Thursday, June 14, 2012

An Experiment In Bottom Fishing

Holding An Outsized Cash Position In Hopes Of Scooping The Market

Like many long term investors, I generally try to stay fully invested as a general rule.  Even at the best of times, cash typically drags down overall portfolio performance over the long term and most of us (myself included) are not great at guessing which way the market will leap next.  However, the past 5 years have presented investors with an amazingly large number of buying opportunities and I often found that being fully invested at such times meant that I could not fully take advantage of such opportunities.  I don't generally like keeping lazy cash around doing nothing, but I decided this spring to try hanging onto an abnormally high level of portfolio cash in expectation that a buying opportunity would materialize shortly.

I did not start out planning to sit on cash.  I sold my entire LOW position and about half of my MEOH position as the market rallied and these equities reached my target for full valuation.  I then started looking around for junk bonds or equities to redeploy the cash, but everything seemed priced just a bit too high.  So I retrenched.  I decided that after being offered ridiculous buying opportunities over and over in the past few years, I would just sit tight with a portfolio allocation of about 10% cash until the next buying opportunity cropped up.  I am not entirely comfortable with this strategy because any number of studies have shown that investors have done a great job of blowing themselves up by getting out at the wrong time and either never getting back in or doing so at the exact worst moment.  However, I view this as an experiment and if I have not found an opportunity by the end of the year I will just deploy the cash into index funds or ETFs.

There are certain risks to this strategy, of course.  The most prominent risk is that you might fall victim to "analysis paralysis."  There is a temptation to stick with what you have and not pull the trigger when an opportunity crops up.  So how do you know when a real buying opportunity has shown up?  It is very frustrating to buy something and be offered the chance to do so again at an even lower price the next trading day.  I have mental note to start buying if the Dow drops below 12,000.  Sure it is an arbitrary number, but a drop of that magnitude from the spring highs signal's a traditional correction which is usually a good time to start buying.

Another important risk is that the market might not provide a real buying opportunity and just churn for a while and then cruise higher.  That would leave me with a slug of lazy, underperforming cash on my hands and mean that I have missed out.  While this is a risk, I believe I have reduced it in two ways.  First, the cash position is only 10% of my portfolio so the damage I can do to myself is relatively limited.  Second, I have set a time limit: end of 2012 I will have found an opportunity or abandoned the experiment.

As always, consult your advisors, do your own due diligence, and take your own risks.  Market timing like this is probably foolish.  Do as I say, not as I do.

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