The Art of War (chest)
I have seen frequent discussions on the amount of cash we should be holding as warchest and opinions varied widely. Some are fearful of today high market in overseas markets and advocate for 100% cash, while others see good values in STI market and maintain a high percentage invested in the market. Questions asked are often the optimum level of warchest to achieve the maximum returns. I been thinking about this and want to pen down my thoughts.
One approach is to determine what is the expected value (EV) using the probability of an event happening. Then based on some reasonable assumptions to work out the two extreme cases of All Equity or All Cash.
For the case of All Equity, the market in the long run will return about 6-7% pa. If we are quite confident of our skill as a security analyst to achieve better result, then a good target will be 11%. A more skilful investor can opt for 13%-18%. But it will extremely tough beyond that.
For the case of All Cash, we can look at the history of market returns. These are roughly what I can deduce from historical data:
- More than 10% drop: 1 every 3 years or 33% chance
- More than 20% drop: 1 every 5 years or 20% chance
- More than 30% drop: 1 every 10 years or 10% chance
- More than 40% drop: 1 every 15 years or 7% chance
Assuming that the returns from each event is the amount of drop itself, then the total EV will be summation of the multiples of returns and chance of occurrence, which comes to about 13% returns. But this assumes that you have to guess all the corrections perfectly, else you will not get the returns. If you have guessed that it is a 20% drop but it turns out to be a 10%, you will get nothing cos you didn’t act. Or if it turns out to be a 40% drop, and you go all in at 20%, you will leave 20% on the table.
As in a guessing contest of coin toss, if it is truly fair, the odds should be 50% of calling heads or tails correctly. Then, I would argue that for the All Cash option the EV should be reduced by 50%, ie EV of 6.5%.
It looks that they are about the same in expected returns.
In short, it boils down to either of these options:
A) All Equity and expects 6-7% on average and 11% based on stock picking skills.
B) All Cash and get 6.5% on average or 13% based on skills in timing the market.
C) Combination of equity and cash.
For me, I want to stay invested and still keep some % in cash. The main reason is that there will be some good stocks that the price may be greatly suppressed during market turmoil, and the returns can be much greater if I can pick them at really cheap price.
I feel there is no magic formula that can determine the optimum level of cash in warchest as everyone investment strategy and skills are different. You can try something like Kelly Criterion which may help, but I think there are too many assumptions for it to have meaningful conclusion.
For me, I am holding 30% (~500k) in cash and plan to allocate the funds in increasing amount as the market drops more. This is to maximise the buying opportunities when the market goes into a deep recession. The plan will be something like this:
STI 3200 - 50k (fired)
STI 2800 - 100k
STI 2400 - 150k
STI 2000 - 200k
If STI hits 2000, the market would have collapsed by 45% and I think many excellent companies will be dirt cheap by then.