In my previous contribution An exception to the no genuine value-add to society filter, I discussed a recent personal deviation from value investing.
This time I will expand on how reading Margin of Safety for a second time made me realize my personal context warrants more risk taking than generally advised in investment literature.
An imperative in investing is diversification. A portfolio of eight equal-sized stocks might be called risky “concentrated investing”.
Again, it is the context that is of great importance. For a wealthy investor holding close to 100% of net worth in stocks, I fully agree (the books are generally written by or for these types anyway). However, for investors that are invested across asset classes and/or benefit from large cash flows from relatively uncorrelated sources, the riskiness of this strategy is mitigated (e.g. an endowment with cash flows from forests, farms and real estate, or an individual that has a job and/or private business).
Seth Klarman highlights the advantage of having liquidity from high cash yielding positions in a downturn in his seminal book Margin of Safety:
The third reason long-term-oriented investors are interested in short-term price
fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. If you hold cash, you are able to take advantage of such opportunities. If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels. This creates an opportunity cost, the necessity to forego future opportunities that arise. If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.
Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities. Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others. Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration. Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value (discussed at greater length in chapter 10). Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends. The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase. Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months. An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one’s initial investment returned to cash, one’s profits are as well.
– Margin of Safety, chapter “At the root of a value-investment philosophy” paragraph “The Relevance of temporary price fluctuations”
It was only after investing on my own and reading this book a second time that I realized that my personal situation is similar to an investor with high cash flows from sources with relatively low correlation to the price of equity markets. Indeed, I derive significant cash flow from a job (rest assured that my employer is not an asset manager. Indeed, AM typically have a revenue ‘beta’ of ~2 to the stock market).
These sources of liquidity are not often discussed in investment books, but once I came to the above realization (in my 7th out of 10 years of investing!) I was embarrassed with my own lack of independent thinking.
Today I hold a lower cash balance in general as my “replenishment rate” is high. However, I do believe that having no cash is only “optimal” in theory. In practice, a small amount of cash can have the huge benefit of getting psychologically undamaged through a market correction, allowing oneself to rationally grasp the opportunities at hand.
Last year I started asking this:
What is the threshold of cash level that would actually make me happy when the market crashes?
What is yours?
My answer is 20% (taking into account my moderately high replenishment rate and the fact that I am a young investor, not an older disinvestor). Note that this is a theoretical question, as a certain M. Tyson said: Everybody has a plan until they get punched in the face. Likewise, the level that will truly feel good is probably a bit higher. Lastly, remember what Warren Buffett says about plummeting markets:
A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.
‘[S]mile when you read a headline that says ‘Investors lose as market falls.’ Edit it in your mind to ‘Disinvestors lose as market falls— as investors gain.’ Though writers often forget this truism, there is a buyer for every seller and what hurts one necessarily helps the other.”
– Buffett in ’97 BRK chairman letter
Oddly, most newspapers and books are written for disinvestors (older and wealthier participants). We can guess to the reasons why:
- in part because this audience has the most money to spend on content
- on the other hand most is probably explained by the insurmountable instinct for many to focus on short-term nominal gains
In the last market correction (Feb ’16) I actually felt content, but that probably meant that my cash level was too high in practice (i.e. 30%). Today it is at 10%.