The CNBC headline from February 29 said it all: 'S&P 500 Logs Best Start to year Since 1991.'
Investors have been waiting for good news for years. And it seems like they're finally getting it. The S&P is up about 8.5% year-to-date. By and large, investors are excited.
Maybe a little too excited. Whenever the stock market delivers big gains for investors, they start thinking they've 'missed their chance.' And then they start thinking they need to 'go where the action is.'
For example, investors start chasing stocks like Sears (NYSE: SHLD), a company whose net income has declined 91% from $1.5 billion in 2007 to $133 million in 2011. Sears is inexplicably the S&P's best-performing stock of 2012 -- up 136% since the beginning of the year.
I hate to mention this when the market is so optimistic, but when investors start chasing the 'next big thing,' it's usually a precursor to a larger market correction.
I'm convinced this is why most investors lose money in stocks.
The point I'm trying to make may be obvious, but I want to be clear: The stock market cannot and will not continue to go up by 4-5% every month. Sometime soon, likely by summer 2012, there will be a 'correction.'
I hate making forecasts, but I'm willing to put my neck out on this one because to me, this 2012 market feels eerily similar to the markets in 2010 and 2011:
Luckily, there's a perfect, risk-free place to park your savings before a correction arrives: cash.
I always try to keep about 12% of my portfolio in cash, which, by the way, is not advice I ever received from a broker or financial advisor.
Instead, I learned it from Warren Buffett.
Buffett tends to keep a lot of cash around. Part of the reason is because Berkshire Hathaway (NYSE: BRK-B) owns a number of insurance companies that need to be ready to pay out claims as they arise. But he also keeps a relatively large amount of cash around so that he can snap up bargains whenever they arise.
You see, Buffett has more patience than conventional investors. While most experts are frantically looking for companies to invest in right now, Buffett holds on to his cash until the company he wants goes on sale. He's used this strategy when he first started investing in American Express (NYSE: AXP) back in 1964. And it's been his modus operandi for decades. In 2008, he was famously one of the only buyers in a market filled with panicked sellers.
So how can we be like Buffett?
First, most of us need to raise some cash. And the best time to do that is well before a market correction hits.
Here are three strategies you can use to build up your cash stockpile before a pullback happens.
1. Build Up Cash Within Your Retirement Accounts: When you make your regularly scheduled contribution to your IRA and/or 401(k) plan, put a portion of the money in a money market fund rather than straight into a stock or mutual fund. The money market fund is used as a parking place for your cash until you're ready to buy stocks after a market pullback. (Remember, you can make 2011 contributions to your IRA until April 17, 2012.)
2. Set Up an Automatic Savings Plan: Every month, automatically transfer money from your checking account to a separate savings or money market account. Over time, you'll build up a nice cash reserve to use for investing if/when the market dips.
3. Rebalance Your Portfolio: Cash should be a part of every portfolio. If your entire portfolio is tied up in stocks or bonds, it's time to diversify into cash (I recommend at least 5% and up to 15%). If you can't build up your cash balance via #1 or #2 above, you can start selling off a small percentage of stocks or bonds until you have the balance you're looking for.
In my personal portfolio, I've been following strategies #1 and #3. All of my 2011 and 2012 IRA contributions have gone into a money market fund instead of stocks or funds. I've also sold just a small percentage of the emerging markets and international investments that did well for me last year. Over time, I've built up the cash portion of my portfolio to 12% of total assets -- right where I want it.
After you've established your cash stockpile, the next step is to make a 'wish list' of stocks that you'd love to own if they were cheaper.
Here are the top three companies I have on my wish list, along with my target price:
1. Mastercard (NYSE: MA)
Price Target: $380
Current Price: $424
2. Google (Nasdaq: GOOG)
Price Target: $545
Current Price: $643
3. Markel (NYSE: MKL)
Price Target: $350
Current Price: $420
The Investing Answer: When buying stocks for the long run, it's important to be diligent. You need to buy them at the right price, and to do so, you need to be patient. I'm going to continue building cash while I wait for a correction that could come as early as summer 2012.
I focus on finding 'forever' stocks. The companies on my wish list are some of the safest, most profitable stocks on the planet. I think of them as 'no brainer' investments because I'm convinced that if you buy them at the right price, they are virtually guaranteed to make you money in the long run.
