Always Keep Some Powder Dry

Published in Investing Strategy on 20 November 2009

Many savvy investors advocate staying fully invested. But how do you take advantage of opportunities?

Apparently, c.95% of all shares listed on the London Stock Exchange fell in value during 2008. They weren't all doing badly, though; or certainly not as badly as the falls suggested. This presented unprecedented buying opportunities for many of us earlier in the year.

If you're a follower of the maxim of staying fully invested, you lost out -- unless you like to mix a few shorts in with your longs. But for those of us who prefer to see ourselves as "investors" following the relatively simple method of buying shares in undervalued companies with good prospects (as opposed to spread-betting and the like) and holding for the longer term, there's no getting round the fact that 2008 was rubbish.

The nature of sharp falls is that they're generally unexpected. They have to be, or they'd have already happened! So you can guarantee that they'll take the market by surprise, whether it's a gradual death by a thousand cuts or another Black Monday with a 26% drop -- save for the few investors or commentators who had "just sold" or had "recently warned" of a correction. And there are always quite a few of these. This is because there are always sound bear points.

The next big fall is just around the corner...

It's said that markets climb a wall of worry and that the bear case always sounds more intelligent, so the next big fall is perpetually just around the corner. And it is; the gainsayers will inevitably be "proved" right if you wait long enough.

For such times, I think it's better to keep sufficient dry powder to take advantage of the falls. This may seem obvious, but many investors advocate staying fully invested on the basis that you can't reasonably predict the market. There's a lot of truth in this, but I've found from personal experience that I've done best when buying on weakness. The more severe that weakness, the better the return.

Nobody rings a bell...

By now, I'm sure you'll have spotted the fatal flaw in this argument -- you never know where the bottom is. "Nobody rings a bell at the top or the bottom of a market" goes the old Wall Street proverb, and it's very true.

All investors can really do is to look at individual valuations, decide whether there's real value there, and act accordingly. If there are further falls, or a sudden generalised fall that presents another big opportunity, it's time to use the dry powder; the cash you've kept back for just such an eventuality. This is the reason you should keep some back.

Ready cash

If the market really goes against you again, then there's no easy answer. How many of us were scratching around for a little more dry powder here and there back in the spring? Fortunately, the Department for Work and Pensions rode to the rescue for some of us, allowing SIPPs to hold protected rights, but the fall was a valuable reminder to keep some powder dry.

Personally, I like to try and keep around 15% of my investing pot in cash, ready to take advantage of a severe ebb tide that drags all the boats down with it, gradually adding this in on weakness. In this way, you should, in theory, find yourself more or less fully invested reasonably close to the times of maximum pessimism -- rather than falling into the nervy investors' trap of doing exactly the opposite.

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rober00 20 Nov 2009 , 4:59pm

Nice thoughtDavid!!

However once invested "dry powder" must be replemished and presumably means that you have at some point to sell something to increase the pot. This of course leads you to the next can of worms. when and what to sell.

lotontech 21 Nov 2009 , 9:36am

Here's an interesting way to "increase the pot" without having to sell something. Use Stop Orders.

Think not of how much money you have to invest, but how much you are willing to put on the line (i.e. risk) at any one time.

Suppose you are willing to risk £1000 on ABC plc at a price of 100p. If the price rises to 150p and you apply a break-even stop at 100p (which would require a massive 33% drop in order to trigger) then you have effectively neutralized your £1000 risk... which means that you can make an additional £1000 investment in something else for no more than your original risk.

Of course, you still have to find the additional £1000 from somewhere, because your original £1000 is still tied up although no longer at risk. Maybe you kept some funds in reserve, or maybe someone will lend it to you if you explain that their £1000 loan is secured against the £1000 that you cannot possibly lose*. Which leads me on to...

Some trading accounts -- such as Spread Betting Accounts -- can help you here because as you reduce your risk by applying and ratcheting up your Stop Orders, the spread betting firm will automatically make more funds available for trading. I've been quite successful in freeing up risk capital by applying Stop Orders to in-profit positions, so as to use the free-up capital for establishing addition positions.

* Of course, this is really only true if you use a "guaranteed" stop order.

Well, it's an idea that has worked for me.

Tony Loton.

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