Flight to cash comes with its own investment risks

Serious Money: Many investors rightly argue that one of the most dangerous asset allocation decisions is to up the proportion of a portfolio that is held as cash. A simple bank deposit or short-dated government bond is as safe as you can get and offers decent liquidity: gaining access to the cash need not be too difficult.

The problem, of course, is that security and liquidity comes at a price, namely the very low returns offered by bank deposits. Nevertheless, cash can be an extremely attractive option when lots of other asset prices are falling.

The problem is that you have to be a pretty skilled market timer to make the right decisions about switches into and out of cash. In particular, the risk to being in cash is that you miss out on stellar opportunities elsewhere.

With stock markets so volatile - and nervous - right now, surely it would be prudent to keep a bit more in cash?

That could well be the right call: Serious Money has taken a more upbeat view of market prospects, so is not being tempted to put his few bob into a government bond, but he has met plenty of people in recent weeks who are just so inclined.

They might be right - they could be superb judges of short-term market movements. And they probably feel relieved that they have taken the risk rating of their portfolios down a notch or two.

Paradoxically, high cash weightings are not without risks of their own.

One of the key points that emerge from any study of the historical pattern of equity returns is, of course, that equities generally go up.

Another lesson is that equity returns are a bit like the number seven bus: you can wait around for longer than seems reasonable, but then lots arrive all at once.

Miss the equity bounce and you could be left regretting it for years.

Anybody who has moved into cash right now is probably thinking that current market turmoil is going to last quite a while and will result in some very good buying opportunities along the way. Some people are very good at that kind of trading, but investors with those kinds of skills are rare and very rich - and probably working at one of the world's large hedge funds.

My own views about this kind of investing is that if you suspect that you are not very good at it, you should not even try.

But I never cease to be amazed by the number of people who think they can regularly time the peaks and troughs of the market.

There are two main types of traders involved in markets: speculators and investors. Each of these can be further broken down in to two more sub-categories: good and bad speculators; good and bad investors.

Most people with a modicum of common sense can become good investors: read a few books and study the methods of the masters (reading everything ever written by Warren Buffett would be a good start). The one thing that all good investors possess, in stark contrast to their less successful counterparts, is patience: long-time horizons allied to a well-articulated and disciplined investment process will take you a long way - and maximise your chances of making lots of money.

But markets are places that pump out incessant noise. The better investors learn how to process the ever increasing flow of information and are strong enough not to pay attention to the vast bulk of it.

Such people are in a minority. It is a difficult act to pull off: human nature is short termist and whether you are managing your own money or somebody else's, the temptation to try and be a market timer is very strong. But one of the surest routes to value destruction is to stare at those flickering screens all day and to trade on the latest piece of news.

Some people can do it, but I've only met a handful in my entire career. The skills necessary to make money consistently by rapid moves in and out of the market are rare and very tough to define. In a sense, trading skill is best evidenced by actual money-making: that's what it is and it is not something that lends itself to easy definition.

But long-term investors don't just sit there gradually adding to long-standing positions. At least not all the time. They do make the occasional big call.

Warren Buffet's style is to make the occasional very big bet. Most of them come off, but usually only after he has waited for a very long time. Interestingly, Buffet has made a promise to start investing some of his large pile of cash (yes, he has had too much cash during the post-2003 stock market rally). There is, as it happens, a very big call to be made right now.

The key driver of all asset prices - equities and property in particular - is a rather esoteric concept called the real bond yield. (A real yield is simply an interest rate adjusted for inflation). And the main reason why equities have had a wobble recently is that real yields have been rising.

Equity prices depend on three things, and three things alone: the growth outlook, investor attitude to risk and bond yields. And when bond yields rise, other things being equal, equities go down.

What the market can't make its mind up is whether those other things are, in fact, equal (so lots of fuzzy analysis about possible recessions and/or a world that has suddenly become more risk averse).

All of this is as it should be. The successful traders make their money by exploiting the naivety of those who think they can time swings in sentiment about growth and risk.

But the smart money is now realising that those higher real yields have implications for all asset classes, not just stocks.

The reason why commodity-related equities have sold off the most is that they are reckoned to be the ones with the most stretched valuations (debatable, but we'll leave that topic for another day) and hence the most exposed to that rise in real yields.

Are there any other asset classes that have been driven up, in large part, by low interest rates and bond yields?

I can't see Buffett moving out of cash and into Irish property.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.