An unconventional view of cash reserves

Asset allocation

The investor is unfettered in taking advantage of opportunities

Most everyone thinks you have to keep a cash reserve. I don’t. We read things like: “Build Cash to Take Advantage of Stocks’ Coming Slump”. Or it may be framed as keeping a cash reserve to be ready for an emergency or some such.  

My policy of keeping no cash reserve has worked for me for decades. So, let me explain.

The general investing policy I follow is to invest only in superb companies. Warren Buffett calls them seven footers. They are bought only when available at a price less than intrinsic value. I am essentially 100% invested in common stocks all the time.

Where cash comes from

You may sell a stock. There are reasons for selling stocks and this is discussed in another post. See 19 Cardinal rules on selling stocks.

Here are some of the reasons. A mistake may have been made in the original purchase. A company may not turn out as we expect or hope. Or a company may lose its way. Or a fine stock in one’s portfolio might become seriously overpriced. Or a stock position may grow to be too high a weighting in an investor’s portfolio.

Selling promptly when a stock should be sold is one of the critical principles of investing. The point here is that sometimes stocks should be sold or sold down to a smaller holding. This produces cash. This happens at its own time. At the time the stock or stocks are sold there may be no candidate for purchase. And so the cash is held. The cash generated in this case did not arise to take advantage of a particular purchase opportunity. It arose because stocks had to be sold. But, it becomes available to take advantage of opportunities.

The same can occur as the young investor is saving and gradually accumulating capital to provide for retirement. Savings are cash that are added to the investment account. As Gerald Loeb notes, most people are over anxious to get their cash working for them. I know that I was. The cash burned a hole in my investing pocket. I couldn’t wait to get it working hard for me. The truth is that there is no hurry to get the cash invested. You need to reframe from what you lose by holding cash to what you gain. What you gain is what Warren Buffett calls the value of a call option with no expiration date. The call option is to invest in a superb company at a bargain price at a time of your choosing.

This gradually accumulated cash was not produced to take advantage of any particular opportunity. It arose through prudent savings. The retired investor can be in a similar situation. Dividends are constantly flowing in. They are held as cash until needed for living expenses or to deploy in a stock purchase.

The point is, cash naturally accumulates in any portfolio. At any point a well-managed portfolio may have an accumulation of cash or it may have no cash. There is no rule saying a certain amount of cash has to be held

Opportunity strikes

Then an opportunity comes along. The company may be a seven footer and the price may have suddenly become a bargain for some reason. See here for list of reasons stocks may become bargains. The investor can compare the opportunity with other stocks in their portfolio. The opportunity may fit perfectly in their portfolio. It may improve the overall balance. It may provide a natural hedge to an existing position. It may offer improved diversification. It may be of better quality than a similar stock in the portfolio.

The cash in the portfolio may be enough to take advantage of the opportunity. Or it may not be enough. It doesn’t matter. The investor is in the delicious position of comparing the new opportunity with all other holdings in the portfolio.

A candidate for sale from the portfolio may suggest itself. The sale of one and the purchase of the other should improve the overall portfolio. The investor is unfettered in taking advantage of the opportunity. The discount brokerage commission cost is minimal. The money lost on the bid/ask spread may be perfectly acceptable. Liquidity is perfect for individual investor. The decision can be taken and executed promptly with appropriate time for reflection. Action is taken.

This situation needed no cash reserve. If the investor were a professional institutional money manager it might not work. The difference is liquidity. The individual investor can sell and purchase instantaneously without causing a ripple in the market. The money manager with a $100 million dollar holding cannot sell it just like that. Nor can they buy the opportunity just like that. The individual investor can.

One small variation on this theme allows investors to make more productive use of cash which may have built up while waiting for a seven footer to come along. This is to buy a conventional high dividend payer. It would have to be of the highest quality. Sometimes banks or utilities can serve. Such high dividend payer effectively becomes dry powder.

An exception – going to 100% cash

I treat true stock bubbles differently. Identifying and dealing with bubbles is a different topic. True bubbles occur very infrequently. There have been perhaps four in the last 100 years. See here. My basic rule is to go to cash or short term bonds when I am convinced the stock market is in a true bubble.

Conclusion

For the individual investor, in the normal course of portfolio management, sufficient cash is either available or can be instantly made available to take advantage of any opportunities that come available. As well, sufficient cash is either available or can be made available quickly to meet personal cash needs. It is not necessary to maintain some predetermined cash allocation.

This topic is discussed more fully in Part 5: Asset Management.

The chapters in Part 5 are:

28. Asset Allocation
29. Bubbles, crises, panics and crashes
30. Cash Reserves

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Click here for the Motherlode – introduction

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