Should you stay fully invested? The relentless tech rally since March 2020 lows has propelled many investors into the “stocks only go up” mind set. Softbank certainly had a hand in this.
Despite the worsening economic data, absence of Covid-19 vaccine (Russia perhaps) and potential 2nd/3rd/4th wave of coronavirus in the fall, the stock market continues to record all-time-highs.
The fear of missing out has never been so wide spread until the Covid-19 crisis started. With money perceived to be made so easily, it begs the question of whether investors should just join in the fun, while it last. Holding cash vs investing just seems like a no brainer!
Everything went accordingly to plan, until the 3rd September, when the Nasdaq Composite, the tech heavy index, fell by almost 5% in a day. To many investors, this is almost unfathomable. But we argue that it is precisely times of stress where more money can be made.
To be a good trader, you have to be a contrarian – Paul Tudor Jones
In this article, we touch on how to take advantage of stock market crashes and what to invest in when the stock market goes down. More importantly, we explore the key message of the article, which is whether investor should stay fully invested at all times. To conclude, we share and highlight the importance of retaining a healthy cash position and being a contrarian during times of stress.
Taking advantage of stock market crashes
Stock market sell-offs happen from time to time driven by a myriad of reasons, some explainable and some not. In essence, the stock market is a reflection of the market’s “emotion” and “feeling” about the future of the economy, rational or irrational, resulting in market gyrations.
In analyzing the historical stock market performances, it's convenient to conclude that investing during stock market crashes generates the largest return. Although, this requires certain amount of patience.
But, why are we not taking advantage when the market crashes or had a significant drawdown?
Well, the main pushbacks are usually lack of capital/cash and the possibility that things may get worse before it gets better. These are valid arguments.
We address the issue of lack of capital/cash later in the article. On the other hand, the idea of “things may get worse” more often than not, dissuades investors from making the hard decisions, which is to increase their exposure.
While we’re not advocating for investors to buy every time the market dips, but a significant drawdown is definitely an opportunity for some discounted stocks.
Consider this. Tesla was trading ~$500 on 1 Sep before losing ~20% value by the end of the week, trading just under $400. Nothing has really changed over the short period of time, but yet, investors felt better buying the stock at $500 when the market is bullish, but refuse to even look at it when it’s around $400. Could this be FOMO? Is this back to a momentum game?
Call me crazy, but if I like a stock at $100, there’s no reason for me to dislike a stock at $80 in a week’s time. We think investors can significantly generate a enhance risk-adjusted returns by using these observations to their advantages.
During significant market drawdowns, our investment approach involves selectively increasing exposure to quality companies that have been unfairly caught up in the sell-off.
Where to invest when the stock market goes down
Man of many wise quotes, this should be in every investors’ rule book.
Price is what you pay. Value is what you get. – Warren Buffett
Speaking on a stock-only basis, a drawdown or a market sell-off tend to be broad-based. In other words, stocks tend to be sell off indiscriminately, where stocks are sold off evenly. For instance, most tech-related stocks are down >10% during the day. Consequently, because not all stocks are equal, opportunities to invest in those stocks arise.
While subjective, we adopt the following measures to prepare for such event.
- Maintaining a watch list. A stock watch list is one that consist of stocks that are of interest to you, but have not reached your targeted entry point. These can be stocks that you've already own and hoping to own. Acting like a shopping list, investors can quickly identify and take advantage of any price anomalies.
- Planning your execution strategy. The question of when to buy can be answered through our enhanced dollar cost average or similar approaches. The goal is to develop a systematic way of purchasing stock during these times. For example, buy 20% of your intended size for every 10% the stock falls.
- The importance of preserving cash balances. As mentioned, this is the single most important enabler for this strategy to work. Holding cash may look stupid in a bull market, but it provides the liquidity needed during time like these. We explore in more detail in the next section.
Should you stay fully invested all the time?
Our answer is no and you're not obligated to. It is a choice.
We think being fully invested all the time reduces the flexibility of taking advantage of the market during times of stress. Not staying fully invested is analogous to keeping a rainy day fund.
Take the Covid-19 pandemic, for example. Being fully invested means the foregoing the opportunity to build positions during the drawdown we experienced in March.
We do, however, acknowledge the temptation of not being fully invested when the market continues to reach all-time high. Based on our limited samples and experiences, we found that investments made during these times often brought us the most attractive risk-reward plays, hence enhancing our investment return.
In fact, a well-known hedge fund Senior Portfolio Manager once told us that the reason they’re able to outperform the market significantly is their free cash that they’re able to deploy during these times. Basically, they were able to acquire discounted stocks when the market is selling. The ability to gradually build their positions while having monk-like patience significantly reinforce their position of one of the leading hedge funds globally today.
This makes perfect sense.
On the contrary, mutual funds are generally required to be fully invested according to their mandate. Their cash position are usually 1-5%. Consequently, the need to be always almost fully invested may (I’ll just say it, often) lead to sub-optimal investment decisions.
Interestingly, as retail investors, we have little to no constraints on our cash position. In managing our portfolio, our rule of thumb is to maintain at least 20% of cash. In fact, our portfolio had a cash position of almost 50% at the end of August 2020. As a result, we were able to add to our positions during the early September drawdown.
We are an advocate of active investment management, taking profits as we set out in our investment framework is one of the key ways we look to shore up our cash position in the portfolio. A good yardstick is to compare your cash position relative to the market’s valuation. Nevertheless, it should be inversely correlated with each other.
All in all, making great investments requires two main ingredients: money and opportunity. We argue that because opportunities are uncertain and tend to happen when we least expected, it’s a good practice and discipline to maintain a healthy rainy day fund in your investment portfolio.
One of the key differences between a great and a good investor is the ability to deploy capital that maximizes risk-reward. Often this requires the traits of contrarian investing. While not a fool proof strategy, stock market sell-offs are often opportunities where investors can purchase quality stocks at significant discount.
In the short run, the market is like a voting machine. But in the long run, it is a weighing machine – Benjamin Graham
Finally, avoiding FOMO and herd mentality helps. It always helps. Godspeed in the markets!