I recently read The Great Depression: A Diary, which was a daily account of the 1930s economic crisis penned by a lawyer named Benjamin Roth. Because of the invaluable lessons emphasized in it repeatedly by Roth, I think the book should be part of every investor’s self-education. Economic crises create some of the best opportunities to make a fortune because it is during these times that stock prices unhinge and can become completely detached from intrinsic value (i.e. value as supported by a company’s earnings). Yet it is always the case that points of weakness in the economy correspond to unemployment – or fear of unemployment – and thus a lack of liquidity to take advantage of bargains. Even the majority of those with excess cash are hesitant to take the plunge and invest with conviction when times look bleak.
My belief is that unless an individual is lucky to gain a windfall just prior to a market downturn – an inheritance, sale of business or home, or being awarded a large annual bonus at work, amongst other things – a deliberate buildup or maintenance of surplus liquidity is required to be able to take advantage of low prices offered by times of crisis. In this regard, the enemy of most investors is the notion of cash drag, defined here as the drag on a portfolio’s return caused by averaging in the zero return earned on the cash portion with positive returns from rising stock prices.
Go Against the Grain – Look Years into the Future
To put it another way, one must go against the grain and look years into the future in order to be positioned to take advantage of bad times. Without doing so, all the forces of nature will line up against an investor so as to preclude him from being able to capitalize on market dislocations. On this point I unfortunately speak from my experience in the 2008-9 financial crisis. Back then, I was a relatively fresh MBA grad with considerable student debt, and to top it off I was fully invested in equities, which were dragged downward for a few years. Even though I was gainfully employed during that period, I wasn’t personally able to take advantage of the fire-sale when the market troughed in March 2009.
Have the Prescience to Reserve Cash
To be clear, I do not believe we will see another 1930s-type bear market again, at least not in my lifetime. The S&P dropped 85% from its peak prior to the Great Crash of 1929 to the summer of 1932. Had an investor set aside 50% of his trading account as a cash reserve prior to the Great Crash, that cash position would have naturally elevated to ~84% of the account at the market trough in 1932, assuming his equities dropped 85% in line with the index. This is cash drag in reverse; cash acts as a partial cushion when stocks drop via averaging in its zero return with negative returns from the equities. From a pain perspective, an investor holding 50% cash pre-crash would have still suffered a 40% paper (i.e. unrealized) loss at the bottom in 1932; however, had he then invested the cash at the very bottom and reinvested the dividends back into the S&P at the end of each year, his portfolio would have grown by a factor of 13.2x from the peak in 1929 to 1954 when the index finally recovered to the same nominal level 25 years later. Annualized, this would have translated into a 10.9% return. While the return may not seem overly impressive, consider the result had there been a zero cash reserve before the bear market began: the account would have increased by a factor of only 4.3x over the same time period, or 6% annualized. Thus having the prescience to reserve cash in the scenario outlined above could have sown the seed for decades of outperformance versus the index.
Our Overriding Goal
Should a cash reserve be kept in every investor’s portfolio even in times when bargains are plentiful? Increasingly, I am of the opinion that some level of cash should always be maintained, as a reserve has two key benefits: (1) bottom-up opportunities can appear at any time regardless of whether markets are at a peak or trough, and (2) it is the most practical source of liquidity to draw from when market corrections occur. As discussed above, the hesitancy towards holding cash typically originates from the fear of missing out on returns. This kind of thinking can be combatted by the constant self-reminder that one should always remain pragmatic; our overriding goal should be long-term compounding, not timing each investment to obtain every cent of potential profit. It is difficult from a psychological standpoint to sell part or all of a holding that is undervalued and well-researched – thus an objective gauge should be used to determine just how undervalued each holding is and rank accordingly, and at what threshold the optionality of holding cash is more valuable.