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the buy side

Over the last two years, I've spent most of my time encouraging people to get invested. As a result of the 2008-09 market meltdown, there were, and still are, too many investors who have strayed significantly from their long-term asset mix and are out of the stock market. I'm speaking of those who have a longer time horizon and want to build their financial wealth.

More recently, I've altered my view and been forced to do something that's very hard for me. I'm preaching the joys of cash. Yes, the stuff that earns 1 per cent. Investors who are on their long-term plan (and are therefore fully invested) should be carrying a modest amount of cash (5 to 10 per cent).

It's hard because I'm trained to be fully invested and feel uncomfortable when I'm not. In my early days at Phillips, Hager & North, my more worldly and wise partners (read: older) pounded into me that in the long run, bonds beat cash and stocks beat bonds. It went something like this, "Tom, you can't call the market in the next month or two, so why do you have that much cash in the portfolio? Don't you know that … ." To which I'd invariably respond, "I know, I know - lower returns, no inflation protection and how do I know when to get back in?"

Certainly that is one school of thought. Over time, stocks rise and cash returns will lag. A portfolio manager has to really be struggling to find well-priced securities before he or she should carry a significant cash reserve.

The fully invested approach particularly comes into play with specialty assignments for institutional clients. What matters to a manager of the Canadian equity portion of a pension plan is not whether returns are positive or negative, but how they compare to the S&P/TSX composite index. And because the index has no cash in it, anything above a token amount represents a bet against the market.

As I work almost exclusively with private clients now, I find myself moving away from the relative approach of asset allocation and toward the other school, which is grounded on absolute valuations. I want to own bonds and stocks because they're cheap, not just cheaper than something else. If I can't find enough undervalued securities to fill out a portfolio, I'm happy to hold low-yielding cash.

To be clear, I'm not any better at timing the market than I used to be (so I don't try) and I still want to beat the cashless indexes over the long term, but I'm more valuation driven today. I hate holding cash, it's true, but I hate holding overpriced assets more.

In a recent report, James Montier of U.S.-based GMO LLC brings the differences between the two approaches into the current context. "One of the 'arguments' for owning equities that we regularly encounter is the idea that one should hold equities because bonds are so unattractive. I've described this as the ugly stepsisters' problem because it is akin to being presented with two ugly stepsisters and being forced to date one of them. Not a choice many would relish. Personally, I'd rather wait for Cinderella to come along," he writes.

Despite the decidedly non-current analogy (couldn't he have used frogs and princes?), Mr. Montier's point is a good one. Methods that allocate capital based on relative valuations have a major flaw - they fail to predict long-term returns for either asset class.

The current market environment is very revealing of money managers' fundamental approach to investing. I say that because many that I talk to seem to have less and less enthusiasm for what they own. They can rhyme off the merits of resources, dividend-paying stocks and/or corporate bonds, but are quick to point out that bargains are harder to come by. Conversations are punctuated with phrases like "it's not as cheap as last year" and "we're being selective." For managers using a relative value approach, this means reallocating from expensive assets into something cheaper. For the more absolute oriented, sale proceeds go into a growing cash reserve, while the search goes on for frogs with prince potential.