Followers of financial markets are often faced with the pressing debacle of what to do with excess cash standing in the bank. Be it cash received from inheritance, retirement or a big annual bonus. Often, investors consider some of the following avenues to to utilize cash as efficiently as possible;
- Fixed Deposits
- Money Market Funds
- Real Estate
Depending on the size of capital, an average investor often faces increasing worry when the size of capital starts to grow bigger and bigger. Much acclaimed father of growth investing Phillip Fischer said it best in his book, "Paths to Wealth through Common Stocks",
"He should realize that selecting the right investment and buying it at the right time is tremendously more important than getting this inflation protection quickly."
Phillip Fischer was a man who was a pioneer in the area of growth stocks, but even he understood the importance of ensuring that wealth allocation had to be on a rational basis.
This article aims to debunk two myths that follow;
1. Dollar Cost Averaging
2. Cash is bad
Debunking Dollar Cost Averaging
Many financial professionals, institutions and business schools advocate the use of dollar cost averaging. It comes with the enticing claims that it reduces risk while providing a hand-off approach towards investing. Your author does not argue against the aforementioned statements, however, there is a fundamental flaw with the above statements.
With dollar cost averaging, the argument made; regardless of price, the market should be bought on a scheduled consistent basis to ensure an average overall price, thereby limiting the risk of over investing from time to time.
The above logic advocates that there is no price too high for a market. This, is an extremely big flaw for investors who understand fair value. Markets with its emotional moods, are subject to highs and lows. At times, it can be overvalued. During the dotcom bubble, an investor who bought in during 1999 was paying a breathtaking 32 times (exclamation) earnings of the overall market (S&P500). Any rational investor using common sense would understand that in the long run, such a high valuation on markets was unsustainable.
There will be times in the markets, at which valuations are simply too rich for investors and should be avoided. Investors who has practiced dollar cost averaging during the dotcom bubble ended with mediocre returns 10 years after the crash.
S&P 500 2000: 1498
S&P 500 2002: 815
S&P 500 2007: 1500
S&P 500 2013 (January): 1500
Investors who had bought the S&P500 at the peak of 2000 would have needed to wait an excruciating 7 years before they broke even. An additional 6 years was needed after the 2008 crisis should the investor continue to hold.
Investors who avoided the sky high prices in 2000 and bought in 2002 would have realized a growth of 84% in 5 years. While investors are unable to time the market, the pulse of the market can be felt using capitalization of market against gdp of the country. While imperfect, the aforementioned measure serves as a tool for the rational investor to capitalize on market follies when the market is undervalued, and stay away from the euphoria when the market is overvalued. The notion that the market should be bought at any price, regardless of its value is the basis of dollar cost averaging. This is simply fallacy for rational investors. The concept of putting aside cash on a regular basis, known as "paying yourself first" has its uses to build a nest egg for long-term financial goals. However, building such a nest through flawed notions give way to mediocre returns for investors.
Should the investor hold cash instead?
Cash is Bad. ?
Worries of inflation on holding cash often encourages investors to take action as quickly as possible. We have already addressed the above notion that investing should be on a rational and not habitual basis. Even more so when the habit is based on flawed concepts.
Growing cash piles worries most investors. Investors worry about inflation eating away capital. This brings the second myth debunking, while investment assets serve as a platform for investors to counter inflation, not all assets are created equal. The notion that investors need to purchase assets as soon as possible to overcome inflation is flawed.
The saying, "in times of crisis, cash is king" is often heard during great crashes throughout history. Yet, many investors do not pay heed into building large sums of cash during bull markets. Instead, afraid of being left out, investors pile on equities and assets, hope to realize an annual gain of 4% to counter the inflation rates year on year.
Rationally, risking your capital for a 4% gain is irrational. Most investors head towards assets to hedge against inflation, while the statement is true, it should not be the first criteria in determining an investment decision.
The first criteria that investors should understand are the risks involved. The most important question that investors should ask;
"Is there a risk that I would lose 100% of my capital?"
It is interesting to note that often, this question comes only at the LAST phase of an investment analysis process. It is probably the most important question investors have to answer. By answering the question before the analysis is conducted, the investor saves himself much time in avoiding securities with systemic risks.
The keys to success of a growing fund overtime is not a measure of IQ but rather, the fortitude of the investor. Warren Buffett is often quoted as saying.
Most investors have the IQ required to handle most fundamental analysis, revenue realization, cash-flow analysis and returns on equity. However, it is not the tools that determine the success of the investor but the utility of character that the investor will make the most money using the tools.
There is little reason to purchase businesses at exuberant prices when there is an option to hold cash while waiting for the great investments to come by. An investor who generates 10% consistently over 5 years while trading could be beaten by an investor who waits for 5 years before selecting an equity that multiplies by 3 in a one year time period. (During 2009, there were plenty of such equities)
Most investors however, do not have the fortitude and character to wait for 5 years before making an investment decision. Often temptation creeps and they take the plunge knowing that the market might be overvalued.
While cash doing nothing, to most investors represent a negative vibe, it has its uses during times of crisis. Investors who aim to outperform the markets will be wise in building up cash positions, while undesirable during the short term, will leave the naysayer's in the dust when overwhelming opportunities appear.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.