A plunge protection fund is a strategic reserve – usually cash – that you set aside to deploy in periods of market panic.

This is not an official investing term. Indeed, Google tells me that across the entire Internet, only the iii blog uses the phrase like I do.

Presumably either one of us got it off the other, or else we both read the same messages in the same bottles!

Alternatively, we might both have been inspired by the so-called ‘plunge protection team’ that supposedly watches over the US market from Washington.

This team is said to have its roots in a group set up in the wake of the 1987 correction that wiped a fifth off US blue chips in less time than it takes to say “flash crash”. Some claim it’s at work whenever we have big falls today.

But despite the similar names, these two plunge protectors are quite different:

• The Plunge Protection Team (if it exists) buys distressed shares to shore up confidence, by putting a floor under prices.

• Your Plunge Protection Fund first dampens the impact of falls, and then buys distressed shares to hopefully make you a profit from other people’s panic!

A plunge protection fund in practice

The term ‘plunge protection fund’ might be a rarity, but the advice is common.

For example, many pundits said you should be buying cheap shares in the wobble of summer 2011, from The Motley Fool to The Telegraph to, well, me.

And indeed, buying when others are selling is generally great advice. But it does necessitate you having the cash to do so.

Hence a plunge protection fund – a reserve of cash that you can invest at just those times when seemingly cheap shares litter the ground like £50 pound notes.

For example, a week prior to writing this piece, I suggested several shares were trading at grab-’em-while-they’re-cold prices due to a big sell-off.

Here’s how they have risen in the six trading days since1:

• Weir: Up 21%
• Medusa Mining: Up 16%
• City Natural Resources: Up 15%
• Tullow Oil: Up 13%
• Xstrata: Up 11%
• RIT Capital Partners: Up 8%
• Tesco: Up 6%

• FTSE 100: Up 6%

My point isn’t to show I’m a market-beating share tipper.

For a start, one or two haven’t done so well yet (though none are down)2, and six days is no time to measure a return over – it’s a crapshoot.

Besides, the strategy needn’t only apply to share picks. Index investors could use a plunge protection fund. I think there’s more chance to profit from individual companies in a panic, but if the market is essentially being sold off irrationally, then you can still benefit by investing when it’s cheap.

Most index players should aim to be passive investors, of course, where any rebalancing is done mechanically, to take emotion of the decisions.

But I included Ben Graham’s shifting bond/equity allocation strategy in our first roundup of lazy ETF portfolios for index investors who couldn’t sit in their hands.

The Wall Street legend specifically suggested moving in and out of equities depending on your reading of the market.

The problem with plunge protection

A plunge protection fund sounds a no-brainer, right? Who wouldn’t want to be protected from a plunge? Who wouldn’t want to buy cheap shares?

Unfortunately, there’s a big, big flaw to the strategy.

You see, rather like the similarly acronym-ed PPE degree that bright young things do at Oxford before joining the Foreign Office, your plunge protection fund will make you sound clever at parties, but it probably won’t make you richer.

The big reason is opportunity cost.

When it’s not invested in the stock market, your plunge protection fund is sitting around in cash. These days, that means it’s earning a barely-there interest rate. You can’t lock it away to earn more – it’s meant to be deployed in a hurry.

Even if you don’t have to wait too long for a crash to make it worthwhile, there’s still the issue of when you’ll invest it.

The trouble is, nobody knows whether stock markets are going to rise or fall over the short to medium term. Over the long-term equity markets tend to trend higher, but as I’ve already mentioned, that’s a problem for the plunge protection strategy, not a positive, since this chunk of your funds won’t be benefitting.

Just like other active investing strategies, then, the plunge protection fund is skewered by our fallibility. We might feel like we’ve got balls of steel when we invest while others are running in the other direction, but our lack of crystal balls means our move may well be unprofitable compared to if we’d just invested earlier and enjoyed some upside on our money.

Consider that the stock market rose 70% from the depths of March 2009 to the recent peak in February. That’s an awful lot of gain to forgo while your reserve is sitting around in cash, waiting for an opportunity to make it back.

Even during the sharp correction in August 2011, shares only got back to the lows of around a year earlier. And in reality, very few investors would have put their spare cash to work in the few hours that comprised the latest market bottom.

Great equity investors like Warren Buffett, Peter Lynch, and Anthony Bolton have tended to be near fully invested in shares all the time for this very reason. They concentrated on relative value – finding bargains – rather than worrying about the overall market situation.

There are a few talented fund managers like the chaps who run the Personal Assets Investment Trust or the odd hedge fund that is happy to sit in cash for as long as it takes. But over greater timeframes, what such funds achieve in lower volatility they are likely to forego in total return.

Variations on the theme

A plunge protection fund then is a glorified trading strategy. Most investors would be better off concentrating on getting their overall asset allocation right.

Still, a case can be made for a plunge protection fund – or a variant of it – for those of us who insist on being more active with a portion of our portfolios.

• Don’t underestimate the emotional benefit. Picking up bargains in a bear market helps you psychologically when your portfolio turns red. I think this alone is a good reason for more active investors to keep perhaps a 5% cash reserve to invest after a sell-off.

• You could keep your strategic reserve in bonds, or lower volatility equities – defensives shares such as utilities or consumer giants like Diageo. When the market falls you recycle your defensive holdings more aggressively. This is closest to my own strategy. Obviously it’s not going to deliver the pure results of a cash reserve – the defensive shares will still be volatile, and there’ll be the costs of churning your holdings, too.

• At times of higher interest rates, the opportunity cost of holding cash is much reduced (ignoring tax), which makes a plunge protection fund less of a luxury.

Cashing up

None of this is to say that keeping a chunk of your net worth in cash is a bad idea.

On the contrary, I think cash is an underrated asset class for private investors.

But that’s as part of your asset allocation strategy, not on a tactical level. Within your equity portfolio, it probably won’t pay to be too clever.

Get your asset allocation right for you and your risk tolerance, and consider keeping a modest extra bit in cash to act as the equivalent of a hill walker’s bar of Kendal mint cake – to keep your spirits up and give you a bit more energy in tough climates, but not to keep you fed.

Leave wholesale plunge protection to the political pros and the central banks. They have unlimited ammunition, and they need to be seen shooting! We don’t.

1. Prices from close of 8^th August to close of 16^th August and gains rounded [↩]
2. Halma specifically as well as the subscription shares that are bound to take a while to kick in due to their unique properties. [↩]

The Accumulator, my co-blogger here at Monevator, is taking a well-earned break for a few weeks.

But his quest to throw light onto the murky world of UK passive investing has not gone to the sunbed with him.

On the contrary, I have added a ‘Passive Investing’ drop-down option to the ‘Investing’ tab above (just beneath the Monevator logo).

Clicking ‘Passive Investing’ takes you to our new passive investing headquarters.

At the moment it consists of just a quick introduction to the indexing lifestyle and highlights some key articles to get newcomers started. But I hope we can eventually grow it into a fully-fledged passive investing bastion for UK savers.

I’d like to create the definitive one-stop guide that you’d feel comfortable sending any member of your family to, in order to get them started with passive investing.

I know we have a long way to go yet – in fact, that goal may be impossible – but if we end up with a modest champion of index investing to stand up against the might of the managed fund machine, then that’d be quite an achievement.

Please do check the page out, and if you’ve got any thoughts or tips on what we should incorporate (remembering the tricky balance between simplicity and detail) then please do let me know in the comments below.

Who knows, perhaps you’ll find an article you missed first time around! 🙂

Good reading from around the Web.

I suspect that if everyone writing articles about the correction in the stock market this week actually went out and bought some stocks, the crash would have been severely dampened.

In fact, one of the only things that makes me nervous about buying in these markets is that so many people are saying you should do so. Normally you get a fair few johnny-come-lately pundits arguing we should run to the hills, but they’ve been very thin on the ground.

According to the FT, even private investors in the UK have been buying quite aggressively. Hurrah, I say, and it mirrors the actions of the Monevator readers who’ve left comments on my articles. But it’s a bit of a negative indicator, unfortunately.

Perhaps the short duration of the bull market since 2009 means we haven’t sucked in enough fair weather investors yet – maybe only the battle-hardened are still standing?

Anyway, of the many pieces I read, my favourite was a fairly dry summary of the current situation from the blog macrofugue, entitled The Fat Pitch.

After pointing out how (US) cheap stocks look relative to bonds, the author also makes an economic case for looking through the panic:

So far in this earnings season, the S&P 500 has a 91% beat rate, and has smashed top-line, bottom-line & operating margin estimates.

There are more than 1.2 million jobs from 12 months ago, 40,000 less per month applying for initial unemployment insurance, and consumer credit rose a mammoth 15.5% (annualised) last month.  The big knock since November on consumer credit was the lack of participation in non-government, revolving credit — we’ve now posted two straight monthly gains in those categories.

The pace of Commercial & Industrial loans is up $55B in 9 months.  The financial stress indices from three Federal Reserve branches, which indicated in the past with months of notice on lending contraction, have been in solidly negative (improving) territory for months.

The end of the dreaded de-leveraging seems in sight.

Saying the economic situation is improving is genuinely contrarian, and it follows my own hunch.

I don’t deny some other indicators look a bit ropey (for example, GDP has been wobbly in the US, France, and the UK, and the latest inventory purchasing data was a bit iffy). But there is good data around if you care to look for it.

Moreover, I’ve been saying all week that if companies can do so well when the US economy is still in the dumpster (particularly unemployment and housing) then there’s plenty more fuel in the tank.

There will come a time when this blog argues that the stock market is expensive and it’s time to be more aggressively overweight in bonds and cash. But I don’t think it will be when the FTSE 100 is on a P/E of around 10 and interest rates are near-zero (cash is king!) and unemployment still high in much of Europe and the US, and investors have rarely had it so rough for a decade.

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