Cash - Good for portfolio?

When in a bull market, the returns are coming in so fast that investors hate idle cash the most. They see cash as a loss of returns, an opportunity cost. So much for not wanting cash in portfolio, they even start leveraging! That is borrow and invest. The euphoria of a bull market usually means extreme and absurd valuations. These valuations are usually justified in the name of growth, PEG, economy boom, etc. There hardly is any scope left for long term investments! Even coal sells at the price of a diamond with the justification that it is a future diamond.

When in a bear market, it is dull, the investors have run away after the crash, every share is hammered and beaten down. Even the diamonds sell at the price of coal, without any justification. Investors are out of cash since the crash has evaporated their portfolio and leverage has made them pay out of their pockets!

So, is cash important?

Mr. Cool and Mr. Furious are 2 individuals who work in a private bank. Both started to invest in equities in 2003 with Rs. 2 Lakhs. By July, 2007 their portfolio had grown to Rs. 6 Lakhs, thanks to the bull run.

Mr. Cool and Mr. Furious catch up for coffee and reflect upon their portfolio. Both are happy!

Cool - It has been a great year buddy, the markets have soared to record highs.

Furious - I agree. But you know what, this is just the start! My broker says Nifty will double from here too!

Cool - Looks tough, it is already at a P/E of 25.. We must reduce our equity exposure and start parking funds in bonds.

Furious - Are you mad? What do bonds give? 6% p.a? I will get that every week. I am infact planning to borrow another Rs. 4 Lakhs and invest to double money fast.

Cool - Hey look, the bull markets are always followed by a crash and you can invest in good stocks when valuations fall. The valuations are not at all justified now.

But Mr. Furious has other plans. He borrows Rs. 4 Lakhs and thus now has an exposure of Rs. 10 Lakhs in equities. 3 months later, the markets have soared by 25%. The friends meet again.

Furious - Whats up brother! My portfolio has touched Rs. 15 Lakhs, I am loving this! How is your portfolio performing?

Cool - Well, I have just sold out my entire portfolio and have parked the funds in bonds. These valuations won't sustain.

6 months later, the markets have crashed by 50%. Mr Furious is upset as his over-leveraged portfolio has fared worse than the market. He has lost 80% of his money in stocks. His portfolio is worth Rs. 3 Lakhs now and he has to repay a loan of Rs. 4 Lakhs + Interest. The friends meet again.

Cool - Well, I didn't expect it to be so fast! Hows it gone for you?

Furious - My portfolio is worth Rs. 3 Lakhs and I have to repay a loan of Rs. 4 Lakhs plus interest of 15%, planning to sell off my holdings. I am done with the stock markets, it is purely insider news run with the operators. It's not for small investors like us.

Cool - Well, I don't think so. Infact I am planning to start shopping now. There are stocks like Page, Eicher, Mayur which seem good and are at cheap valuations.

Furious - Even if I want to invest now, I have no money. And they say that the markets will crash even more. Better stay away from stocks!

Cool - There might be blood on the street for now but these valuations will never come back again.

See the difference between the situations of both of them! At this point everyone wants to be "Cool" but noone would have the guts back then to take this decision. 10 years later, lets see what has happened.

Furious - Nice house friend, where did you get the funds from?

Cool - My stocks have become huge multibaggers! An investment of Rs. 6.5 Lakhs back then in 3-4 good stocks has given me Rs. 2 Crores now!

Furious - Wow. All I am now getting is 5% p.a. on my FD's. Wish I too had shifted to cash at that time.

This story, though imaginary reflects the truth about stock markets. At the peak of a bull market greed blinds all rationalism and the bottom of a bear market fear grips the minds. 1 secret to make a fortune out of investing is to be ready when opportunities strike. Having cash in hand at the right time is necessary for this. For example, Nifty is at a P/E of 21 now, how much cash should you be holding? The answer would differ from person to person.