[Yesterday], I wrote a column arguing that investors should be rooting for a market sell-off rather than feeling anxious about the idea.

Down markets create bargains.

Most investors don’t think this way, however. They either hope (unrealistically) that stock prices will keep going up and up and up… or they fear even a temporary reduction in share prices.

This makes no sense.

[ad#Google Adsense 336×280-IA]As Warren Buffett once said, “When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household.

When hamburgers go up in price, we weep.

For most people, it’s the same with everything in life they will be buying – except stocks.

When stocks go down and you can get more for your money, people don’t like them anymore.”

I couldn’t agree more. However, one reader raised an important point:

“You say that you look forward to market pullbacks as opportunities to buy. It’s only a buying opportunity if you have cash or other liquid assets that you can use to make those purchases. So what percentage of your assets do you keep in cash so that you are ready in case of a correction? How do we balance our need to be in the market when it is rising with the need to hold dry powder in case of a buying opportunity?”

Excellent question. Fortunately, Aristotle gave us the answer 2,300 years ago when he counseled moderation in everything.

Only investors with tons of real-world experience, a cast-iron stomach and ice in their veins should be fully invested in stocks. This is doubly true for those who are not only fully invested but carrying a margin balance.

(Not recommended, especially now.)

A portfolio that is fully invested in stocks will get more banged up than a diversified one.

Moreover, if you have everything invested in stocks when it goes off the cliff – as it will eventually – you won’t, as the respondent noted, have the wherewithal to take advantage of the situation, assuming you have enough gumption to act.

Will you?

Here’s how to grade yourself on that score: In the recent financial crisis, I give a yellow ribbon to investors who held on but didn’t buy anything, a red ribbon to investors who held on and reinvested their dividends at sharply lower prices, and the blue ribbon to investors who bought with both hands or used margin if necessary.

(Those who sold in a panic get the booby prize. Indeed, most have felt like a boob for the last six years.)

Expect the unexpected. You will need cash in the next market break – or must be willing to sell bonds, collectibles, real estate or precious metals if a big enough opportunity arises.

How much cash? That’s really a personal decision based on your own risk tolerance and temperament. (If you sold in a rush last time, please don’t imagine that you’ll rejoice at the next market drop. My many years in the money management business taught me that folks who panic in one crisis will do it again in the next one. And the one after that. And the one after that, too.)

After the stock market crash in 1987, a buddy told me his grandmother phoned him and told him to invest every spare penny of cash he had in Coca-Cola.

He told her he didn’t have any cash. “Then go to the bank and get a second mortgage on your house,” she insisted.

He did. And later celebrated her memory for passing along the best investment advice he ever received.

I don’t necessarily endorse this approach, especially putting a large sum of borrowed money into a single stock. But at least he had the backbone to do something, even if he needed a push from Grandma.

If you don’t have much cash, it’s a good idea to go ahead and set up a line of credit against your house now to give yourself future purchasing power.

Because having a substantial percentage of your liquid net worth in a money market fund is like dragging an anchor at sea. It’s going to take you a lot longer to get where you’re going.

In short, embrace market sell-offs when they happen. History shows they are superb opportunities.

But only for those with a bit of nerve – and a bit of cash.

Good investing,

Alex

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Source: Investment U