Another great question that comes with portfolio management is the question of liquidity. Some investors advise to keep 5%-10% in cash in order to seize opportunities. Others will advise to keep a higher amount around 25%-30% in cash to avoid market crashes and be ready to pick-up the market when it is at its lowest.
I personally think you should keep lower than 2% of your portfolio in cash.
I’ll explain you why in a minute. But first, let’s take a look at the theory of keeping an important amount of cash in your portfolio.
Interesting enough, there are lots of pessimists investing in the stock market. Those people are always looking for the next market crash, the next recession to invest their money. They think they are able to make a better return if they “time” their entry in the stock market.
We have already demonstrated that time in the market is more important than market timing. The problem is that it’s nearly impossible to know when the market is about to drop or jump. Therefore, it is a safer strategy to stay the course and ride the market as long as you can.
Now, if you do not have intention to time the market, but rather use lump sum investments during down time, it might make sense in a few occasions. For example, if you receive a sizeable amount of money to invest (an heritage, sell of another asset or a bonus received at work for example), you might want to wait for the next 10% drop of the stock market. Since this happens on a relatively steady basis, you may end-up waiting only a few months or a year before going in the market. This is probably a strategy that is worth it… as long as the market goes down. For example, if you were in this situation in early 2012, there wasn’t a 10% drop before September 2014… after the market went up by 55%. Even after a 10% drop, you still “lost” 45% of market return by waiting on the side lines:
This is the main reason for me it doesn’t make sense to have an important amount of money waiting on the sideline: the downside of missing a bull market is more important for me than getting into a bear market. This is even hard to capture a bull market as only 3 calendar years shows losses over 10% over since 1988:
Source: ycharts (note that 2000 shows -9.10%).
In other words, you would need to follow the market closely to identify the 10% drops during a year as a yearly check-up is not enough to capture any market drops. Chances are you would need to check the market every 2 weeks to make sure you capture one (remember how fast the market recuperated from the Brexit of 2016?). Do you have this much time to spend on your portfolio?
Let the dividend payment convince you
The other reason why I prefer to invest almost 100% of my money at all time is the payment of dividends. Imagine dividend stocks in your portfolio generate 3% on average. This is a very easy yield to achieve for any dividend investors, but I rather use conservative numbers (plus you know my affection for low dividend yield stocks). This is a 3% cheque you receive on a yearly basis no matter what is happening on the stock market. This is quite a good payment to keep you waiting and doing nothing. Does your money market fund is that generous?
If you are not in a hurry to cash your investment, letting dividends getting paid and compounding in your portfolio is a much better investing strategy than waiting to capture a 10% stock market loss. As you can see on the previous chart, the stock market rarely stayed in the red very long. Therefore, if you are patient enough, you will not only see your initial portfolio value gaining in value, but you will also get paid a juicy yield in the meantime. And this, off course, is during the worst investing case scenario where you would enter the day before the market crash. On the other side, if you invest at the beginning of a bull market, your return will only get stronger.
Do you still have any doubts by now?