Active stock traders need to keep some dry powder so they can buy stocks when the stock market falls. Dry powder usually means cash. Allocating a portion of your portfolio to cash will be a drag on your returns, especially in a low interest rate environment with a rising stock market.
Traders need to be nimble so they can pounce on stocks when they drop. A cash hoard gives them the opportunity to act quickly without selling another position. This strategy works well when stocks fall, and they act on their impulse. If they time their purchase correctly, they can make a lot of money. Of course, if they don’t act quickly or time their purchase correctly, their strategy is for not. In a stock picker’s market cash is needed.
Traders look for fallen angels and Boeing is a classic example. Due to their unfortunate tragedies, the stock has dropped from its high of $440. Traders felt that Boeing below $400 was a bargain. The stock went through $400 like a hot knife through butter, falling another $62 to $338. Traders took their dry powder to buy it at $400 only to see their investment fall 15%.
Timing the market is extremely difficult. According to one study, asset allocation accounts for 93.6% of your investment return with the remaining 6.4% attributed to market timing and investment selection.
During the fourth quarter of 2018 the Dow Jones fell 12.5% and investors withdrew $183 billion in mutual fund assets. Investors were storing up some dry powder, I guess. This year investors have added $21 billion to mutual funds, or 11.5% of what they took out last year. Meanwhile, the Dow has risen 13.8%. Dry powder?
A better strategy for most investors is to own a portfolio of low-cost index funds, diversified across asset classes, sectors and countries. This portfolio will give you exposure to thousands of securities doing different things at different times. It will allow you to stay fully invested because you never know when, where, why, or how the stock market will take off. It reduces your risk of market timing and eliminates the cash drag on your performance.
But what if, or when, the market falls? In a balanced portfolio you will own bonds of different maturities. For example, during the Great Recession stocks fell 56%. Long-term bonds were up 16.6% while intermediate bonds stayed steady at 2.94%. Dimensional Fund Advisors Five-Year Global Fixed Income fund rose 4.9%. True, they did not offset the entire drop-in stocks, but they did hold their own.
It’s possible, and recommended, to rebalance an index portfolio on a regular basis. When your asset allocation changes, rebalance your portfolio to return it to its original allocation. This strategy allows you to buy low and sell high on a regular basis. I once heard an advisor compare rebalancing to getting your haircut. When your hair gets too long, cut it back to its original length.
Shouldn’t stock pickers make money in a stock picker’s market? According to Morningstar only 24% of active equity mutual fund money managers beat their passive index over a 10-year period. Is it possible to pick the top quartile funds every year for the next ten years? Doubtful.
Dimensional Fund Advisor’s found that over a 20-year period only 42% of equity funds survived. Their database started with 2,414 funds and only 1,013 survived twenty years. If more than half the funds fail, how will you be able to pick the top 25%?
Rather than keeping dry powder or trying to time the market, focus on your financial goals and invest in a balanced portfolio of low-cost index funds.
Don’t let dry powder blow up your portfolio!
My mission in life is not merely to survive, but to thrive; and to do so with some passion, some compassion, some humor, and some style. ~ Maya Angelou
June 19, 2019
Bill Parrott, CFP®, CKA® is the President and CEO of Parrott Wealth Management located in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose.
Note: Investments are not guaranteed and do involve risk. Your returns may differ than those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation.
 Determinants of Portfolio Performance, Financial Analyst Journal, July/August 1986, Vol 42, No. 4, 6 pages; Gary P. Brinson, L. Randolph Hood, Gilbert L. Beebower.
 https://office.morningstar.com/research/doc/911724/U-S-Active-Passive-Barometer-7-Takeaways-from-the-2018-Report, Ben Johnson, February 7, 2019