FP Article 32 (For a FREE eReport on Dollar-Cost Averaging and Value-Cost Averaging, click here.)

Dry Powder - Asset Allocation

by Rajen Devadason

The reason for maintaining a store of dry powder is easy to understand. Over the very, very long-term, say more than 30 years, equities tend to  outperform every other major asset class. Equities, which grant us access to partial ownership of businesses that potentially are able to re-price their goods and services to stay ahead of inflation, are usually, over multi-decade timeframes, able to grow more than fixed income instruments like bonds, cash instruments like money market funds and bank deposits, real estate and soft and hard commodities. Unfortunately, most of us have to deal with pragmatic investment time horizons that are much shorter than 35 or 40 years because of pressing economic needs like paying for today's expenses, yesterday's excesses and tomorrow's fast-approaching requirements such as a child's tertiary education or our own retirement.

That's why understanding and utilising the power of asset allocation to always guide us to retain some level of dry powder is wise. By the way, in case you aren't familiar with the nomenclature, dry powder is a common term used in investing for excess cash that always allows us to invest more when asset prices plummet, thus creating a potentially valuable opportunity to 'buy low' and one day, hopefully, 'sell high'. The term stems from the historic use of gunpowder on battlefronts. Although a potent tool in the hands of soldiers, gunpowder is only useful if it is kept dry. Should it get wet in the rain or because a barrel rolls into the river, it loses its explosive usefulness!

The Father of Security Analysis, Benjamin Graham, wrote two books that all serious investors should read, reread, study and memorise relevant portions of! They are Security Analysis and The Intelligent Investor.

Multiple editions of both have been published since their respective first releases in 1934 and 1949. In my opinion, the best version of Security Analysis is the first edition, which thankfully is available as it was re-released as an investment classic original. Any edition of The Intelligent Investor you can get your hands on makes great reading.

In his writings, Graham suggested that a smart or intelligent investor should consider maintaining a stock to bond ratio in his portfolio of between 75:25 and 25:75, depending on market conditions. (In today's environment, he might well have included money market funds as another asset class that is even safer than bonds.)

Frankly, today other asset classes like real estate investment trusts (REITs) and precious metals also vie for our attention and our limited pool of investment dollars. But the possible addition of these asset classes into any sound portfolio mix does not change the fundamental premise that we should invest wisely in a manner that will permit us to stay invested over the long haul.

Note: Even if, going forward, equities continue to outperform all other asset classes over the very long-term, which is likely but not a certainty because the future is inherently unknown to mere mortals like us, each of us needs to take into consideration his or her personal appetite for risk.

A long time ago, I structured, coined and then extensively wrote about a four-dimensional risk profile model called the 'Devadason W-A-N-T Model'. It is a simple mental construct that allows financial planners and other financial professionals to sit down with clients and gain insight into their unique capacity to stomach investment risk.

The 4 components of the Devadason W-A-N-T Model are:

1. Willingness to take risk - a psychological quantity usually gauged by a risk profile test

2. Ability to take risk - a financial capacity that is tied directly to the health and strength of a person's cash flow statement

3. Need to take risk - an emotionless assessment based on a person's financial robustness as measured by his net worth statement

4. Time - the time available to achieve key financial goals.

There is a lot more to say about investment risk, but I don't want to digress from the key issue of this article, which is the importance of retaining dry powder. So, let me leave you with these 3 pertinent considerations:

1. People feel calmer when they have cash in hand.

2. The emotional balance that is gained from having that cash often results in a higher inner capacity to deal with potentially scary downward shifts in asset prices that occur from time to time.

3. This enhanced level of emotional balance during times of economic turbulence and having available cash in hand, the dry powder, mean that instead of unwisely bailing out of the market AFTER a precipitous drop, there is the added capacity to make additional purchases of assets at depressed prices.

If some reasonable, percentage-based asset allocation model is selected, perhaps through deep personal study and thought or, more likely, in concert with an appropriately licensed financial planner, then after that you should stay tuned to what's happening in the markets you are invested in.

The reason is obvious: You must eventually take profit as once low markets rise higher. The process of extracting cash in this manner increases your store of dry powder for future use. Incidentally, that use is long-term wealth creation.

Toward that end, I often urge my clients, readers and seminar attendees to revamp their thinking and consider themselves lifetime investors. Once a person is able to think in such liberating terms, the wisdom of always, always, always retaining a store of dry powder through the emotionless guidance of a sound asset allocation approach grows crystal clear!

Finally, just how much dry powder you should retain is up to you. Based on Graham's advice, updated for today so you consider using cash alternatives like money market instruments instead of just bonds, your dry powder portion should never be less than 25%. Personally, when I see enticing opportunities in historically very low price levels, I have been known to allow my dry powder ratio to drop even lower, say to 20%.

Just bear in mind that dry powder refers to your portfolio's cash component and NOT to your cash reserve or emergency buffer fund (EBF) for personal emergencies (as opposed to investment opportunities).

If you'd like to learn more about structuring an EBF, read my article here. And if you'd also like to download a FREE eReport I wrote on two valuable investing strategies, dollar-cost averaging (DCA) and value-cost averaging (VCA), you may do so here.

(If you live in Malaysia AND believe you might require my help in the realm of financial planning and retirement planning, you're welcome to learn more about me here.)

© Rajen Devadason