It pays to be fully invested during a bull market.
Of course, as we've seen, no bull market lasts forever. And when the bull stops running, it hurts to be fully invested.
That's why long-term investors must maintain a stake in the safest investment going: cold, hard cash. The size of your cash position will vary with your outlook, but as you become more bearish, cash should increase.
That's intuitive, sure, but what was surprising is that leading up to this current period of volatility, professionals were doing the opposite. With the Dow setting record highs before a near-700-point correction in July that has continued into 2008, retail mutual fund managers held precious little cash.
Get a load of this
A survey by the Russell Investment Group before the correction reported that 17% of money managers believed the market had become overvalued. That was a significant increase over the past year's data, and Russell summarized its findings with the headline: "Managers Warily Eye Aging Bull."
In other words, these folks were spot-on in their assessments and should not have been caught off guard by the market's volatility.
But they were
Data from the Investment Company Institute told a different story. The percentage of mutual fund assets stashed in cash in June fell to an all-time low of 3.5%. That was down 10 basis points from the previous month and 70 basis points year over year.
In other words, even as money managers said they were growing skeptical of the market, they kept buying stocks!
It doesn't make any sense
That's a bit of a bizarre parlay until we remember that mutual fund managers are under a lot of short-term pressure to perform. If you're sitting in cash while the market roars upward, you will be replaced.
After all, most investors don't want to pay a money manager to do nothing. But being prepared to do nothing and having the courage and conviction to do so is exactly how you can build -- and how some of the world's best money managers have built -- a fortune in the stock market.
Meet the world's most boring money managers
Bruce Berkowitz, Larry Pitkowsky, and Keith Trauner manage The Fairholme Fund (FAIRX). Their motto: "Ignore the crowd."
It's a marketable aphorism, sure, but it's also one the team believes in. In a recent letter to shareholders, the trio wrote a passage that is applicable to today and should be tacked inside every investor's locker:
Being prepared for unpredictable stock market storms is an integral part of the process of seeking above-average long-term returns. While always prepared to snap at the right opportunity, we view the Fund's meaningful cash and U.S. Treasury Bill holdings to be a strategic advantage ... [one that] should give our shareholders a measurable advantage over their investing lifetimes.
That's why Fairholme was carrying more than 20% of its assets in cash at the end of August, alongside holdings in White Mountains Insurance (NYSE: WTM ) and Penn West Energy Trust (NYSE: PWE ) . By giving the fund ballast against volatility and the means to take advantage of big buying opportunities when they present themselves, the folks at Fairholme believe that keeping cash will help their clients do better over their "lifetimes." What's more, I'd suspect that when Fairholme next reports its holdings, we may see it holding more stocks and less cash.
A lifetime is a long time
Not many other fund managers take such a long view. Instead, for marketing purposes, they try to make sure their fund looks good -- or at least not too bad -- on a quarter-to-quarter basis. And that's why so many managers were buying stocks even when their intuition told them to be careful.
As an individual investor, you don't have to worry about the politics of fund management. You don't have to compare yourself to your peers on a quarterly basis or answer to a marketing department. Rather, like Fairholme, you can invest for a lifetime.
That's a huge advantage you can exploit.
What you should do
While the market seems to have stabilized, rest assured that the next drop is never far off. That means now's the time to prepare.
Here are five ways to do so:
- Own only stocks that you'd be willing to hold for the next three to five years, at least. (Given the increasing global demand for energy and its effects throughout the economy, W&T Offshore (NYSE: WTI ) and Dawson Geophysical (Nasdaq: DWSN ) are two small energy plays I'm happy to hold for years.)
- Maintain a wish list of great companies you'd like to buy at better prices. (Candidates on my list include Apple (Nasdaq: AAPL ) and MercadoLibre (Nasdaq: MELI ) -- both of which are getting more appealing thanks to recent drops.)
- Only invest money you don't need for the immediate future.
- Stay focused on the long term. Studies show that volatility decreases as time passes.
- Always keep some cash parked on the sidelines.
Helpful ... but not too much
That last point is a tricky one, particularly when it comes to "How much?" Too much cash and you'll lose out to inflation; too little and you won't be able to take advantage of buying opportunities.
In my own portfolio, I was keeping two full positions (10%) in cash -- or 5% to 10% -- but have since reduced that to about 3% thanks to a recent buying spree.
The key is to be willing to be fully invested when the right opportunities present themselves. That means keeping a wish list and constantly ranking your best ideas.
One more thing to do now
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This article was first published on Aug. 1, 2007. It has been updated.
Tim Hanson owns shares of W&T Offshore and Dawson Geophysical. Dawson Geophysical is a Motley Fool Hidden Gems recommendation. Fairholme is a Champion Funds recommendation. Being clever is working out pretty darn well for the Fool's disclosure policy.