It’s a great feeling to have cash when the stock market is down.
After all, who wouldn’t want to pick up stocks when they are cheaper?
In fact, some may say it makes sense to always keep some money on the sidelines, ready to deploy when the opportunity arises.
Others, however, will point out that waiting for stocks to fall would be akin to trying to time the market, an unwise thing to do.
So, who is right?
Clearly, a case can be made for both sides of the argument.
Investors, though, may want to look at the bigger picture before deciding what they want to do.
As markets go down, fear goes up
Market downturns are a fact of life when it comes to the stock market.
According to wealth manager Ben Carlson, the S&P 500, a barometer for the US stock market, undergoes a 10 per cent or more decline once every two years.
Larger falls, such as last year’s bear market, are less frequent but will happen from time to time.
Either way, every investor knows they should be buying stocks when they are cheap.
Yet, in practice, few actually do.
Why is that the case?
For starters, fear is a strong emotion, especially when it comes to investing.
In the book, Thinking, Fast and Slow, Nobel prize winning psychologist Daniel Kahneman said, for most people, the fear of losing money can be as much as 2.5 times more intense compared to the hope of gaining money.
Given this ratio, it’s no wonder many investors are consumed by fear during market downturns.
Now, don’t go thinking you are exempt from this emotion.
If left unchecked, fear can take over and you may find yourself paralyzed and unable to act even when stocks are cheap.
It’s all in your mind
Conquering your emotions is easier said than done.
Understanding what helps you keep a level head is paramount.
For my co-founder, David Kuo, dividends are his comfort zone. In his mind, receiving cash from his stocks is the best thing since sliced bread. In fact, David doesn’t keep much money on the sidelines for his portfolio.
He doesn’t see the need to do so since he will be receiving more dividends every month.
For me, I prefer to have some cash on the sidelines.
Cash keeps me calm when there is a market downturn. How much you decide to set aside is up to you. The key here is to maintain this cash at a level where your mind is able to make rational decisions when the moment to buy arrives.
In both cases above, figuring out your comfort zone is key.
Whether it is having cash on the sidelines or receiving regular dividends, it has to be the place where you are able to make fearless decisions, supported by the measures you have put in place for yourself.
Only you will know what keeps you calm.
Therefore, in my view, the decision on whether or not to keep cash on the sidelines should be motivated by what helps you keep a level head when the heat of a market decline is turned on.
The best stock analysis will not mean much if you are unable to execute when it matters.
Having a level head is your best strategy when the market falls.
Rules should work for you
As humans, we are captivated by stories of catching the big fish in the wide ocean, that magical single move that leads to millions in the stock market.
In reality, the moves an investor makes should be much more mundane.
When it comes to buying stocks, it doesn’t help to have complicated rules. When markets decline and fear exerts pressure on your mind, complex steps will leave yourself flustered and unable to make a rational decision.
Keeping it simple is far more effective.
For instance, if you have cash on the sidelines, you can choose to moderate your pace of investing depending on the degree of the market decline.
One way would be to put 10 per cent of your cash to work when there is a 10 per cent decline, and increase the cash allocation if the market decline deepens. That way, you will still have cash available if the downturn deepens.
Alternatively, you may want to make it even simpler by investing on a set date every month.
The key here is about finding the set of rules that work for you when the heat is on. The best strategies in the world won’t matter if you can’t put them into action.
On this note, catching the market bottom is a myth.
Even Warren Buffett doesn’t know when the stock market will reach its nadir.
Case in point: on 16 October 2008, deep into the Great Financial Crisis (GFC), the Oracle of Omaha penned a op-ed, simply stating that he was buying stocks.
His timing wasn’t perfect and it wasn’t even close.
From the day Buffett penned the op-ed, the NASDAQ index went on to decline another 26% before bottoming out more than four months later.
Did it matter? Not one bit.
Between 16 October 2008 and today, the NASDAQ has risen by over 670 per cent, a satisfying return despite missing the bottom.
So, don’t add stress on yourself over matters even Buffett is unable to do.
The three buying decisions that matter
We can’t control where the stock market is headed in the short term but we should recognise that there are three buying moves within our control.
The first is your choice of stock to buy.
For this decision, Warren Buffett keeps a tray marked “TOO HARD” to remind himself that there are many stock ideas which are not worth his time.
At first glance, it would seem ridiculous to even suggest that one of the smartest investors in the world would have trouble understanding any company. Despite his ability, the Oracle of Omaha is smart enough to know you are not rewarded based on difficulty.
Attempting simpler ideas can have an equal or better payoff. As investors, we would do well to follow Buffett’s lead.
The next decision is about how much to buy once you have chosen the stock.
For me, when it comes to buying stocks, I prefer to start with small amounts and slowly build up my position.
Why? Because the stock market, as we have shown, will be volatile.
If you commit too much cash to a stock, your mind may not be able handle the inescapable volatility of the stock market. At worst, you may end up capitulating to the fluctuations and selling your stocks too soon.
That’s not the result that you want.
What you want to aim for is a position you can hold for the long term.
The final decision is when to add to a stock.
A stock may pass Buffett’s “too hard” test, but every stock will still have a different risk profile.
You can tie the pace of your investing to the risk profile of the company.
If the stock carries more risk, you can always give yourself a year or more to learn about the business before you commit more funds.
If the company behind the stock has a lower risk profile, and you have a good handle on the business, then you can consider shortening it to six months.
As always, keep it simple.
To be a successful investor, what matters the most is a calm mind and a simple plan you can put to work when the moment comes. The rest will take care of itself.
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: Chin Hui Leong does not own any of the stocks mentioned.