When Markets Look Expensive: The Psychology of Holding Cash

Strong investment returns are generally welcomed by investors. But when markets have risen significantly and valuations appear stretched, those same returns can create a difficult question:

Do we keep investing, or is it time to be more cautious?

This is the environment we find ourselves in today.

We remain positive about the long-term role of equities in portfolios. However, parts of the developed global share market are trading at elevated valuations, which means expectations for future earnings and growth are already relatively high.

For this reason, we are deliberately maintaining higher levels of cash than we normally would.

This is not a prediction that markets are about to fall. It is a recognition that the prospective return from taking additional equity risk is currently less compelling than it has been at other points in the cycle.

Valuation is not a timing tool

One of the challenges with valuation is that it can be right about the long-term outcome while being completely wrong about the short-term timing.

An expensive market can become more expensive.

Equally, markets can fall sharply without ever having appeared particularly expensive beforehand.

This is why we don't use valuation as a signal to simply exit markets. Instead, we use it to influence how much risk we are prepared to take and how much capital we are willing to commit at current prices.

That distinction is important.

Expensive doesn't mean volatile

There is also a common misconception that an expensive market should necessarily be a volatile market.

Markets can remain expensive and remarkably calm while investor confidence is high and corporate earnings continue to meet expectations.

The risk is often more subtle.

When valuations are elevated, relatively small changes in expectations can produce disproportionately large changes in prices. A weaker earnings result, higher interest rates or a deterioration in economic conditions may cause investors to reassess what they are prepared to pay.

In other words, the concern is not necessarily that volatility is high today — it is that the potential consequences of disappointment may be greater when valuations are elevated.

The psychology of holding cash

This is where investor psychology becomes particularly important.

Holding cash feels comfortable when markets fall.

It feels much less comfortable when markets continue to rise.

If equity markets deliver another strong year, investors holding additional cash may start to question the strategy:

“Are we being too cautious?”

That is a perfectly reasonable question.

But it is important to remember why the cash was held in the first place.

The objective isn't to call the top of the market. It is to maintain the flexibility to deploy capital when the prospective return from doing so becomes more attractive.

That opportunity may come through a market correction. It may come through stronger earnings growth catching up with valuations. Or it may simply emerge over time as valuations become more reasonable.

We don't need to know which one will happen.

The discipline to wait

The hardest part of an investment strategy is often not making the decision - it is sticking with it.

There will always be a market narrative encouraging investors to do the opposite of what they are currently doing.

When markets are rising, the pressure is to invest more.

When markets are falling, the pressure is to invest less.

Good investment decisions are rarely about eliminating uncertainty. They are about having a framework that allows us to make decisions without being driven by the emotion of the moment.

For us, that means remaining invested in quality assets for the long term, while retaining additional liquidity where we believe valuations and the outlook warrant greater caution.

Our approach

We are not attempting to predict the next market correction.

We are acknowledging that price matters.

When valuations are attractive, we are more comfortable committing capital. When valuations become stretched, we are prepared to be patient.

That patience can be frustrating if markets continue to rise. But investing is not about maximising returns in every calendar year. It is about achieving an attractive risk-adjusted return over the period that matters to our clients.

Sometimes the most important investment decision is not deciding what to buy. It is deciding how much you are prepared to pay for it - and having the discipline to wait when the price is not compelling.

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