It pays to be fully invested during a bull market.
Of course, 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's surprising is that professionals have been doing the opposite. With the Dow setting record highs before a near-700-point correction in July, 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."
So money managers weren't caught off guard by the market's volatility.
Or were they?
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 May and 70 basis points year over year.
In other words, even as money managers grew 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 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 is carrying more than 20% of its assets in cash alongside holdings in Mohawk Industries
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 its growing presence in online options trading, expanding profit margins, and tremendous return on equity, optionsXpress
(NASDAQ:OXPS)is a company 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 Infosys Technologies
(NASDAQ:INFY)and Global Payments (NYSE:GPN).
- 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'm keeping one to two full positions in cash -- or 5% to 10%.
That, however, is no hard and fast rule. We should 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 optionsXpress. optionsXpress is a Stock Advisor selection. Fairholme is a Champion Funds recommendation. Being clever is working out pretty darn well for the Fool's disclosure policy.