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Why it makes sense for traders to hold some cash

One concept many people struggle with is holding cash in their investment accounts. They feel that their ENTIRE account has to be 100% invested ALL the time. During market corrections, you should have at least some of your money in cash in order to protect your capital, to protect your confidence, and to have some money available in case the market continues lower.

One of the main reasons I keep a larger than normal cash position during corrective markets is that 4 out of 5 stocks move with the general direction of the market. For example, during the financial crisis of 2008, Apple (AAPL) dropped from $200 down to $80, and that was right as they were releasing two of the most revolutionary products of our lifetime (the iPhone and iPad). The main point here is no matter how great the company is doing, nothing is safe when the big institutions are dumping stock and the market is under heavy selling pressure.

I have studied some of the best traders who ever lived, such as Jesse Livermore and Gerald Loeb. They believe that you should only be in the market when probabilities are in your favor, and that the LESS you are in the market, the better. According to Harvard Business Review, since 1886, the US economy has been in a recession or depression 61% of the time. I realize that the stock market does not equal the economy, but they are somewhat related and the markets tend to correct when they foresee an economic slowdown on the horizon.

I’m sure many questions are going through your mind such as: How do we know when we’re in a correction? How do we know when to get back in? What about short selling? What about long-term investing?

This strategy isn’t for everyone

A common indicator that we are in a correction is when the general market (S&P 500) closes below its 10-week moving average because this is traditionally an area of institutional support. I personally moved my clients to a larger than normal cash position in early October 2018 when this occurred. Some longer-term trend followers use the 40-week moving average. Either way, please keep in mind that the concept of raising cash isn’t for everyone. It is more for traders and active managers than long-term investors.

Most people prefer not to raise cash because they’re worried they will never get back in. Again, please remember that being proactive involves making decisions. Too many people are incapable of doing this because they don’t want to put in the time or effort. In addition, they don’t have enough confidence in what they are doing, they don’t have the patience to STAY in cash, and they don’t want to make decisions out of fear. I’m a firm believer in one of Stanley Druckenmiller’s quotes “Probably one of my greatest assets is that I can change my mind very quickly.” In other words, when conditions improve and the market gets back above those key averages, I have no problem making decisions and getting back in.

Short selling is difficult because by the time we realize we’re in a correction, many stocks are already down -20% or more off their highs. What adds to the challenge is that some of the market’s biggest up days occur during market corrections. I always say “Do what works for you,” and I personally find it too frustrating and prefer a mental break from the market. In William O’Neil’s interview in the book “Market Wizards,” he says, “I don’t normally advise people to sell short unless they are professional traders. Selling short is quite tricky. I myself have only made significant profits on the short side of two of the last nine bear markets.” In other words, this is one of the top 10 traders who ever lived affirming the challenges of short selling.

I would like to emphasize that the strategy of using cash as a position isn’t for everyone. If you are an investor or someone with a longer-term time horizon, then I recommend staying invested for the long-term. Keep contributing to your retirement funds, 401k, etc. and do not move them to cash. The concept of cash is more for traders and active money managers. For me personally, my goal is to protect client assets and to protect my confidence during market corrections. Of course no one knows how long this correction will last, but one thing I will guarantee is that when it’s over, the market will have an amazing new uptrend and there will be incredible opportunities. The key is to have patience and discipline until market conditions improve, and hopefully have some cash available to put to work.

I can be reached at: jfahmy@zorcapital.com.

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