Investors: Don’t Keep Your Powder Dry

It is common for many investors to want to have some cash on the sidelines. They want to have money available to use if an outstanding investment opportunity becomes available to them. They do not want to sell stock or bonds from another account to pursue a new deal.

However, the concept of having some cash on the sidelines to pursue potential future market opportunities is a mistake and erodes your investment returns.

The Concept of Dry Powder

The use of the term dry powder in business and investing refers to the holding of cash or other liquid securities to have money available for opportunities that might arise in the future. The Investopedia article on dry powder notes that it might make sense to keep dry powder in other business environments — for example, Apple reported over $285 billion in cash reserves in February 2018. They may choose to spend that money on things like buying companies, stock buybacks, or paying taxes.

Dry Powder In Venture Capital and Private Equity

Another example where dry powder might make sense is in venture capital or private equity. The time at which you are able to raise money for your venture capital or private equity fund might not exactly match the time when investment opportunities might arise. As a result, these funds may have significant money in their fund that is not yet invested in startups or private equity deals.

According to Pitchbook, the amount of money raised but not invested (“dry powder”) exceeded $1 trillion dollars between private equity and venture capital funds in 2017. Since venture capital and private equity deals generally invest in private, illiquid investments, of course they shouldn’t rush out and invest in deals. However, while waiting for opportunities to invest, they don’t just leave the money sitting in a bank account to earn interest. It turns out that many funds are increasingly investing in index funds and ETFs to earn money while they are waiting for deals. Even these venture capital funds understand that their dry powder shouldn’t be sitting around in cash.

Regular Investors Should Not Have Dry Powder

The concept of dry powder, which might make sense in the business or private equity worlds, is not appropriate for the regular investor. Holding cash to wait for market opportunities feeds into the mentality of market timing and the desire to buy low and sell high. There is a belief that if you wait on the sidelines and allow a stock to fall, you will be able to swoop in and buy at the bottom. This approach is rarely successful.

When stocks were falling at the start of 2016, Jim Cramer urged investors not to buy into the pullback, but rather to keep some powder dry and sell struggling stocks on a subsequent rally. Of course, the stock market did rally higher in 2016, and made new highs in 2017 and the beginning of 2018.

Later, in March 2018, as the stock market was dropping because of the threat of a rising trade war between the United States and China, Jim Cramer urged investors to stay on the sidelines and keep their powder dry.

Your expected returns are eroded whenever you spend time out of the market

Of course, I’m being unfair to Cramer, because I cherry-picked the times when he has made incorrect calls on the market. There probably were many examples where he encouraged investors to head to the sidelines to keep their powder dry, and the stock market continued to fall. However, on average, keeping your powder dry by keeping cash on the sidelines only serves to decrease your expected return.

In fact, you can estimate how much your expected return goes down when you keep cash on the sideline. It is proportional to the amount of time you are out of the market multiplied by the expected return of the market.

Assuming that the market moves in a random walk, then every market trading day has a slightly positive expected return. Over the course of one year, your expected return in the stock market might be around 8-10%. Assuming 252 trading days a year, the expected return in one trading day would be +0.03-0.04%.

A gambler might believe that they can beat the house on any one blackjack hand or roll of the dice. But the casino is just as confident that because it has a small edge, they will make money over time. The more the gambler plays, the more the house will win. In investing, you are the casino, and keeping your powder dry is the equivalent of the gambler sitting on the sidelines.

Should you be 100% stocks then? No!

Of course, this doesn’t mean you should hold all of your money in stocks 100% of the time.

The stock market has the highest expected return, but it also has the highest risk. Most people cannot stomach the risk of a 100% stock portfolio, so almost all investors should hold some bonds in their portfolio. Bonds also have a positive expected return, and is preferable to cash in most investing situations. A common misconception is that one should not hold bonds when interest rates are rising. The bond market already prices in future rate increases — therefore, bond returns are based on changes in future interest rate expectations.

There are of course good reasons to hold cash. If you have an emergency fund, or are saving up for a down payment or a car, then holding money in a high-yield savings account can make sense. In addition, everyone needs to hold a little bit of cash to manage the month-to-month cash flow of their daily lives.

However, holding cash in order to wait for market opportunities is a mistake.

Conclusion

For most regular investors, keeping dry powder in the form of cash is a form of market timing. Leaving cash on the sidelines while waiting for “opportunities” only erodes your investment returns. The more time you spend in the market, the higher your expected returns.

What do you think? How much of your portfolio is in cash? What is the purpose of the cash you are holding (emergency fund, savings for a big purchase, dry powder, etc.)

[Charts courtesy of StockCharts.com]