Warren Buffett is well known as being a very successful investor. He has built a portfolio that focuses on investing in undervalued companies in order to outperform the S&P 500 on a regular basis. In doing so, he has become one of the richest people on earth.
However, Buffett has a slightly unusual view on asset allocation. While the vast majority of his wealth is invested in companies that he feels can deliver high returns in the long run, he also has a sizeable amount of his wealth in cash at all times.
Although this may lower his overall returns versus the stock market in the short run, it provides him with the financial firepower required to invest in highly undervalued stocks during bear markets. As such, following the same strategy in your Stocks and Shares ISA could lead to higher returns in the long run.
Unexpected events
Of course, in a perfect world, an investor would be able to accurately and consistently identify when a financial crash will occur. That way, they could sell their shares just before a bear market and move into cash. This would enable them to continually ‘buy low’ and ‘sell high’.
However, the unpredictability of the stock market and the world economy means that this strategy is unlikely to be as effective in practice as it is in theory. Therefore, gradually building up a cash pile during a bull market could be a safer means of providing the capital required to take advantage of unexpected events, such as a financial crisis.
Return potential
The impact of this strategy on your returns could be exceptionally high. For example, in the financial crisis, the FTSE 100 halved in value. This meant that investors were able to purchase large-cap stocks while they traded on significant margins of safety. Although in some cases it took time for them to recover, the index itself proceeded to record a new all-time high in the years following the financial crisis.
As such, while building up your cash balance in the growth years prior to the credit crunch may have caused your returns to be reduced, the buying opportunity provided by the financial crisis is likely to have more than made up for it.
Uncertain future
With there being a number of potential risks facing investors at the present time, such as a global trade war and Brexit, building up your cash reserves could be a shrewd move. History shows that the stock market never rises in perpetuity, and that bear markets always follow bull markets.
Having cash in hand could allow you to boost your long-term returns through being capable of buying high-quality stocks while they are undervalued. The strategy of holding significant amounts of cash has worked favourably for Warren Buffett over a long period, and could do likewise for any investor.