Why Cash Should Be A Significant Portion Of Your Portfolio

Includes: AAPL, IBM, KO, MSFT
by: Rodolfo Avalos

What do Apple's (NASDAQ:AAPL) top executives and a portfolio manager of an investment fund have in common? That both are under enormous pressure to use their cash. There's a constant push for them to quickly find the "best use of their cash", instead of leaving it there producing absolutely nothing, being eaten away by inflation. After all, what is the point of handing your hard-earned money over to them (and incur management fees) if they don't actively put that cash to work? Investors' urge for seeing their cash deployed "at least somewhere" at all times (be it Gold, U.S. Treasuries, REITs, Bonds, Equities, what have you) is what oftentimes results in very unwise and ill-timed investments, especially amid market rallies.

For a variety of reasons (some not for our best interest), we are constantly bombarded by the media, brokerage houses, bloggers and analysts that keeping cash in a portfolio for a prolonged period of time yields the worst returns in an asset allocation strategy. I confess I have also experienced the tingling sensation of needing to "do something" with my cash when markets rally for fear of missing it out. Not only does this psychological urge pushes you to overtrade and unwisely invest, but it also makes you lose sight of a fundamental reason for having the cash in the first place.

While you begin to think where I am heading to with this topic, let me bring, in a parallel manner, another important subject. Realistically speaking, the amount of time and effort required to analyze, evaluate and understand one single company, its competitors, and the overall sector it operates in before making an investment decision is simply overwhelming.

Unless you have a fully dedicated team of analysts behind your back to help you analyze and evaluate dozens if not hundreds of companies at any given time, there's only so much an individual investor can do in terms of financial analysis (considering you have a normal life). Yes, there are some of the so called "super-humans" who can efficiently and quickly deal with a lot more information and analysis than the average investor, but they are more the exception than the rule. I, for instance, am not one of them, and I'm well aware of my natural human limitations.

I find it difficult to comprehend how nowadays just about anyone can issue an opinion, analysis, or investment recommendation in unrelated companies or sectors every other day. The amount of financial analysis and actionable information available to investors for consumption on a day-to-day basis is truly mind-boggling. Every day you encounter new bloggers, new analysis, and new opinions on pretty much everything and anything. I am beginning to think that this much information and "analysis" is more detrimental than beneficial to my investment goals.

As of late, I struggle to find real value in many (and growing by the day) of the financial articles I can get myself to read. Quite frequently is just a lot of nothing about anything. Nothing new, nothing relevant, just a waste of valuable time. Even with the advent of technology, which granted has made it a lot easier for independent analysts, bloggers and individual investors to analyze pretty much any company, true "due diligence" requires much more than just quickly glancing over some important financial ratios in the web, making quick computations, and spotting some trends before making an investment decision.

Moreover, once you make a decision, it just doesn't magically end there. You need to keep up. You need to read everything and anything that becomes publicly available about the company, the sector and the competitors. You need to stay on top, constantly monitoring whether the fundamental principles upon which you relied to make your decision haven't materially changed.

Now picture this process not only once, but many times over. I read quite often that 30-40 names is about the right number the so called "financial experts" advocate in order to have a properly diversified portfolio. If the average investor intends to do true "due diligence" in each and every one of them and subsequently stay on top, well, all I can say is good luck with that. It's no surprise then that over the long-run, the average investor can't simply beat the market and can only obtain, at best, sub-par returns. A truly comprehensive analysis prior to making an investment decision requires more than just reading a few press releases, some annual reports, and crunching some numbers.

Does this mean that we, as individual investors, are doomed to never benefit from the stock market? No. Quite the contrary, now more than ever we have more and better opportunities to invest our own money. We just have to know how to properly do it, and find the midway point between reality and fantasy.

Connecting the dots

In order to address the central dilemma of having unused cash and fighting the urge to deploy it all in lieu of the limited bandwidth the average investor has, we need to go back a little bit in history. At the end of the 90s I came across a book named "The Davis Dynasty" written by John Rothchild.

What fascinated me about this book was the simplicity of its central theme. The Davis family had turned an initial $50,000 investment into a staggering $900 million over the course of 50 years, simply by following a very basic principle: Wait long enough with enough cash available, sift through opportunities in your area of expertise, of what you really know, and when you find such opportunity, load up.

Now, it is not my intention to amass a similar fortune during my lifetime, or even 1/100 of it. I also have a lot less time than 50 years for it. But it certainly is to retain the basic principle. This helps me keep perspective when holding cash in my portfolio. The exact same principle has been followed by Warren Buffett, Peter Lynch, Ben Graham, or John Paulson.

To be succinctly clear, I am by no means implying that we should try to find the next Microsoft (NASDAQ:MSFT), or Apple , or IBM (NYSE:IBM) or Coca-Cola (NYSE:KO), or the next subprime crisis to short. Even less, to try to emulate either one of these renowned investors of our times. I'm simply stating that having cash available at all times and waiting for the right time to use it by buying some high quality businesses at decent (if not bargaining) prices is a lot wiser than you might think.

To this point, we only need to recall some of the wise words spoken by Charles Munger during his investment lesson at the University of Southern California in April 1994:

"It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it-who look and sift the world for a mispriced bet-that they can occasionally find one.

And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.

That is a very simple concept. And to me it's obviously right-based on experience not only from the pari-mutuel system, but everywhere else.

And yet, in investment management, practically nobody operates that way. We operate that way-I'm talking about Buffett and Munger. And we're not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they'll come to know everything about everything all the time.

To me, that's totally insane. The way to win is to work, work, work, work and hope to have a few insights.

How many insights do you need? Well, I'd argue: that you don't need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And that's with a very brilliant man-Warren's a lot more able than I am and very disciplined-devoting his lifetime to it. I don't mean to say that he's only had ten insights. I'm just saying, that most of the money came from ten insights.

So you can get very remarkable investment results if you think more like a winning parimutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And you're probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It's just that simple.

When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches-representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all."

He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better."

And the Berkshire system is not "bonkers". It's so damned elementary that even bright people are going to have limited, really valuable insights in a very competitive world when they're fighting against other very bright, hardworking people.

And it makes sense to load up on the very few good insights you have instead of pretending to know everything about everything at all times. You're much more likely to do well if you start out to do something feasible instead of something that isn't feasible. Isn't that perfectly obvious?

How many of you have 56 brilliant ideas in which you have equal confidence? Raise your hands, please. How many of you have two or three insights that you have some confidence in? I rest my case."

Fortunately, as individual investors we do not have the pressure to deploy our cash or keep it invested at all times. We can hold our cash for as long as we want and wait for an opportunity to arise, because when you eat, sleep and talk financial markets, opportunities do arise. During the past 14 years, we've witnessed all kinds of situations, ranging from economic bubbles to financial crisis, and amidst all this mess, several opportunities to invest in high quality companies at decent or bargaining prices have arisen.

As an important takeaway, size matters to regular investors, in respect to the fact that being an individual investor comes with a huge advantage. And what is that advantage, you ask? It is the ability to load the boat on your best ideas. You are not constrained in any shape or form, and your highest conviction ideas have a much better chance of adding out-performance to the portfolio.

To explain this average investor's edge, Hedge fund manager Joel Greenblatt, whose Gotham Capital fund earned 50%+ returns for more than a decade, uses in his book the example of "Bob", a pseudonymous friend tasked with allocating billions under strict institutional rules:

From a practical standpoint, when Bob [a big-time equity fund manager] chooses his favorite stocks and is on pick number twenty, thirty, or eighty, he is pursuing a strategy imposed on him by the dollar size of his portfolio, legal issues, and fiduciary considerations, not because he feels his last picks are as good as his first or because he needs to own all those stocks for maximum portfolio diversification.

In short, poor Bob has to come up with scores of great stock ideas, choose from a limited universe of the most widely followed stocks, buy and sell large amounts of individual stocks without affecting their share prices, and perform in a fish bowl where his returns are judged quarterly and even monthly.

Fortunately, you don't.

No matter how much the market pundits advocate against it, I know convincingly that keeping enough cash in my portfolio is the very right thing to do (and so should you), for when the opportunities arise, and arise they will. For those times when you don't find yet any opportunity but still want to keep some of your money invested, you can simply resort to a broad-based index in the form of an ETF, but that will probably not get you very far (see why).

Me? I'll just keep waiting, with cash on hand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .