One of the many investing mistakes I made during the early part of my investing career was to be rash with cash.
One salary hike, one bonus, or one big inflow of money (family gifts etc.) and I would invest the same into stocks I liked, irrespective of what the stock markets were doing.
Cash in bank was considered a wasted opportunity and every chance to “let-me-buy-stocks-now” was grabbed upon.
The question I used to ask myself was – “Why should I hold cash when it is paying nothing while stocks can grow my money much faster?”
However, over the years and after learning my lessons (from not holding cash) the hard way, I’ve found several reasons to ‘hold cash’.
Here are the biggest three of them:
- When my cash is paying nothing and my stocks are losing, “nothing” beats losing.
- If I don’t have cash, it is almost impossible for me to take advantage of opportunities that may present themselves in the future.
- Holding ‘emergency’ cash for a short-term need or even a short-term potential need is always a good idea (I realized this when, during a medical emergency in 2008, I had to ask for cash from my family since all my cash was fully invested in the markets that were going down).
Accepting these reasons has made me fearless of holding extra cash.
Some cash in the bank (or liquid funds) helps me with emergencies, with keeping things together during difficult or changing times, or even with taking advantage of great opportunities.
But this is easier said than done. Holding cash, and not earning anything on it, is often a painful decision.
In a letter written in 2004, the legendary Seth Klarman wrote about this painful decision of holding cash most investors face. He wrote…
Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.
The alternative to remain in cash is truly painful. As Klarman writes…
The alternative is to remain liquid, defy the steady drumbeat of performance pressures, and wait for the prices of at least some securities to drop. (One doesn’t need the entire market to become inexpensive to put significant money to work, just a limited number of securities.) This path also involves risk in that there is no certainty whether or when this will occur; indeed, securities prices could rise further from today’s lofty levels, making the decision to hold cash even more painful.
And because it is painful, and often requires tremendous patience, most investors – large and small – will choose to remain 100% invested, and also invest any new cash that is generated.
Klarman writes, and you will agree with him on this…
Human beings are only endowed with so much patience, after all. Few are able to look past near term returns, and today anything appears to offer better returns than cash. Also, given their relative-performance-oriented, competitive nature, investors loathe the possibility of underperformance that comes from sitting on the sidelines; they find it better to be in the game (unless, of course, the market drops). Most significantly, they remain highly skewed toward the greed end (how much can you make?) and away from the fear end (how much can you lose?) of the spectrum of investor emotions.
In short, investors remain the consummate yield gluttons, seeking high return without regard for the likelihood of actually achieving it or for the risk incurred in the process.
What Are YOU Doing?
When I talk about the importance of holding some cash in your portfolio when attractive investment opportunities are hard to come by (like now), a lot of people argue that that is same as gambling, that being less than fully invested is akin to market timing.
“Who knows whether the market falls or rises from here on?” is what they ask me. “What if I hold cash and the market keeps rising?”
That’s a valid question, but then isn’t a yes or no decision the crucial one in investing?
Who says 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 him or her.
As Charlie Munger says…
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.
And then, here’re Warren Buffett’s classic words of wisdom…
“Lethargy bordering on sloth remains the cornerstone of our investment style.”
You don’t need to always be in action, dear investor. Don’t be a yield glutton, as Klarman says. Holding cash when you have nothing to buy is a good decision.
It’s painful, but not knowing what you are doing with your cash and why you are doing it, often ends up being more painful for your long-term returns. So, please choose carefully.
Nice article Vishalji. I used to hold most of my networth in the form of cash, mostly because it gave me a good feeling that I have some money. My first investment was in 2005 when a broker convinced to do a SIP in Franklin India Bluechip fund. After paying 6 SIPs, I continued holding cash till 2008. One fine day when I checked how that SIP was doing, I saw it doubled in a span of less than 4 years. That was the day I realized the difference between holding cash and investing.
During the boom of 2008, I got into stocks without understanding much about it, made a few quick bucks and then the fever of investing came down with the crash.
That was the most important learning curve for me. I started reading a lot, mostly about Mutual Funds, Personal Finance, Goal setting etc and from past few months, I have been investing time on learning about stocks too. I do hold emergency fund, that’s my top priority, of about 6 months of my expenses. Then I hold some more liquid cash for monthly expenses. I have made a promise to myself that I will buy only the right stock and at the right price only, and not to sell it atleast 3 years before my goal is to be realized. I do have your “Investment Owner’s Oath” from chapter 20 at my hometown (don’t have any witnesses though 🙂 ).
Yes, I can hold cash and practice the virtue of patience as I am in touch with legends on a daily basis.
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After reading (3 times so far) The Intelligent Investor (TII), the biggest take-away, for me, has been 50-50 asset allocation. In fact, when I first bought the book way back in 2004, I could not understand
the book . I was in a hurry – I wanted to learn as quickly as possible, about investing in the stock market, and here was a book that talked about asset allocation and bonds – that did not interest me at all. So I kept the book aside, thinking that I would read the book again some time later. I decided to read TII again, because it had been highly recommended by many experts. And when I read the book again (if my memory serves me right, it was in 2009), I already had paid considerable tuition fee to Dalal Street and had seen the expensive IPOs of 2006 and 2007. The IPOs looked as if no one new the word “risk”, and retail investors (including yours truly), were falling over each other to give their money to promoters of businesses.
But, when I read TII again, after some painful real experience in the stock market, what Ben Graham had written made hell a lot of sense. As I have already mentioned, the most important thing I learned from TII is 50-50 asset allocation, and varying the allocation 75-25 or 25-75 depending on Mr Market’s mood.
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Now how have I been doing such an allocation in real life – that is, holding cash equivalents?
1) I have been reading investing books since year 2003. After my market lesson in 2008, I have been investing only the money which I do not need in the next 10 years;
2) Since my investing horizon is long term, I ensure I invest in quality stocks – time is the friend of a good businesses (+ve compounding=profit) and enemy of a bad business (-ve compounding = grueling loss=my retirement is far away);
3) I set aside the money (say X) which I might need anytime for buying a house. This money is saved
in fixed income securities – short term, ultra-short term and dynamic bond funds;
4) All other savings are kept in liquid funds. This takes care of my emergency needs if any, and also forms the bulk of my investing capital. This capital grows every month slowly from my savings;
5) After 2013, I am inactive and have not bought a single stock or mutual fund. Also, I have not sold a single stock or mutual fund.
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In my understanding, liquidity is the first and most important reason for the irrational continuously-increasing asset prices (including stocks). Fundamental reasons lag liquidity. Imagine a scenario: a wonderful asset is available at a very attractive price, but I do not have the money to buy it. So, when the market(s) run out of money [tightening by central banks and fear exhibited by investors sucks money away from market(s)] and if I happen to have money, I can buy assets (stocks) at attractive prices.
But, as many legends have been teaching, and as mentioned here by Vishal, practicing patience (holding cash) is not easy, as any other simple things in life. Because, by nature, people want to get into action after learning…. After all, how long one can only do theory…and no action; practicing patience can be really difficult.
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But, what have I been doing to improve myself to practice this virtue of patience?
1) The biggest motivator for me to practice patience is: My freedom. I do not want anybody to take away the small amount of freedom I enjoy. I do not want to be laughed at by stupid and ignorant people because I am reckless with my money – loosing money that can never be recovered can be fatal to one’s soul.
2) I have realized that: I am not young (40+) and cannot go on working for ever. In fact, given my temperament, I would like to retire early. So, I simply can’t afford to loose money. What do I do if I have to be inactive, doing nothing? I enjoy the free time and keep reading. My only hobby is reading, which I enjoy.
3) From my own experience:
— Sound sleep in the night=emergency fund in liquid assets=quality long-term assets;
— Confidence during market crash=cash on hand (you do not panic, when stocks become bargain);
— I am a contrarian=cash on hand (I can invest when the crowd runs for cover).
4) Recently, few of my happiest moments have been when I received calls from my stock broker saying my account has been inactive for quite some time. I felt very very happy and told myself that I am in the right direction and I am able to practice what other value investing legends have been practicing. Also I thanked God that I am knowledgeable enough to ignore investing advise dished out over phone;
5) By practicing inactivity, I am at peace with myself when I am at office. Some years before, when I was buying and selling frequently, I had to watch behind my shoulder, all the time, to see if some one was seeing me doing market activities during office hours. Also, I had the urge to stay connected to internet all the time. Now, at office, I do not buy/sell, and I am more relaxed and do not have to worry about some one watching me.
6) To keep me grounded at all times, I keep reading Ben Graham, Warren Buffett, Charlie Munger, Seth Klarman and other legends, which reminds me that inactivity makes money, not activity.
Some key learnings:
— Mr Market
— Margin of safety
— Conserve energy and wait for the right pitch
— Frictional cost
— Fee for helpers
— Buy quality and sit tight
— Tax-free compounding
— There are times to be in the market, and there are times to go fishing
— I have heard investing legends saying: if you have to entrust your money with investment professionals, do so when stock prices are low.
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in India the inflation is so high that holding cash seriously destroys value. I don’t think the words of foreign investors apply to India verbatim. You are always better off looking for mediocre returns rather than hold cash and do nothing.
Another point is that over 1yr equity returns are tax free in India. This is a huge thing. I don’t think the gurus you mention would’ve kept cash lying around if they had this opportunity. In a liquid fund if you pay 30% tax on returns you’re seriously destroying your wealth.
You don’t always have to put money in risky stocks, choose wisely (e.g arbitrage fund, hedging etc), but no point holding cash beyond a certain point.
I got to disagree here. Holding Cash is essentially trying to time the market, in a very broad sense. Assuming that a constant/increasing cash flow is available for investment through the years and If you are a very long term investor (> 20 years), then staying invested at all times, and periodic rebalancing asset classes should be the most optimal way to build wealth. Not hold on to cash, waiting for markets to fall. Trying to time the reentry with cash requires a lot of work and luck.
And retail investors are not Buffett/Munger. It makes sense for Buffett to hold on to cash till a better business opportunity arises. That is a business decision. A retail investor would still be better off Buying Berkshire stocks instead of sitting on cash.
Investment strategies of Buffett’s and Munger’s of the world cannot be compared with those of small retail investors. Couple of Buffett quotes below explain the reasons. Just my 2 cents worth on this discussion….
“On the size of his stock portfolio:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
“The universe I can’t play in [i.e., small companies] has become more attractive than the universe I can play in [that of large companies]. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
I think people are making underlying assumptions that a person who is holding cash is definitely trying to time the market. Holding cash should be understood in terms of margin of safety rather than timing the market. If you are already in a very good stock and want to sell and hold cash just because the stock may be little overvalued and you think that you can make a better entry at lower price is definitely a false ability you are relying on. But say if most of the good stocks you want are already stretched a lot and you have cash available you can do the following 3 things:-
1. Buy average stocks which are relatively cheap (because everything good is overvalued) but doesn’t have sustainable business model so there is definitely a chance of permanent loss of capital
2. Continue buying the good stocks even at exorbitant prices you may have to forgo 2-3 years of return but there is still very little chance of loss of capital but no margin of safety
3. Hold cash not because you are planning to time but because you want to only buy very good business but at reasonable prices
90% of the population will go with the 1st option which I believe is the worse among the 3 and should be considered as speculation. It might happen that the markets will remain irrationally overvalued for long time so the speculator might think he made the right decision but in long term only will he/she find out who is swimming naked when the tide goes out. Among the other 2 options it depends on what kind of temperament you have, if you are ok with missing out on 2-3 years returns and at the same time look like a fool because margin of safety is the underlying principle which you don’t want to compromise on, then as history shows with numerous examples in long term you will do the better than 99.99% of the stock market participants.
And for the people saying that these long held principles don’t apply to Indian markets because of inflation, no capital tax gain beyond 1 year and other reasons I would suggest you to find the courage and read the bible of investment books i.e. Security analysis to understand the concept of margin of safety much better than you would do if you read only Intelligent investor and the likes.
For the same question I guess its Irving Khan who famously said “there is always something to do”
I have thought a lot about holding cash, spoken to lots of investors and come to conclusion that if one find opportunity invest else hold cash. Overall market valuation is USELESS. Bharat Shah says one is investing in stock s and not markets…
Vishal,
Holding cash can be conceptually viewed as a call option on the underlying stocks/portfolio, albeit with unlimited tenor. It immediately follows that the decision to convert cash into stocks is analogous to the decision of exercising American call options on dividend paying stocks.
This embedded option value in cash is obviously higher in those markets that are very choppy and volatile. In emerging markets like India, where every year there are some days when a government created crisis (like retrospective taxes, FII taxation uncertainty, etc…) leads to gapping in the markets, this option value is bound to be significant. It may be optimal to hold cash in such cases, unless the “opportunity cost” (the return on the stocks/portfolio under consideration) is significant.
So, depending on what investments one is looking at and their inherent volatility, it may pay to be patient and sit on some cash. There is no set rule. It varies from market to market.
Ambarish