The typical equities investment mandate and most mutual funds are required to be fully invested in stocks. The mindset being that the asset allocation decision is a separate function from stock selection. So for instance in the case of a balanced fund, the asset allocator determines the percentage of total assets allocated to each asset class - cash, fixed income, bonds, alternatives etc. The equity manager gets the equities allocation and must remain fully invested in equities regardless of whether or not he or she can find quality assets at attractive prices.
In such an approach, the individual tasked with the stock picking is prohibited from holding cash even at times when they perceive valuations as unattractive or macro risks as elevated. It's not whether an investment makes or loses money that is important (ie absolute returns), their concern is the investment's performance relative to the stock market.
Many prominent top-down asset allocation models predominantly emphasize an investor's risk profile as the primary factor in establishing suitable asset exposures. Typically, this assessment is based on age, where a younger age corresponds to higher risk tolerance and, consequently, a higher allocation to equities and a lower allocation to bonds. However, these models often overlook the consideration of the relative attractiveness of each asset class at the time of allocation. This oversight was starkly evident during the global financial crisis.
In practice, adhering strictly to age-based allocation without weighing the current market conditions can lead to significant drawbacks. The flaw becomes apparent, particularly during broad market sell-offs, making it challenging for equity managers to generate attractive returns when compelled to remain fully invested.
“For most people, the most dangerous self-delusion is that even a falling market will not affect their stocks, which they bought out of a canny understanding of value.” Leon Levy
“Unfortunately, an emotionally inspired selling wave snowballs and carries with it the prices of all issues, even those that should be going up rather than down.” J Paul Getty
“I used to hold Berkshire stock as a proxy for cash and that was a mistake. During times of distress, everything will go down, including Berkshire.” Mohnish Pabrai
“When the market falls sharply, it doesn’t distinguish between the good girls and the bad girls.” Peter Cundill
“You're deluding yourself if you believe your stocks, however cheap they are, won't temporarily go down when Mr Market decides to correct." Charles de Vaulx
The person responsible for selecting stocks lacks the authority to determine their attractiveness. Moreover, accountability for suboptimal outcomes seldom falls on the asset allocator, who often shelters behind historical asset class returns. When a balanced fund experiences losses in equities, the equity manager deflects blame, asserting, "I had to remain fully invested." Simultaneously, the asset allocator points to age-based guidelines, stating, "The ultimate fund investor is 20 years old, justifying the prescribed percentage in equities." It becomes a game of passing the buck.
In contrast, the Investment Masters acknowledge that the ideal allocation to equities at any given moment hinges on the relative price levels prevailing then, recognizing that these relative prices are in a perpetual state of flux.
In contrast to the aforementioned strategy, the Investment Masters adopt a flexible approach to investing. They are willing to retain cash if appealing opportunities are scarce, steadfastly refusing to compromise on their pricing criteria. Operating with flexible mandates that don't necessitate full investment, they acknowledge the advantages of maintaining financial firepower. This reserve allows them to seize opportunities and acquire assets when the right moments present themselves.
Despite Warren Buffett advocating index funds to Joe Public his largest current holding is cash. In a recent CNBC interview Buffett stated ..
"Now unfortunately right now the largest 'business' we own-- we've got about $95 billion in and it's selling at a 100 times earnings. And the earnings can't go up, which sounds like a pretty dumb investment and it is. But that's what we get on treasury bills basically and-- we literally have-- it's not all in bills. But we have $95b in cash including mostly bills and we are paying a 100 times earnings for something like I say whose earnings can't go up. You get 1% and that does not make me happy. And I like to buy businesses. We will buy businesses. But it makes it much tougher-- when there's 1% money around and the people who-- many of the people who buy businesses use as much borrowed money as they can. And when they get that-- at rates that are based off that very low rate of 1%-- they can pay a lot more money than we can - using what-- pretty much all equity money 'cause that's the way we look at money. So-- we have not—made significant acquisition now for 15 months or thereabouts"
Although Buffett asserts that he doesn't base his investment decisions on the macro environment or the specific level of the stock market, he emphasizes the importance of only investing when he can discern attractively priced opportunities. It makes sense that there are less attractively priced opportunities when markets are elevated rather than weak.
“It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.” Charlie Munger
The lesson from the Investment Masters is not to be afraid of holding cash. Cash is an asset which allows you to take advantage of opportunities when asset prices are subdued.
“Cash combined with courage in a time of crisis is priceless.” Warren Buffett
"In many different ways, cash gives you options. It offers wonderful downside protection and upside optionality" Mohnish Pabrai
"Because we are focussed on absolute returns, we will hold cash in the absence of values and a margin of safety. We view cash as an opportunity fund" Arnold Van Den Berg
The ability to hold cash provides investors with the flexibility to avoid buying unattractive assets. It is better to receive little or no returns from cash than exposing the fund to the risk of permanent loss of capital.
“Holding cash is uncomfortable, but not as uncomfortable as doing something stupid” Warren Buffett
"Thinking outside the box about the optionality of cash gives quiet but resolute credence to the contention that this seemingly benign asset is in reality a double edged sword, defending against loss on one hand and arming for gain on the other." Frank Martin
Further Reading: Tutorial - Investment Masters 'The Value of Cash'
Frank Martin: 'An Enterprising Thought - Cash as an Option'
John Neff [Akre]: ‘How We Think About Cash - by John Neff’