One of the nice things about our investment approach is that we always have cash available to take advantage of bargains – Seth Klarman
I’ve also been thinking that even if I was buying index funds based on Earnings Yield of 10 year AAA Bonds with Margin of Safety, the Margin of Safety wasn’t enough. The reasons are two-fold.
Firstly, if Earnings Yield of AAA Bonds were to drop, then theoretically speaking the price I’m willing to pay for stocks increases, but this doesn’t take into account that the drop in Earnings Yield of AAA Bonds AND the increase in stock prices could be irrational at the same time.
Secondly, Seth Klarman mentions that when stocks approach full value, the birds start chirping. Even if Earnings Yield of AAA Bonds AND increase in stock prices are rational, buying closer to full value means I’m buying with less margin of safety.
Therefore further margin of safety is required in the form of hedging with cash. Not only does it allow me to hedge against losses, it also allows me to take full advantage of ridiculously excellent investment opportunities. In the words of Benjamin Graham, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return.”
The reason why safety of principal is so important is because it is far harder to make money than lose money percentage wise. An example would be if a stock’s priced dropped 1/3 (33.33%) in price from $100 to $66.66, it would have to increase by 1/2 (50.00%) in order to recover back to $100. This conviction basically means I’ve completely invalidated my previous essay “When Does Investing with Debt Make Sense“, because the potential to lose all my principal makes investing with debt not make sense at all despite the potential for very attractive returns.
So in practice, not only does buying index funds have to compare to Earnings Yield of AAA Bonds with 2/3 margin of safety (max AAA Bond Yield), I will only allocate at most 2 times the % the index funds is undervalued compared to the max AAA Bond Yield to the index fund I’m investing.
So for example, as of Nov 16th 2014, the max AAA Bond Yield is 2.62% (10 year Bond of Microsoft expiring on 15 Dec 2023), which would mean with a margin of safety of 2/3, the maximum P/E * P/B multiple I’m willing to pay is 25.45. Since Vanguard Asia ex Japan High Div Index Fund (SEHK:3085)’s Graham Number is 18.77, thus 26% undervalued against the max AAA Bond Yield, I’m willing to invest 52% of my portfolio into Vanguard Asia ex Japan High Div Index Fund while hedging it with 48% cash.
If I have multiple index fund investments, then my portfolio will be equally split by the number of index funds I’m invested in, and the index fund to cash allocation will then be further split with the formula above.
Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)