Importance of cash when it is scarce

After reading the heading of this page, please don’t go out and sell your portfolio. It is not a warning from our end and neither are we saying that we are close to stock market crash. The idea of writing this piece of article is to make sure you are ready for such crash whenever it happens.

So imagine markets around the world are trading down in range of 15% – 20% and Indian markets will open in five minutes. As expected, Indian markets too follow the rest of the world and decline 15% – 20%. There are only sellers in the market and they are desperate to convert their portfolio into cash.

Suddenly the liquidity disappears from the market and no one is willing to buy anything in the stock market. You see all the big and small names that you always wanted to buy are now trading 20% – 30% down from the last close.

Investors have started believing that future prospects for the world are gloomy and it is better to hold cash rather than invest in the stock market. Even when their favourite stocks are trading at deep discounts.

So my question to all of you is when should you hold cash more?

The simple answer is: when fewer people are holding it. Because that’s when it is more valuable. Most of the investors sit on cash when market nose dives and at no cash when stock market is at all time high.

Back to the reality, see what is happening around you right now? We are in the Bull Run and not only the stock market but many other assets are trading at premium prices and investors are pouring in more cash everyday thinking of gaining 10% – 15% in the short term. They believe that they can as in the past year will be able to execute such strategy couple of times successfully.

If you aren’t selling any stocks today then you are buying them. And what you are buying assets today most of them are giving inadequate income stream or very high PE or PBV. The classic response I get from investors is that no matter they are producing lower or no profits today, investors will do well from capital gains. The point over here misses out that in order to make capital gains the next buyer to whom you will sell should be willing to accept lower yield and higher PE and PBV than yours. Capital gains do not happen in vacuum. In order to sell there must be a buyer, and that buyer must be greater fool and willing to pay even higher PE and PBV ratios.

Of course, there is nothing to worry about anything right now. Everything looks rosy and stock market is going high every day. But if you are sitting on lower cash levels than ask this question to yourself: if I need to get out in a hurry, will I be able? If you are not highly leveraged and are okay to ride a cycle or two then you have little to worry about. And if you have other income stream that allows you to add to your portfolio at lower prices, again you have little to worry about.

Remember cash is most valuable when nobody has any. Illiquidity in the market could trigger a significant fall in the asset prices.

If I had to build a portfolio of 10 stocks last month in April, our asset allocation tool was not allowing us to invest more than 30% in the stocks and to hold 70% in cash.