Is it rational to be fully invested all of the time? If it is not, what is the right amount of cash?
Judging by a few managed funds that I looked at recently, it appears that fully invested is a tactic that managers hope will elevate their returns. It is obvious that cash earns nothing so it won’t help them. Why hold it? I suspect the same philosophy is held by many independent investors.
Cash matters because it is a characteristic of the patient investor. Patient is not just holding a stock for a long time. It is also about not getting into an investment without the right conditions. Fully invested increases volatility and that creates problems.
Volatility scares enough people out of the market to generate superior returns for those who stay in. – Jeremy Siegel
The stock market is a device that transfers money from the impatient to the patient. – Warren Buffet
People have known about the value of liquidity for a long time. In 1928 Henry Ford pointed out that everyone should get $100 million and set it aside for a rainy day. Roughly $1.5 billion today. Nice rainy day fund.
Warren Buffett likes to keep a minimum of $20 billion in cash and near-cash. Current balance is over $70 billion.
As recently as 2014, Seth Klarman held 50% of his Baupost Fund in cash. “There are no acceptable investment opportunities.” He eventually sent some of the cash back to investors.
People argue that holding cash has an opportunity cost. True in a narrow way. It earns nothing and does not grow. Might even depreciate. The cost is what you could have made if it was invested.
The other side of the argument is that being fully invested has an opportunity cost. Not intuitive.
Without cash, someday you will sell something because of volatility or because you need the cash. More expensively you will miss an opportunity that shows up because someone else needed money.
The difference is the cash opportunity cost is now, the fully invested opportunity cost comes later
Which cost is more material? The wise investor compares costs before making a decision.
Here’s why it matters
If you can manage liquidity, Volatility is not Risk. If you cannot manage liquidity, Volatility is Risk. Yamini Sood
Just like the idea that it doesn’t matter what happens to you, it does matter how you react to it.
In the fully invested situation downward volatility hurts you. With cash it is an opportunity. Upward volatility helps you if you are fully invested when it happens, but only if you sell things and violate your principle of being fully invested.
Being fully invested, and seeking higher yield by doing so, has a built in contradiction. Unless of course you think volatility has gone away.
Contradictions make investing harder. Go for simple and have enough cash on hand that for you, volatility is risk free.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772