Holding cash is like holding an option--the option to take advantage of volatility in the market. The value of this option rises when market volatility rises. Thus, when the volatile stock market provides you an opportunity to buy wide-moat companies at bargain prices, you'll be ready with cash in hand to take advantage of the irrationality.
Many market participants often neglect this important aspect of investing and stay fully invested at all times. For instance, many professionals getting paid to invest other people's money feel they are actually required to stay fully invested even if there's a lack of fat-pitch opportunities. Thus, when the market drops, they often can't do anything but watch (or worse, sell out near the bottom).
Being fully invested at all times goes hand-in-hand with the professional's focus on relative returns--beating an index. For example, if the market drops by 10% in a year, but the fictional Relative Return Fund dropped only by 8%, Relative Return's manager has provided value because the fund had a better return relative to the market. However, had you invested in this fund, you'd still be 8% poorer, not exactly anything to cheer about.
We argue that individual investors should care more about absolute returns (how much money did you make) and less about relative returns (did you beat a benchmark). So if the market isn't throwing you fat pitches, just hold on to your cash and wait until it does, because fat-pitch investments are much more likely to provide strong absolute returns over time.
Don't Be Afraid to Hold Relatively Few Stocks >>