One of the biggest advantages of being a small private investor over professional investors, such as investment and mutual funds, is flexibility.
A professional fund, often called institutional money, is usually set up according to a mandate. This may specify the investment style it will focus on, size, geography, sector, stage and other factors.
Overarching all of these is that the manager is usually allowed only to keep a small percentage in cash. Otherwise, why would investors in the fund (the general investing public, either directly or through pension funds) pay the manager to invest?
You may think the professionals have a big advantage over you with resources, finance qualifications and teams of analysts. However, the ability to hold cash in unspecified amounts gives you a huge advantage. Here’s why:
1. Improve your investment results. Holding cash is one of the best ways to improve your investment results. It means you can have cash ready when really attractive opportunities present themselves.
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Or as a successful hedge fund manager profiled in Barton Bigg’s “Hedgehogging” said, having cash allows you to “Stay close to shore” until a sound investment opportunity comes along.
Unless you are a market timing guru (apparently, these are more common in folklore than real life), how do you know when such opportunities will present?
You don’t. All you can do is know what a good opportunity looks like when it comes and have cash available to take advantage of it. It could be in the form of an overall market drop, such as following the banking crisis in 2008, or for specific situations.
2. Gives you peace of mind. As a private investor you are much more at the mercy of the markets than your professional competition. You are putting your own money at risk in the market every day, rather than investing gazillions for other people and earning a management fee.
Your results are also more likely to have a more tangible and direct impact on your life – kids college fund, retirement or, if you’re like me, early financial freedom where your plan is to earn full financial control of your life in a few years.
By having cash reserves, whether for emergency “rainy-day” needs or to put to work when good opportunities come along, it gives you peace of mind and helps you sleep better.
3. Ride out market fluctuations. By having cash reserves you know you can meet short-term demands on your finances. This means if you know a situation you’re currently invested in is good but may be suffering some short-term paranoid thinking from Mr. Market, you can hold out. Or you can even double up.
If you don’t have the cash reserves, you’re more likely to feel the pain of any short-term loss and sell too early.
Even regular stock price fluctuations can be 20% or more each way in any given year. This may be too painful in the absence of reserves, forcing you to sell on completely normal short-term price changes, even when there is no negative change in the underlying story.
4. Emergency “rainy-day” fund. Strictly speaking, this fund should be separate from your investing fund.
Your investing money should be that which you can afford to leave alone for 5 years and not negatively affect your lifestyle if you lost it. For example, don’t invest money you need to keep up house payments, or to buy food.
The emergency fund is money that’s readily accessible, and equal to 6 months of normal cash burn. Say you spend $2,000 a month on basic living requirements (housing, food, transport, clothing – at necessity level), you would need to build up savings to $12,000 cash.
Some folks would suggest 3 months, others 1 year. There’s no hard and fast rules; it’s really what you feel comfortable with. Start off with just saving up $1,000 rainy day fund – for those unexpected bills that floor you if they have to come out of regular income. Then build it up.
Why does this help your investing?
It means even if you lost your primary source of income, you still would have 6 months to get back on your feet – whether a job or develop a small income producing business. Or if you had unexpected expenses, you would not have to take out a loan to do it, or curtail your regular investment fund contributions.
It means the emergency (whether income loss or unexpected expenses) doesn’t affect your day-to-day budget and you don’t have to sell off investments just to cover basic spending needs.
5. Makes you feel richer. Since you are thinking and working from a position of relative abundance, rather than scarcity, you are more open to other ways to produce wealth.
Some folks say you “attract the universe” to help you. Others will say that you are more relaxed and in a productive and positive state so are better able to take action from opportunities and to help others. It doesn’t really matter what you want to call it, but it does seem to work.
I’ve been on both sides – relative abundance and scarcity – and I can tell you abundance is a much better place. Interestingly, once you understand the effect, you can even program yourself to behave as if in abundance, even when not, and it still seems to work (though it takes more focus).
Of course, you still have to take action for things to happen. But they seem to work better with the right mindset.
There you have it, 5 reasons to keep cash. If you already do, good, keep at it. If you don’t, start small and build just a $1,000 fund to start with. Then grow.
Once in awhile, you may see more great investment opportunities than the cash you have available. When this happens, it makes sense to be fully invested. But the rest of the time, try to keep cash on the sidelines or better still assets that through up free cash flow.
Do you know any other reasons a cash cushion is helpful – as an investor or otherwise?
Raman Minhas writes about using value investing, saving and psychology to help you reach financial freedom. If you enjoyed this article, join his free newsletter.