Monday, October 18, 2010

Finding a cash position for my portfolio

How many of you have a budget?

When I moved out on my own, I lived check to check and most assets were donations from family.  Every check was earmarked for the long list of items needed to live independently.  I shopped for furniture
by asking friends and family: the parent's old couch; a table from one  friend and a chair from another.  None of it matched, but the price was right - free.  Slowly over time, I built up savings and assets.
Now, when I shop for furniture, I start at a store.  Now, I save money from each check.

This growth and maturity and planning is the same for a portfolio.

I started investing in stocks about 12 years ago.  My first purchase, after careful research, was Adobe (ADBE).  I used a free trade at a discount broker and spent $100.00 to buy two shares.  Those two shares cost $95.00.

I used the four guiding principles (as I understood them) of BetterInvesting:
1.      Invest a set amount regularly
2.      Reinvest earnings dividends and profits - be fully invested.
3.      Invest in quality growth stocks and equity mutual funds
4.      Diversify your investments

Cash is not mentioned.  My understanding was I needed to be fully invested at all times.  As I ran the numbers, investing $100 a month into the market would result in lots of transaction fees which would
eat into my returns.  I decided to set a threshold of $500 to keep the  fees lower.  Waiting five months to make a purchase seemed really hard.  Stocks were going up and I was not fully invested in the
market.  I was in a hurry to build a portfolio.  I thought cash on the sidelines was a wasted opportunity.  I thought cash on the sidelines meant not being fully invested.

Running a home takes financial planning and a budget.  Everyone get this concept.  Using a budget allows you to take advantage of sales on the things you need and want.  Using a budget allows you to plan for future spending.  The same holds true for a portfolio.

There was a great series of articles on (subscription required, free 30 day trial).  An article from June 2010 mentioned the amount of cash being a floating function of the expected returns of the portfolio.  Whenthe expected returns are high (stocks are on sale), cash should be low; when expected returns are low (stocks are high in value), cash should be high.

It was an a-ha moment.  Of course!  It only makes sense that the  amount of cash varies with expectations of the portfolio.  And a formula makes it even better.  The amount of cash ranges from 0%
(everything is on sale) to 25% (nothing is on sale).

As of 10/17, the median projected annual return (PAR) for all stocks followed by MANIFEST is 8.5%.  This results in an ideal cash position of 0.25 (1.25 X 0.085) = 0.14375 or 14.375%.  My current cash position is 10%.  This does not mean I need to sell stock to bring cash up to 14%  - but it does mean I am keeping my monthly deposits in cash.

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