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Stepan Lavrouk
Stepan Lavrouk
Articles (634) 

Seth Klarman Explains Why Investors Should Retain Cash

The notion that investors should always be fully invested is incorrect

December 08, 2020

What percentage of capital should you have deployed at any given moment? If you ask some investors, they will tell you that everyone needs to be fully invested at all times, as it is impossible to time the ups and downs of the market anyway. However, from a value standpoint, this perspective doesn't really make sense. Of course, you can't know exactly when asset prices might start going up or down, but that doesn't mean that you should ignore price altogether.

Using tools like the stock screeners that are available for GuruFocus users, you can arrive at accurate assessments of value for different companies. Sometimes there will be an abundance of attractively valued businesses. At other times, these opportunities might be scarce. In such environments, it is prudent to hold and save up cash. After all, it's hard to build up wealth if you are using your capital inefficiently.

Cash is king

Value investor and Baupost Group leader Seth Klarman (Trades, Portfolio) is no stranger to hoarding cash. He has, from time to time, been perfectly happy to build up large reserves of capital during periods when markets have been richly valued. In 2005, the market was in a somewhat similar situation to today - investors were chasing lower and lower returns by paying more and more money for the same assets, and benchmark indexes were beginning to approach the levels that had previously only been experienced during the dotcom bubble.

In other words, there was a lot of pressure for investors to put money to work, and a lot of "fear of missing out." No money manager wants to field awkward questions from their clients as to why they missed out on a rally, so it makes sense that the participation in these rallies is generally wholehearted. Around this time, Klarman wrote:

"Some argue that holding significant cash is gambling, that being less that fully invested is akin to market timing. But isn't a yes or no decision the crucial one in investing? Where does it say that investing means always buying something, even the best of a bad lot? An investor who can't or won't say no forgoes perhaps the most valuable tool available to investors. Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio)'s long-term partner has counseled investors: 'Look for more value in terms of discounted future cash flow than you're paying for. Move only when you have an advantage. It's very basic. You have to understand the odds and have the discipline to bet only when the odds are in your favor.'"

Klarman drew an analogy between investing and corporate management. You wouldn't want to invest in a business that was spending its hard-earned cash on growth simply because it had nothing better to do with the money, so why should investors behave any differently with their own capital? At the end of the day, capital should only be deployed if the prospective return justifies the investment. This is true for businesses as well as portfolio managers. If there are no good returns to be had at a particular moment in time, then it might be a good idea to wait until a better opportunity arises.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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