I know there are many investors who have a lot of cash on the sidelines. They may have raised cash fearing a pullback in 2014. Or maybe they made contributions to their IRA and didn’t invest the money because the market was at or near a high. Others sold positions once they reached their price targets and have been sitting in cash ever since.
Looking at today’s valuations, it’s a lot tougher to find bargains that seemed plentiful a few years ago. Unfortunately, holding cash cost investors plenty last year, when the S&P 500 Index was up more than 13%. And that’s the problem with trying to time the market with your purchases: you can miss a lot of upside by being on the sidelines, even if you’re out for a relatively short period.
If you have a significant level of cash in your portfolio that will not be needed in the next couple of years, it probably makes sense to put your cash to work. And while there’s no guarantee (ever) that the market will be higher in a month or a year from now, that’s the uncertainty that we have to accept in order to make more than the risk-free rate over time.
I can understand that putting a lot of cash to work at once is daunting when the market is up like it is today. So rather than thinking in black and white terms of all-in or all-out, let’s consider three strategies to help you get that excess cash invested prudently.
1. Dollar Cost Average. We invest in three tranches, 90 days apart, investing 1/3 of the cash position each time. This gives us the advantage of getting an average price over time. If prices drop, we can pick up more shares at a lower price.
Dollar Cost Averaging worked well in the second half of 2014, as we had cash to invest in October when the market was down 7%. Of course, there are also times when the market rises, and the lowest prices were available at the first trade date. In that case, Dollar Cost Averaging can increase your average cost basis.
2. ETF Limit Orders. One of the advantages of Exchange Traded Funds (ETFs) compared to Mutual Funds is the ability to use limit orders. If you believe there might be a pullback in 2015, place a limit order to buy ETFs at a set price or percentage below the current values.
For example, if you think there might be an 8% correction, we could set limit orders that are 8% below the current price of each ETF. This way we have a plan in place that will automatically invest cash if the market does in fact drop. Even though there is no guarantee we will have such a drop, this is still a much better plan than saying “Let’s wait and see what happens”, because when the market is down, people don’t feel good about making purchases. And recently, any corrections in the market have been short-lived, so there has been only a small window of opportunity.
3. Use “Low Volatility” ETFs. If the primary concern is market volatility, there are Low Volatility products can help reduce that risk today. These are funds which quantitatively select stocks from a broader index, choosing only the stocks which are exhibiting a lower level of fluctuations and risk. Low volatility funds are available in most core categories today, such as large cap, small cap, foreign stock, and emerging markets.
Over time, a Low Volatility index may be able to offer similar returns to a traditional index, but with measurably lower standard deviation of returns. These ETFs have been available for only a couple of years, so this belief is largely based on back testing, and there’s no guarantee this strategy will work in the immediate future.
We should also note that a Low Volatility strategy is likely under perform in Bull Markets (think late 90’s, or 2009), and could lag other strategies for an extended period of time. Additionally, Low Volatility does not prevent losses, so the strategy could certainly lose money like any other equity investment in a bear market.
With those caveats in mind, I am happy to use Low Volatility funds if they give an investor some more comfort with their equity positions and the willingness to put cash to work. Time will tell if these funds are successful in achieving their stated objectives, but in my opinion, Low Volatility funds are among the more compelling ideas offered to investors in the past several years.
Each of these three strategies has advantages and disadvantages, and there is no magic solution to the conundrum of how to get cash off the sidelines today. My role is to work with each investor to find the best individual solution to move forward and have a plan to accomplish your personal goals. Luckily, we have a number of tools and techniques available to help address your concerns.