The stock market's surge in the past year means that an increasing number of shares appear to lack wide margins of safety.
In previous bull markets, many investors would typically hold cash in this scenario until more attractive buying opportunities materialized. However, today's low interest rates and the threat of a higher future rate of inflation may naturally push them towards buying equities – even if they currently appear to be overvalued.
In my view, holding cash in the short run may still be the more prudent move. It could mean an investor avoids overpaying for stocks, while also providing the opportunity to buy undervalued shares in the next bear market.
Avoiding overvalued stocks
Holding some cash until stock valuations become more attractive could help to avoid losses in the next bear market. After all, the stock market's recent rise is very unlikely to continue uninterrupted. In fact, the stock market has never experienced a perpetual bull and bear run cycle throughout its history. This suggests that recent gains are unlikely to persist.
Bear markets have previously occurred every four years on average. However, the time between them has not been uniform in recent decades due to a variety of fiscal policy acrobatics. This means the next bear market could occur at any time.
Holding cash may mean an investor avoids purchasing today's overvalued shares. They may be hit particularly hard in the next market downturn because they lack a margin of safety. Lofty investor expectations could mean they are already priced for success, which may lead to relatively disappointing returns.
Buying undervalued shares
Holding cash may also allow an investor to more easily capitalize on attractive buying opportunities in future. Trying to time the market by selling richly-valued stocks just before the next downturn commences is an impossible task, in my view. An infinite number of geopolitical events that cannot be accurately predicted in advance can prompt a bear market.
By holding cash, an investor has the liquidity required to quickly act on lower share prices that may only be available temporarily. Indeed, the average length of a bear market has previously been just ten months. Investors who hold cash in preparation for the next market downturn are more likely to realize an opportunity to take advantage of the average bear market decline of 36%.
The challenges of holding cash
Of course, holding cash is a difficult task at the moment. Low interest rates may push investors away from cash and towards buying shares. In addition, the stock market's recent gains may attract them to equities in the hope that recent upwards trends are repeated in future.
One investor who has a long track record of holding large amounts of cash in preparation for more attractive buying opportunities is Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice-chairman Charlie Munger (Trades, Portfolio), who once stated:
"It takes character to sit with all that cash and to do nothing. I didn't get to where I am by going after mediocre opportunities."
In my view, Munger's words are extremely relevant in today's stock market environment. Holding cash while share prices are rising takes a large amount of discipline that is difficult for any investor to maintain. It also means accepting there will be an opportunity cost in the short run from the lower returns offered by cash.
However, holding cash could avoid overvalued shares that are hit particularly badly in the next bear market. Being liquid may also provide greater opportunities to benefit from the market cycle, which can lead to a more efficient allocation of capital in the long run.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Peter Lynch: Buying Familiar Stocks Can Be Dangerous
- Warren Buffett: Asset-Light Businesses Offer the Best Results
- Howard Marks: Focus on the Present, Not the Future
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