Build Cash Reserves For Superior Stock Returns

by: John Tobey, CFA

Photo of cash and investment pageIn my previous article I discussed moving to a new stock strategy that includes cash reserves. Some readers asked if, in this time of near-zero interest rates, it wasn't a better to stay fully invested.

My answer is "no" because yield isn't the issue - it's the benefits to be had from using cash reserves in the market ahead. Here's the explanation.

First, a quick historical look

A cash reserve strategy, although infrequently discussed today, has always been a component of good investing.

When I began investing in 1964, cash was a desirable asset in a stock brokerage account. (Back then, all cash earned 0%. Money market accounts and funds had not been created.)

Investors wanted reserves so they had funds available for opportunities that could present themselves at any time. Investment wisdom argued against trying to keep money "at work" all the time. Various average levels were discussed, with 10% probably being the more common. (The actual level varied as buys and sells occurred.)

Today, the more common approach is little or no cash reserves, with money being fully invested.

"Fully invested" is not a requirement and can be a trap

With institutional (e.g., pension) funds and retail (e.g., mutual) funds, staying fully invested is important. These funds are in competitive races against indexes, and having a cash allocation is viewed as a potential drag on performance.

However, we investors are not restricted by that need. We are free to invest whenever and however we believe is best to meet our goals. Therefore, we should not view being "fully invested" as a must, or even a good investment approach.

But don't we need to keep our money invested for best results? No. That idea presumes that all investments are fairly priced and move in unison, market risk factors remain consistent, investors act in a rational manner and returns are earned in a fairly steady manner. As everyone should know by now, none of those criteria is accurate.

Bonus: Using cash strategically can make us better investors

Besides being ready for that special opportunity, cash reserves provide other benefits that can make us better investors:

  • The decision shifts from, "Is that stock better than this one?" to "Is this stock's potential return worth the risk?" The former question, required by the fully invested approach, means second-guessing and being forced to buy something when we sell anything and vice versa (or, worse, deciding to do nothing). The latter question, asked about both potential buys and holdings, gives us the freedom to separate buy and sell decisions, taking action only when the time is right.
  • A more relaxed and constructive view of price movements in down markets. Fully invested and the stock market drops 10%? Result: Worry, frustration and the possibility of shifting to "safe" holdings or, worse, moving money out stocks at the low. Cash reserves and the market drops 10%? Result: Desire to check out bargains that might be available.
  • A more realistic and constructive view of price movements in up markets. Fully invested and the stock market runs up 20%? Result: Enthusiasm and, perhaps, even a desire to make some shifts to higher performing (riskier) areas or, worse, put more money into the stock market at the top. Cash reserves and the market runs up 20%? Result: Cherry pick some winners to sell, buy some laggards and build cash reserves for the inevitable market pullback and currently unknown opportunity.
  • A higher conviction that the investment choices are good. When the pressure is off being fully invested, investments are chosen with more care. Therefore, there is a greater willingness to stick with them, even when prices go the wrong way. Confidence in the stocks held, when combined with an available cash reserve, goes a long way to our being able and willing to do the right thing at the right time (i.e., to invest well in both good and bad markets).
  • A chance for rest & relaxation. Humans require respite after times of endeavor or stress, both physical and mental. Investing's challenges and the stock market's periodic "excitement" create such times. However, fully invested investors cannot take a breather and escape the continuing pressures, leaving them susceptible to missing opportunities or making mistakes. Those with a cash reserve strategy are free to close out positions, build reserves and then take a break to clear their minds. Doing so improves the chances for subsequently making good decisions.

The bottom line

It's time to ignore the "cash is not king" mantra. Cash reserves can be a powerful tool for achieving superior stock returns. We gain freedom and flexibility that allows us to grab opportunities, sell when the time is right and remain confident throughout. With the new bull market upon us, now is the time to build cash reserves to pursue superior stock returns.

Disclosure: I am long U.S. stocks and U.S. stock funds, plus cash reserves built from recent U.S. stock and U.S. stock fund sales.