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UNDERPERFORMANCE/OVERPERFORMANCE

By Louis P. Stanasolovich, CFP®, CCO, CEO and President of Legend Financial Advisors, Inc.®and EmergingWealth Investment Management, Inc. and Editor of The Global Investment Pulse

A substantial number of active portfolio managers who run domestic and foreign mutual funds, especially value-oriented ones, currently have significantly larger cash positions than normal.  In some cases, cash being held is in the 20.0% to as much as 70.0% range.  Why?  Are they trying to time the equity markets?

Generally, these managers are not trying to time the equity markets.  Instead, they are finding valuations of most stocks expensive regardless of the country.  While investing in funds with large cash balances may be unattractive to investors who want to keep up with the stock market whenever it rises, the strategy may outperform in the long run (over the next five to ten years).  Some readers may say, “How is this possible?”  Well, to understand this thought process, think of how Warren Buffet manages money.

Mr. Buffet sometimes holds as much as $40 to $50 billion of cash in his portfolios.  Why?  Well, it can be safely said he’s not looking to earn those high market returns!  Instead, he’s being patient, looking for opportunities when certain select companies that he likes drop in price.  That’s when he’ll buy.  That strategy has proven to be very successful over several decades for Mr. Buffet, who is widely considered the world’s most successful investor.

The next benefit of large cash balances within portfolios will come when the stock market eventually does fall.  Those investors (Portfolio Managers) with significantly larger than normal cash balances will suffer less of a decline in their portfolios.  After all, if one suffers a 50.0% decline in their investments, they then have to earn a 100.0% return to break even (See the chart below.).  However, if they suffer a 20.0% decline, it requires only a 25.0% return to break even.  With a smaller loss though, the same return will result in a higher long-term return.  As a result, the biggest risk is missing out on near-term future returns.  Remember 1998 and 1999!  Therefore, each individual investor needs to determine how aggressive they want to be in the short-term and how much further they expect the equity markets to rise.  Considering we are at one of the top ten valuation peaks in history, at best, it would appear another year or two of increasing equity markets is all that should be expected.  The bottom line for every investor is: “Does the risk justify the reward?”

 

 

COPYRIGHT 2014 LEGEND FINANCIAL ADVISORS, INC.®

 

REPRINTED WITH PERMISSION OF LEGEND FINANCIAL ADVISORS, INC.®

 




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