Don’t Keep Dry Powder

So we left off with our last post on why I don’t like the concept of dry powder.  What is dry powder? The concept of holding money to the side until stocks or other investments are on sale.

Tilting as a Response to Market Valuation Beliefs

So we established with my last post that I don’t believe someone can accurately price the stock market accurately.  I also noted that while this is true, there is still a point at which I believe the market is over-priced.    And sometimes, despite accuracy issues, I may have a reasonable amount of confidence that stocks are overpriced at any given time.  Tilting is a useful way to act on this belief when I have some indication that things might be a bit inflated.  So even though I can not be sure of my thoughts regarding market overpricing, I do tilt when my metrics indicate an overpriced stock market.

I do not believe Holding Money for Dry Powder is a Good Idea

If I noted that I believe an asset class can be overpriced and you can/should tilt your assets towards or away based on these beliefs, does that mean I believe in dry powder?  Well no.  Dry powder generally assumes you are holding money on the sidelines to take advantage of a dip in that assets price.

Cash is Not an Investment 

The problem with this assumption is, holding money on the sidelines is not an investment.  To understand what I’m on about here you really have to understand the function of money.  Money is simply a store of value, value as a result of production in the economy.    Cash, pure cash and not CDs, bonds, etc are not investments.  They are just a store of existing value.  The problem is that store does not gain in value over time.  In fact, it is constantly declining in value due to inflation.   In essence, you are losing money in any period where you leave your funds uninvested.   Again, uninvested means truly in cash here, not actual investment vehicles.

The True Cost of Dry Powder

What that equates to is if you truly are maintaining dry powder by keeping funds in cash, then you are just letting your money decline in value.  For what?    You can’t be 100% sure your target investment will decline in value from here based on our discussion the other day.  As such you are potentially losing twice, once from inflation and once from an investment that may not behave the way you expect.  There is a potentially large penalty for being wrong.   

Timing Dry Powder: Being Right Twice

Even worse than the cost of inflation is the reality of how difficult it truly is to time dry powder correctly.   You have to be right twice.  Once when you sell and once when you buy back in.  Sell too late and you lock in the bottom.  Sell too early and like 1996 you may never get another chance to buy in at that level.   

Buy in with dry powder too early and you haven’t avoided the decline in the asset.  Buy too late and you miss what is often the largest increase of a recovery, the initial part.    Statistics do not favor you being able to accurately time your exit or entry into an asset class.  In fact, even large active funds are statistically horrible at this.  So what makes you think you’ll be more successful.  Would it be your research department of 1 person or the few hours a week you spend understanding the market versus their entire staff researching as a job? As a result of having to be right twice the probability of getting it wrong is high. 

Cash Dry Powder is an Unmitigated Risk

As I discussed in my analysis on risk mitigation, it’s generally considered a bad move to not mitigate a high likelihood high penalty event. Using dry powder to market time fits both criteria.  Ie. most well thought out risk mitigation plans would preclude dry powder. Statistics generally show that time in investments leads to superior results. 

Dry Powder with Other Investment Classes: Tilt

But time in what investment?  There is a glimmer of possibility here if you define dry powder differently.  What if you define your “Dry Powder” as bonds, real estate, or perhaps even higher yielding CDs?     Well, honestly then I don’t have the concerns I listed above.  Why?  Because in reality, you don’t have dry powder.  You have a tilt towards another investment class based on your expectations for it to long-term outperform another class.  By definition, if not done wholesale or rapid fire, that is a tilt.    

Tilt Can Include Near Cash or Risky Assets

It does not matter if that investment is near cash like a CD, or completely unrelated like crowd-funded real estate.    You are still essentially choosing one investment class over another.    Of course, I believe tilting should be based on your risk tolerance and your expectation of long-term investment performance.     I would also never abandon a class entirely simply based on valuation expectations.  But otherwise, I see no concerns with tilting towards your pricing expectations.

Waking the Line Between Tilt and Market Timing

Now as I noted in my post about tilt.  Tilting is a hop skip and a jump from Market Timing.  If you change your belief about the pricing of an asset class once a week or even once a quarter then, to be honest, you are probably not tilting.  Tilts should be written into your Investment Policy Statement, including the points at which you might implement them.  They should be implemented as part of rebalancing and that rebalancing should be infrequent and scheduled.  But fundamentally I see no issue with implementing such investing techniques.

Do you believe in the concept of dry powder?  How do you define dry powder?  How do you define investment action points?

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