Anytime the stock market goes down, people start talking about “dry powder.” Dry powder is a reference to a habit among frontiersmen, soldiers, and sailors to keep some of your gunpowder in a dry location, because wet gunpowder doesn't work. So dry powder is what you pull out when you're attacked right after a downpour.
When applied to financial markets, keeping dry powder is simply a market timing strategy, where the market timer feels the benefit of having cash to invest in a downturn outweighs the “cash drag” of keeping that powder dry the rest of the time. You'll also hear real estate investors talk about having cash available to invest in case a really good deal comes up and must be acted upon quickly. That's basically the same thing. Another common phrase heard in a downturn, “Cash is king” has a similar meaning.
To be fair, sometimes people use the phrase “dry powder” as a behavioral crutch, to help them to stick with their investing plan behaviorally. In that respect, it is no different from a buy and holder celebrating the opportunity to tax loss harvest, rebalance, or buy low with their next 401(k) contribution. If it helps you to stay the course, it's a good thing. Sometimes people simply use the phrase inappropriately, for example: “I just got paid so now I have some dry powder to put into the market.” That's not really dry powder that you kept in the event of misfortune. Kind of like the difference between dollar cost averaging and periodic investing. If there was never a lump sum you could have invested all at once, you can't actually dollar cost average, you're just periodically investing.
However, there are some people who seriously think that keeping dry powder is a good strategy — that you will actually come out ahead for doing so. Personally, I have always thought cash drag would outweigh the opportunity to buy low, especially when you take into consideration transaction costs, taxes, the value of your time, and the likely behavioral errors inherent in doing this sort of a thing willy-nilly, but I confess I have never run the numbers personally. Today, I would like to do that.
My “Dry Powder” Hypothesis
My hypothesis is that a dry powder strategy is a bad idea, that you'll be better off staying fully invested. In order to test this hypothesis, we'll have to take a look at some retrospective data. This comes with lots of limitations. Let's list them in advance so we are all aware:
- Past performance does not indicate future performance
- The performance of one asset class does not indicate the performance of every asset class
- A strategy may work in one time period but not another
- Just because one strategy didn't work doesn't mean no strategy could have worked
So what asset class and time period will we look at? Well, let's pick a convenience sample, since access to ideal data is often limited. Let's use the US stock market as tracked by the Vanguard ETF VTI, the Total Stock Market Index ETF. Our time period will be the longest time period that I can obtain quarterly returns for the fund. In this case, our period begins with the first quarter of 2010 and runs through the present, May 28, 2020, the day I did this analysis.
I have tried to pick a simple, straightforward strategy that could be followed robotically without having to watch the market every single day. Here is the strategy and assumptions I followed:
- In any quarter where there is a loss of 10%+ over the entire quarter, we will put “dry powder” into the market at the end of the quarter.
- We will leave the “powder” in the market until the end of the quarter in which the % gain is equal to the loss in the losing quarter.
- When the “powder” is not in the market, we will place it in the Vanguard Prime MMF.
- To keep things simple, we will not add any new money to the portfolio over the time period.
- We will assume this all takes place with zero transaction costs (no bid-ask spreads, no commissions) and in a tax-protected account, so there are no taxes on dividends or capital gains. Obviously, this skews the data a bit in favor of the dry powder strategy, but I want to give it every possible chance to succeed.
Before we run the analysis, let's take a look at three placebo arms in this “trial”:
Placebo # 1 Staying Fully Invested
If you take $100,000 and invest it into VTI on from January 2010 through May 28, 2020, you would end up with $331,206.
Placebo # 2 Leaving the Money in Cash
If you take $100,000 and invest it into the Vanguard Prime MMF from January 2010 through May 28, 2020, you would end up with $106,502.
Placebo # 3 Placing 75% of the Money into VTI, and 25% into Cash
If you take $100,000, and place $75,000 into VTI and $25,000 into Prime MMF, and leave it there from January 2010 through May 28, 2020, and rebalance it at the end of each calendar year, you would end up with $255,432.
If you take $100,000 and put $75,000 of it into VTI and $25,000 into Prime MMF (the dry powder) starting in January 2010, and then move the dry powder into VTI after every quarter with a 10%+ drop in the market, and leave it there until the % of market recovery in a quarter is at least as high as the loss (12% loss must be followed by a 12%+ gain), you will end up with $304,299.
You would have put the dry powder to work in four instances:
- 3rd Quarter of 2010
- 4th Quarter of 2011
- 1st and 2nd Quarter of 2019
- 2nd Quarter of 2020
Here's the data if you feel like spending a couple of hours crunching numbers to check my work.
The Bottom Line
- Fully Invested: $100K –> $331K
- Not Invested: $100K –> $107K
- 75% Invested: $100K –> $255K
- Dry Powder Strategy: $100K –> $304K
Obviously, this is only one strategy, one asset class, and one time period. If you change those three factors around enough, you will likely find a time when a dry powder strategy came out ahead. If you torture the data long enough, you can get it to confess to anything you want. But in a simple, reasonable look back at this strategy, it did not perform. Cash drag matters more than having dry powder to invest. Yes, it does a little better than keeping dry powder all the time, but not as well as just staying fully invested. This is not intuitive to many people. Check out this Twitter poll I did back in April:
A dry powder strategy is market timing. And market timing usually doesn't work. Even an unemotional, robotic strategy is unlikely to bring enough advantage to overcome the opportunity cost/cash drag, and that's without taking taxes and transaction costs into account. The typical, emotion-based strategy most of these folks use is almost certain not to work well. It's just an excuse to try to time the market.
Update after publication (10/20/20):
I received a bit of feedback on the study that it was not useful due to three issues with the “study”:
- There was no money added during the study period
- The dry powder was not left in the account
- The study period wasn't long enough or didn't include enough bear markets or in some way was cherry picked
To address issues 1 and 2, I did another study, using the same returns, but starting with $1M in the account and adding $100K a year. In the fully invested account, the $100K went into stocks. In the dry powder account, the $100K went $80K into stocks and $20K into the dry powder fund. The dry powder account started with $800K in stocks and $200K in cash. The entire cash account was dumped into stocks at the end of any quarter with a 10%+ drop and left there to the end of the study.
The results were the same as the study above. I also included data from Q2 and Q3 of 2020.
Fully Invested Strategy: $5,725,029
Dry Powder Strategy: $5,718,327
The benefits of dumping dry powder in at market lows did not overcome the downside of cash drag. I also ran it with the entire $100K added each year going into the dry powder (cash) fund. It performed even worse than the above. I suppose the only good news is that the dry powder strategy was not significantly worse, so if you want to try it in a tax protected account, it may not cost you much and maybe over some short time period, could even come out ahead.
What do you think? Do you use a dry powder strategy? Why or why not? Were you surprised by these results? Comment below!