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3 Ways to Use Cash to Protect Your Portfolio From a Crash

Value investor with a deep passion for understanding and a desire to improve results over time.

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Is Cash Trash?

Cash is trash, according to Ray Dalio. In an inflationary environment where money is worth less a year from now than it is today, an investor is motivated to put their money to work pretty much anywhere it earns more than the rate of inflation.

Low-risk bonds aren't much help; if inflation is 7% a year and you have your money parked in Treasury bills that return 2% a year, you're going to lose a very real 5% per annum.

In fact, people often mean "Treasuries" when they say "cash" since the yield you can get from the former has the same effect on your portfolio as washing your hands does to a bar of soap. However, there's a compelling reason to hold cash as a portion of your portfolio: to be able to take advantage of amazing deals when the price is right.

For this reason, I'm offering you three different ways to attain this goal, each with pros and cons that may fit your own personal investing style and temperament better or worse. Let's get started.

Method 1: Staying Disciplined

The classic investing example is Warren Buffett, whose Berkshire Hathaway keeps as much as a third of their portfolio in cash or cash equivalents. If Buffett can't find a good deal, he doesn't buy anything, and so cash piles up. This naturally leads to the ability to buy when stuff isn't so expensive, and this is the core of value investing.

Buffett says that when it's raining gold, you should reach for a bucket and not a thimble. Your bucket here is cash, or the ability to catch the rain (gold) as it falls from the sky. Berkshire also has to maintain something like $70 billion in order to cover investment-related obligations, give or take, so you should keep that in mind when thinking about how much of their cash Buffett is really holding.

Seth Klarman, who manages the Baupost Fund, and one of today's Superinvestors of Graham-and-Doddsville, is even more extreme than Buffett. At times, Klarman has held more than 50% in cash, something unheard of on Wall Street. Klarman's disciplined, steady hand allows Baupost to buy distressed debt and ultra-cheap businesses when there are few buyers even taking a look, yielding occasional bonanzas of incredible deals.

Clearly, this requires an incredibly patient temperament, along with a very long time horizon. If you have both of those, this method may work really well for you. If nothing else, it represents the conventional, classic value-investing approach to cash: hold a bunch when stuff is expensive, and wait for opportunities. Only buy then.

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Method 2: New Money From Outside

If you're anything like me, holding onto 30% of your portfolio in cash can be agonizing. Maybe you're still finding good deals right now, but you're worried about the way macro conditions are pointing, leading you to believe there might be an even better buying opportunity ahead.

In that case, it's incredibly useful to have some new money coming in from outside the portfolio. If you have income you can invest regularly into your portfolio, you're like most investors.

The trick here is to figure out how much of the new money to spend, and while it's impossible to predict exactly when a crash will occur, you can certainly invest in less stuff as prices go up, leaving you with more cash saved up (not invested this week).

I like this approach a lot since you can sort of have your cake and eat it, meaning you can still buy the stocks (or stock) you really want to buy, but you're also able to save up just in case. Clearly, this is a concession to the macro gods, and everyone knows value investors "don't try to time the market," except for when we do . . . we just do it by saving cash during exuberant times.

And, if you have new money coming in constantly, managing how much you're investing depending on how the market looks can be a great way to do this.

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Method 3: New Money From Inside the Portfolio

Hopefully, you're not making the "mind blown" hand motion right now. You probably remember that there are several factors that determine how much you will make from a stock. Let's focus on two of those paths: dividends and selling covered call options (I'm sticking with covered calls since the nature of value investing is very conservative, but you do you).

Dividends come in consistently, like clockwork, and typically show up in your portfolio once a quarter, although some dividends can pay monthly or biannually. If you want to have a completely hands-off approach, you can keep your DRIP (Dividend ReInvestment Plan) turned on and just forget about it, meaning the dividends from that stock will just repurchase fractional shares of that same stock.

On the other hand, if you want to decide whether that's the very best investment opportunity you have at that moment—and, what are the odds, really, that your one stock happens to be the best opportunity right then and there?—then you want to turn DRIP off and invest those dividends yourself. That's one source of new money generated from right there inside of the portfolio.

If you have a dividend growth portfolio, this will grow to become a significant amount of regularly recurring income for you, and you can get an idea of how much cash it will be by looking at the dividend yield.

You can do much the same thing with a covered call portfolio, but you'll need to stay on top of things a bit more than with just reinvesting dividends. However, you can get new money coming in weekly or monthly by writing calls, and you can choose to hold or invest the income from the calls you've written.

You can also set your strike prices higher than your cost basis, so every time you have a sale, you'll get some amount in capital gains to reinvest along with your original principle.

Experiment

New money coming into your portfolio, either from the outside or inside, completely changes the style you need to use in order to be successful. I highly recommend running experiments in your portfolio and thinking like a scientist during this process, allowing you plenty of room to make mistakes and learn from them.

If you have more than one portfolio in your brokerage (or if you have multiple brokerages), you can run one portfolio with a "new money in" strategy while refusing to add any new funds to another. This will help you practice both strategies, so you can get good at both over time. Life will present you with plenty of opportunities to use both skill sets.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith