Set Your Investment Standards Higher

 | Aug 12, 2013 | 4:30 PM EDT  | Comments
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The basic premise of investing relies on the basic economic law of supply and demand. Shares of a company's stock will move higher if the demand for shares is greater than the supply of shares for sale. The reasons for increased demand vary, as it relates to the short term or long term. In the short term, stock prices can climb higher for many reasons, the least of which could have anything to do with growth in earnings and cash flow. In the long run, demand for shares is borne from the quality of the business operation. The same goes for the conditions that set supply.

When it comes to the treatment of your investment portfolio, I would apply the same basic economic principle in the following manner: the less cash you have on hand in your portfolio, the greater the demand for upside potential. Allow me to elaborate. When you begin with a portfolio that consists of 100% cash, your opportunity cost of not investing is at its absolute lowest. Also, in most market environments, the availability of investment candidates that can offer 25% to 50% upside is often there.

So you have invested 50% of your portfolio and are now left with 50% in cash. Your opportunity cost is now a bit higher and you should be demanding much higher returns from the cash you deploy. Why? It's all about a margin of safety. An investment that you deem to be worth twice the current market value has a greater margin of error and, therefore, offers more protection to your cash outlay.

Now, let's fast forward to real time and today. With the market at all-time highs and stocks going and higher and higher, odds are that most investment funds are probably sitting on 5% to 15% in cash in their portfolios. At this level of cash-to-stock ratio, I wouldn't make any investments unless you find an opportunity that offers you the chance to make at least three times your initial investment, or 200%. That's right, at least 200%. If this sounds irrational -- you may argue that a 200% return seems unrealistic or ask, "Why forgo a 100% return?" -- just hear me out.

When forecasting a company's future value, most investors tend to err on the side of optimism. By looking at opportunities that offer this excessive rate of return, you are doing one very important thing: giving your last batch of cash the ultimate degree of a margin of safety. And that is the most important thing. Why? Consider what happens when, not if, the market starts declining. The stocks with the biggest margin of safety tend to decline the least and when it's time to raise cash in your portfolio, you can do so with very little pain.

I'm sure you all are wondering: "Where are the 200% opportunities now?" The reality is that very few exist. As a result, you are left with some cash in your portfolio that will be available when the buying gets good again. If I must give you a name, it's one I've pounded the pavement on a few times: Chesapeake Energy (CHK). The funny thing is that in the past month, the shares are up 18%. There are good arguments that CHK could be worth $60 or more a share in due time. So buying it at $20 -- even in this market -- makes sense with your last bucket of cash. It may never reach $60, but it may move quietly from $17 to $20 to $25.

Set your investment standards very high when it comes to investing your final 15% of your portfolios cash. Demand the most and you will lose the least.

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