's the chart, along with the rest of the research note.

S&P 500 - Money Market Assets
Source: Lexis Nexis, Strategic Insight, FMRCo (MARE) as of 12/31/2008.

Fleeing to cash during a bear market reduces one's exposure to stocks when they are at historically lower prices. Back in October 2002, although a new bull market had begun, investors kept an above average level of cash until February '04 -- meaning in the aggregate, investors overallocated to cash during a 15-month period when stocks rose more than 30%.1 As a result, some investors who kept long-term capital tied up in cash likely missed out on big gains in the early stages of a rebound.

Bottom line: Ineffective market timing can be costly
Historically, many investors overcome with fear have increased cash positions during bear markets but have been slow to reallocate to stocks in the early stages of a new bull market. This sell-low, buy-high behavior is a suboptimal strategy, and can cause investors to end up with returns that are worse than the market's average performance.

Perhaps just owning U.S. stocks has been the more fundamental suboptimal strategy...

Obviously, the chart and the words make a compelling case for what the Fidelity research team thinks investors should be doing right now, but, when you look a little deeper, it gets much more interesting and greatly lessens the importance of the argument being made.

Consider the following, based on the two data points cited above in the chart below - the market peak in 2007 (indicated in red) and the end of 2008 when the cash held totaled 37 percent (indicated in violet).
If you had $100,000 invested exclusively in cash and an S&P500 index fund in May of 2007 in the ratios shown above, you'd have $80,000 in stocks and $20,000 in cash.

Fast forward to late-2008 and notice that the cash percentage has risen to 37 percent as the S&P500 has dropped some 42 percent.

So, the question is, "How much of the change in the cash percentage was attributable to the lesser value of stocks and how much had to do with people "herding" into cash?"

Well, that $80,000 in stocks is now worth just under $47,000 and, assuming a modest return on the $20,000 in cash brings that to around $21,000.

This leads to the conclusion that, without doing any "herding" at all (i.e., no stock sales), the cash as a percentage of overall assets has moved from 20 percent to 31 percent!

Assuming no inflows or outflows to simplify this entire discussion, it turns out that about two-thirds in the change to the bottom portion of that chart - from May of 2007 to late-2008 - was due to declining stock prices, not people panicking.

While this may have been unintentional, it does raise serious questions about their motives.

Anyone who did hit the sell button over the last year must surely look at that chart and see themselves in that rapidly rising green section at the bottom and wish to become part of the future rise of the orange curve at the top.

But, as it turns out, that green area isn't really what it appears to be.