Immobilized by the stock market’s precipitous fall and unexpectedly strong resurgence — all in the course of the past year — clients are heading into this RRSP season with a strong preference for the safety of cash. The challenge for advisors will be to convince clients of the benefits of moving from low-return cash assets, such as money market funds and deposits, into higher-return investments that will give clients the growth they need to finance what could be long and costly retirements.

The mountain of cash in the hands of Canadian households is estimated to be a monumental $1 trillion, according to a recent report by Bank of Nova Scotia, and is described by Derek Holt, the bank’s vice president of economics in Toronto, as “simply and astoundingly massive.”

The total includes currency holdings, deposits in financial services institutions, short-term paper and assets in money market mutual funds. Even if fixed-term deposits, which are not liquid, are stripped from the pile, that still leaves a cash stash of $635 billion. Having been mostly flat through the 1990s, cash and near-cash holdings have been piling up as the fear factor has escalated in this decade due to a series of unsettling occurrences. Fear has been fuelled by events such as the implosion of the high-tech bubble, the tragedy of 9/11 and the global financial crisis of last fall.

“Investors are choosing to sleep well at night,” Holt says. “But in the long term, hiding out in cash-type investments is going to put clients behind the eight ball, in terms of inflation-adjusted returns.”

The $1-trillion cash mountain on which Canadian investors are sitting is $120 billion above normal levels, according to Benjamin Tal, senior economist at CIBC World Markets Inc. in Toronto. When the stock market hit a low last March, Tal says, Canadians had $80 billion in excess cash, which means that amount has escalated by 50% in a little more than half a year — ironically, at the same time as the stock market was enjoying a forceful rally of more than 50%.

“Most Canadians missed the rally from the market lows of March,” says Tal. “It happens every time there is a severe bear market; human nature does not change, and people succumb to fear.”

While the level of cash appears to have stabilized, Tal says, polls have shown Canadians continue to be in a cautious mood. A recent survey by Toronto-based Maritz Research Canada found that Canadian investors are re-examining various aspects of their investment strategies, from the firms and advisors they work with to the makeup of their portfolios. And 70% of those surveyed believed “less risky,” deposit-type investments are currently the best strategy for this RRSP season. Although 66% of respondents felt the economy has turned around, 68% were concerned about further downturns in the next three to five years, and 40% believed the economy is headed for another decline within six months.

This excessively cautious mood is reflected in the latest mutual fund figures produced by the Investment Funds Institute of Canada. For the nine months ended Sept. 30, 2009, the most popular category has been bond funds, with net sales of $8.7 billion, compared with net sales of only $261 million during the same period last year.

Balanced funds are next on the list, with $5.9 billion in net sales for the period, up from $3.3 billion for the same period a year earlier.

Clients continue to bail out of equity funds, although at a slower pace than last year, with net redemptions of $4.3 billion in the first nine months of this year, down from comparable 2008 net redemptions of $7.9 billion.

Clients have also been bailing out of money market funds, but much of this short-term money is simply going into short-term bank deposits that pay higher rates of interest.

“Investors have dramatically shifted their risk tolerance over the past year, and the move to cash has been a defensive mechanism,” says Andrew Pyle, a financial advisor with ScotiaMcLeod Inc. in Peterborough, Ont. “However, the lower returns in cash will affect their long-term return assumptions, and may not mesh with their needs and objectives.”

Fearful clients have moved marginally from the extreme position of investing “under the mattress and in GICs” to a slightly braver stance of GICs and bonds, says Pyle. But, he warns, in shifting heavily to bonds, clients may unwittingly be putting themselves in danger of being sideswiped by the bursting of the next bubble. With interest rates at rock-bottom levels, he says, it’s a matter of when, not if, interest rates will head upward again.

@page_break@When interest rates go up, bonds issued previously at lower rates become less attractive and fall in value. The longer the maturity of the bond, the greater the risk if interest rates head upward, as the client is locked into the inferior rates for a relatively longer period. Many clients have been gravitating toward longer-term bonds recently, Pyle says, as the shorter-term bonds are simply not offering a decent yield, and these clients could be setting themselves up for capital losses.

“Investors who are not educated in the ways of the bond market could run into another shock, and many are still recovering from the past year’s sharp drop in equities markets,” Pyle says. “Many people think they are buying a risk-free asset with bonds, but risks exist if they are buying too long in maturity. You don’t put money away for 30 years in today’s low interest rate environment.”

Pyle advises clients in bonds to stick with terms of less than five years. He also suggests sticking to bonds that are safe, in terms of the creditworthiness of the issuer, and he would emphasize Canadian government and provincial bonds rather than corporate bonds, for which there can be risk of bankruptcy or default on interest payments.

“The past year shook a lot of people up, and many have come out of it re-evaluating how much risk they were taking,” Pyle says. “A lot have pared back their exposure to equities, which is not necessarily a bad thing, as long as they have an appropriate amount invested in assets with growth potential. But some people have swung too far the other way, and have become too defensive.”

Cautious clients will not be making any hasty decisions to jump back into equities, and the key is to lead them back slowly if they need more stock exposure to meet their long-term goals, sticking to blue-chip, dividend-paying stocks.

CIBC’s Tal expects dividend-paying blue-chips will be among the first wave of beneficiaries as money starts to flow out of the cash vaults, given the demographic of the savers. He says the cash hoard is sitting primarily in the pockets of 50- to 65-year-olds and, unlike younger age groups that are saddled with debts and mortgages, the older age group has largely paid off its debt. That means the excess cash is more likely to find its way into securities such as stocks as the fear ebbs, Tal says — but it will be stocks at the conservative end of the spectrum.

“Most people would like to find a 10% GIC, but that isn’t going to happen,” Tal says. “With dividend-paying stocks, even if the stock market is flat, at least you’re getting paid.”

Gavin Graham, director of investments with BMO Asset Management in Toronto, warns that with longer lifespans and the trend toward greater government spending and deficit financing, there is a high risk that most retirees will be contending with inflation at some point. Although clients have been “scared witless” by what has been the worst bear market in 70 years, their need for income and growth may drive them back to investments such as investment-grade corporate bonds and dividend-paying equities.

Regarding stocks, Graham suggests sticking to companies with pricing power that will be able to pass on the rising costs of labour and production to consumers of their goods. He also suggests looking at companies that have been able to raise their dividend during the past 18 months of turbulent times, an indicator of the ability to survive hardship. He cites such companies as Rogers Communications Inc., Telus Communications Inc., Canadian National Railway Co., TransCanada PipeLines Ltd. and Power Corp.

Jaime Harper, executive vice president and head of advisor distribution with Fidelity Investments Canada ULC in Toronto, expects many wary clients this year to be most receptive to balanced funds and fund-of-funds portfolio products that provide a predetermined mix of assets. The appeal of these products is that clients do not need to make an all-or-nothing bet on either the stock market or the bond market, and the fund manager takes care of adjusting the asset mix when it gets out of whack due to changing values.

These funds typically sell down asset classes as they become overvalued and buy up undervalued assets to keep to their predetermined allocations, something that is difficult for many clients to do on their own.

“It’s difficult to persuade investors to wade into the market when the stocks have taken a beating and values are attractive,” Harper says. “But, invariably, markets bounce back, and that speaks to the need for products that will help clients stay invested. In previous bull markets, 25% to 30% of the gains were made in the first three to six months, when everyone was still afraid. Last March, it did not feel like a recovery was underway, but many investors missed the 55% recovery from the lows in March.”

For clients who lost 30%-50% of the value of their equities portfolios, it will be next to impossible to recover by sitting in cash that pays paltry rates of interest. David Lupini, director of product management with Hartford Investments Canada Corp. in Toronto, points out that recovering from a 50% drop in value requires a return of 100% on the remaining assets.

Even assuming an interest rate of 2%, which is still more than many clients are making on their cash deposits, advi-sors can demonstrate easily to their clients through basic math that recovery in the value of their portfolios could take more years than many people have left in retirement.

“It’s a matter of simple, logical math,” says Lupini. “It’s impossible to recover in GICs. But at times like this, clients become risk-averse and irrationality sets in.”

Hartford Investments offers an easier way to coax clients off the sidelines. Its DCA Advantage Program allows clients to average automatically into their selected Hartford mutual funds during a six-month or 12-month period, while receiving a premium interest rate on money waiting to be invested. The six-month program pays 3%; the 12-month program pays 2%.

“Dollar-cost averaging provides a solution to the fear of ‘What happens if the stock market drops again?’ — as it allows clients to spread their purchases over time and to pick up more fund units when prices are lower,” Lupini says.

“It’s a disciplined process, and an easier decision than trying to pick the right time to get back in.” IE