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The Importance of Cash at the Present Time

February 03, 2014 | About:

Pavelg

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Have you ever asked yourself this question: What percentage of cash should be held in hand and what percentage invested? This percentage may vary from one investor to the next: There are those who will prefer 2%, while others will want to hold 5% or even 10%.

The big question here is what is the optimal percentage of cash to hold so that, on the one hand the portfolio’s return is not unduly affected (on the negative side), while, on the other hand, opportunities that present themselves can be exploited.

Green and Red Screens

We all know that share prices on the world’s stock markets do not rise and fall in a straight line (unfortunately!). In other words, the global capital markets are cyclical and are subject to volatility most of the time. Even if we were to find ourselves in a bull market, we would see that some days would be green (probably a sizable majority), but there would also be some red days (hopefully, very few). The previous sentence is applicable not just in relation to weeks and months, but whole years can be green or red.

I believe that many people would agree with me that it is not possible to accurately schedule when to enter the market and when to exit. This is also something that is not so usual with long-term investors. This does not mean that shares are not occasionally sold and others bought in their place. It also does not mean that we don’t wait for the price that we set for ourselves in order to sell/buy a certain share. Incidentally, even after having decided on an entry price, waiting for it and then buying the share, this does not mean that the share will change direction on the following day and move in the direction we wanted. In most instances, this does not actually happen.

In any event, decisions to sell are not taken for the reason that the market has declined or the share price has fallen by 2%, 5% or more. Selling occurs for totally different reasons, or – as more correctly expressed – for totally different considerations, such as: the share has reached its fair value, the company’s financial data give a less favorable impression than previously, a significant downturn is anticipated in the sector in which the company operates, etc.

So what can we, as long-term investors, do in order to protect ourselves and our portfolios against falling markets?

The answer is: Hold a certain percentage of the portfolio in cash.

Exploiting Opportunities

Before I go on to discuss what percentage is appropriate, I would like to reflect on why part of the portfolio should be held in cash. Why not simply invest all the funds and wait for the desired returns? The answer to this can be found within the expression “exploiting opportunities”.

In order to explain this point, let us examine the following example:

Let us say that, six months ago, we performed an in-depth analysis of a certain share and reached the conclusion that its fair value is $30. Its market price at that time was $20; in other words, the share was being traded at a 33.33% discount. This would seem to justify taking a position. Several months later the share had risen to $22, but subsequently fell to $15.

What should be done? We need to update the analysis that was performed six months earlier with the latest data and draw fresh conclusions. Perhaps something has changed at the company and the share is no longer worth $30, as we believed six months ago. Alternatively, we might conclude that the share is still worth $30. Assuming that a material error was not made in the analysis, it would seem that the market has still not identified the value of the company or that something specific has happened to the company and therefore the share is being traded at an even greater discount.

In any event, the company’s shares that were valued at $30 six months ago are now being traded at $15, in other words, at a discount of 50%. There is thus now an opportunity to strengthen our position in this share and use the cash in the portfolio in order to buy this good share in which we have confidence, at an even cheaper price than six months earlier when we first opened this position.

So What Is the Appropriate Percentage?

At the outset, it should be stated that the percentage of his portfolio that each investor should hold in cash depends on his strategy, his investment term, his goals and even his character. In addition to these factors, there is another parameter that I view with equal importance and that is “the period in which we currently find ourselves”.

What does this mean?

I would assert that it is very important to know in which period we currently find ourselves. Are we currently in a bull market, a bear market, one year after a 50% drop in the market or five years after a 200% rise in the market? Understanding the current situation affects the percentage of the portfolio that should be held in cash.

Why does this have an effect?

It would be reasonable to suppose that, following steep and ongoing declines, we would prefer to hold as large an amount of cash as possible. The reason for this is that the merchandise being offered for sale on the market is cheap, and cash is needed in order to begin acquiring it.

During one or two years of rising prices, our preference would be to hold a smaller amount of cash, since we want our money to already be invested and “enjoying” the price rises occurring on the market, which it seems will continue for several more years until the present cycle reaches its end.

Where Do We Stand at Present?

As we stand here today, we can look back on five years of gains on the US stock markets. Recently, all sorts of highly respected people who understand this field have been appearing with great-frequency, trying to warn us that the stock market is expensive and that there is no logical justification for the high prices of shares. One can watch interviews with famous Wall Street analysts who are predicting declines of 25%, 30% or even 50% in the short term, if not immediately. In an interview he gave a few months ago, Warren Buffett (Trades, Portfolio) said that these days it is hard to find companies that are cheap enough to invest in, and that it would appear that the market has already reached a level where prices are high enough. All these factors lead me to believe that this fall will apparently materialize at some stage. I do not know when this will happen: maybe tomorrow or in another month, or perhaps in another year…

In any event, it is clear to everyone that we are not at the beginning of a recovering market following large declines.

Bottom Line

Every investor needs to hold a certain percentage of his portfolio in cash, and this should be appropriate to his needs and his strategy. However I am not calling on investors to begin selling shares from their portfolio in order to increase their cash percentage.

As a general rule of thumb, I deem it fitting to hold between 5%-10% of a portfolio in cash. However, in periods when the market is expensive, consideration should be given to how this percentage may be increased.

In addition, during periods such as that in which we currently find ourselves it is reasonable to assume that some shares have already reached their fair value, and it is perhaps time to reduce positions in such shares. By so doing, you will be able to increase the amount of cash in your portfolio in order to exploit market opportunities that will occasionally appear. Moreover, by following this course of action, you should be better able to survive periods of large drops and emerge from them in a stronger position holding a portfolio of quality shares that will have been bought cheap.

Fair Disclosure

At the time of writing this article, the author holds 27% of his portfolio in cash.

About the author:

Pavelg
I am an independent investor with a passion for the stock market. I enjoy finding, researching, and analyzing stocks.

My investing methodology is influenced mostly by such great investors as Benjamin Graham, Warren Buffett, Peter Lynch, and Joel Greenblatt.

Rating: 3.9/5 (12 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 6 months ago

''We sometimes enter the arbitrage field when we have more money than ideas,'' says Buffett. 

 

 

Source:

SMART MONEY * ON THE SIDELINES Money managers of the Benjamin Graham school fear buying pricey stocks in the stampeding bull market. Big winners in the past, they are sitting on cash and their performance is off. The lack of bargains is enough to drive a Grahamite crackers.

By Edward Boyer, April 14, 1986, Fortune

http://money.cnn.com/magazines/fortune/fortune_archive/1986/04/14/67387/index.htm

snowballbuilder
Snowballbuilder - 5 months ago

Great article on a really central and important topic

"I will tell how to become rich. Close the door. Be greedy when other are fearfull. Be fearfull when other are gready" buffett

"Wait patiently some big fat pitch" munger

"the time to buy is when the blood is on the street" rotschild

"ignore the crowd" berkowitz

if you want to have market result you can stay full invested all the time (or buy an index)

But if you want to get rich , i think, you ve to invest only when the blood is on the street and build up cash the rest of time. That what i think. And that what i m traing to do whit my personal portfolio.

Its simple to say but really difficult to do (klarman, munger, sequoia, berkowitz are among the greatest and the few) . But if you have cash , when , SOMEDAY, (as klarman wrote) the blood and fear will be again on the street you will probably be ready to invest and get rich.

best wishes to your investment journey. Take care.

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