Markets have been pulling back severely in the last couple of weeks. Some market participants are "pulling in their horns", but this situation can be an opportunity for individual investors.
Many individual investors try to optimize their cash holdings in bull markets just like the professionals. Optimizing means keeping as much invested as possible while reducing cash holdings at all times. While this is accepted practice with the professionals, I have always found it to be an unwise investment policy. It trades off short term returns for much better long terms returns.
Professionals are usually forced to optimize because they are competing for assets to manage. They are focused on achieving the highest returns for their investment objective. While this sounds prudent on the surface, there are different ways to look at this process.
Most professional investors optimize because it is typically essential for preserving their jobs. The driving force behind optimization is the investors they invest for. Many of those investors let their emotions flow with the market and their returns relative to the market. They chase high returns, and dump their holdings when immediate gratification doesn't occur. For the professional investor, lower returns often results in their investors reducing their holdings under the pro's management. When investors sell, the pro's assets under management (AUM) shrinks. Now here's the key point, if AUM shrinks too much, the professional manager can lose their job. Thus, they optimize.
An individual investor does not have the same constraints of a professional portfolio manager. A big constraint of the professional is the unrealistic expectations of their clients for the manager to ALWAYS be in the top returns for their investment objective. This is quite frankly an unrealistic expectation.
When the market sinks severely, like the last several weeks, fully optimized investors are left with little “dry powder” to buy securities when they come on “sale’. They must sell currently held securities before buying other securities that they believe have greater future prospects. While they have some cash, it often isn’t enough to take advantage of really great deals to a significant degree.
This is why Warren Buffett keeps so much “dry powder” on hand (100B). If there aren’t deals, Warren isn’t buying. When there are deals, he is all over them.
Sure, the non-optimizer is giving up some immediate returns that others are getting in the bull market, but when those folks turn sour on the market, many start selling indiscriminately and create FAR BETTER long term investment opportunities for the non-optimized investor. The babies get thrown out with the bathwater!
To follow this methodology of non-optimization, you have to be able to do several things:
- Train your mind and your behavior to look at pull-backs as opportunities and not setbacks.
- Don’t excessively compare your returns to other’s returns. This is a trap that causes most investors to overpay for their purchases in a bull market and it is also the most difficult to avoid. Why? We all compare ourselves to others each and every day in just about everything we do.
- Be willing to wait for an extended periods of time for the opportunities to come to fruition. Look up the Marshmallow experiment on the web. "All good things come to those who wait!"
- Know the details of the investment – qualitative and quantitative. Don’t assume the market is always right. It is not short-term efficient! Going with the flow can be hazardous to your financial health.
- Keep higher levels of cash in bull markets. This is your dry powder.
- Dribble the cash in when the market pulls back. If it goes lower, dribble some more in. Train your mind to look at the pullbacks as opportunities to buy on sale. No one has a crystal ball to tell the bottom, but are the securities you’re interested in “relatively cheap”? To do this you MUST know if the market price is relatively cheap compared to the security's fundamentals.
- While 3% cash is too small, more than 20% is too much cash.
Optimizing is not the optimum strategy!
Be safe, be smart, be prepared, be well read and be successful!
