In early 2020, I sold my house, moved overseas and decided to rent instead of buy. As a result, I found myself holding a large amount of cash. I intended to invest that cash, in the stock market, but with the all-consuming, crazy process of moving internationally, I just didn’t get around to it.
About the time I got settled and ready to invest my extra cash, March 2020 happened and the market started tanking.
I bought a little bit here and there, but not nearly as much as I now wish. Because….and I think I speak for us all here….I had no idea what was going to happen and I was scared.
I wanted to do what we’ve all been taught to do…..buy when stock are on sale! But as I watched the market went into a full blown nose dive, I chickened out.
Now, it’s 2021 and I still have a sizable amount of cash just sitting on the sidelines. The markets are making new highs and now I feel like “I missed my chance”.
So now I’m asking myself, “Should I hang on to this cash and wait for another pull back? Should I just dump it all into the market at once and get it over with? Or, should I buy in little-by-little (aka dollar cost averaging)?
These questions don’t just apply to when the market is making all time highs, what I found are principles that work for every market season. So, let’s tackle these questions one-by-one starting with how much cash you should hang on to….just in case.
How much Cash Should You Hang on To?
With interest rates at record low, holding cash will get you negative returns. Thanks a lot inflation! However, there are a least two good reason (and one bad reason) to hang onto some cash:
- Emergency Fund
Good reason #1. You need to have an emergency fund, because life happens. If 2020 taught us anything, its to expect the unexpected. Even if you have plenty of money (in investments) to weather life’s storms, you don’t want to have to liquidate those investments every time things get tight.
Now, how big should your emergency fund be? Good questions, There are literally 428,000,000 opinions on “how much you should have in your emergency fund”
Let me save you some research. There are two common responses to this question:
- You should definitely have an emergency fund.
- It should be enough to cover 3-6 months of living expenses.
I know I just said that holding cash right now is guaranteeing negative returns…and that’s true. But you shouldn’t look at your emergency fund as an investment.
2. Short Term Savings
Good reason #2. Aside from your emergency fund, you should hold short-term savings in cash. Any expense that will occur within the next 4 months should be in cash. This is because it takes an average of 4 months for the market to recover from a correction (10% decline). So, let’s say you’re saving up for something like a car, or a new roof and the market takes a dive. You may not be able to hold off for 4 months until the market recovers.
3. “Dry Powder”
Dry powder is investor speak and often refers to cash that is intended to be used when buying opportunities (such as market dips) arise. Here’s my hypothesis on dry powder:
Hypothesis: Dry Powder = Market Timing = Bad Strategy
If you’re sitting on cash waiting for the market to drop before you buy, that’s the definition of trying to time the market, and market timing doesn’t work.
Not only does it not work for amature investors, it doesn’t work for the pros either. Here is just one (of many) studies showing that even seasoned wall street veterans can’t beat the market average. They have way more knowledge, more time to dedicate and much better tools. So why would amateur investors think they can do better?
I don’t know, but I’ve tried….and failed.
As I mentioned, at the beginning of the article, I was sitting on an abnormally large amount of cash at the beginning of 2020. The market was marking record highs, so understandably, I didn’t want to go all in “at the top”, so I decided to wait for a pullback.
And I felt super smart a few months later in March 2020. I would’ve lost 37% because the market did this:
But the thing is, the market went back up (as it always does) and a few months later the market is looked like this:
It was up from the beginning of 2020 and WAAYY up from March of 2020. And guess what, I was still sitting on that cash because I was nervous and couldn’t decide when to buy back in. As a result, I missed out on a 9% gain because I tried to time the market.
Let me give you one anecdotal piece of evidence. Whitecoatinvestor does a great job of breaking down the math here. He demonstrates that even with a very disciplined and mechanical approach to holding dry powder and buying when then market corrects, “the benefits of dumping dry powder in at market lows did not overcome the downside of cash drag.” For those of us without a PHD….timing the market just doesn’t work.
I hope you didn’t miss what I said there, “even with a very disciplined and mechanical approach”.
Because, that line is the icing on the cake for me. Most of the investors I know don’t have this type of robotic discipline…..I certainly don’t. I get emotional, or distracted or even apathetic. I put together a great strategy and then quickly deviate from that strategy for any number of reasons and wind and sabotaging my gains.
For me, this alone is enough reason to advocate an approach that minimizes my need to be perfect involvement and maximizes the chances that I simply stay fully invested for as long as possible.
Lump Sum vs. Dollar-Cost-Averaging
Supposing I’ve convinced you not to try and time the market, what’s the best way to invest your cash? Invest all your cash all at once, or trickle it in over time. In other words, lump sum investing vs dollar cost averaging.
For those that are unfamiliar with the concept of dollar cost averaging, the idea is to buy into the market at regular intervals with regular amounts. This way, you protect yourself from unintentionally going all in at the beginning of a long bear market.
But when you think about it, isn’t this is fundamentally the same thing as holding dry powder? You’re intentionally holding cash back because of concerns about the timing. It just happens to be a more “defensive” approach to market timing, whereas holding dry powder is more of an “offensive” strategy.
In the end, dollar cost averaging is just a more disciplined and conservative attempt to time the market. So not surprisingly, we find the same results (market timing doesn’t work) when we do the math.
Actuaryonfire does an awesome analysis showing that no matter the time horizon (2-30) years or allocation (stocks and bonds) lump sum consistently beats dollar cost averaging in practice. In fact, for periods over ten years a lump sum strategy is more effective over 90% of the time (for equity-heavy strategies).
Summary
There you have it. If you, like me, often suffer from analysis paralysis on how and when to invest your cash, it’s simple:
- Make sure you’ve set aside 3-6 months of living expenses in an emergency fund.
- Do not hold back dry powder and try to time the market.
- Invest the rest as a lump sum right now.
Logically, the next questions is, invest in what? Stocks, bonds, real-estate? In this article, I break down my allocation strategy and why I believe this is the ideal strategy for long-term passive investors.
Also, tell me what you think in the comments. I love to hear different opinions, it’s how we all get better.
