There is a story of a policeman walking his beat and coming upon an inebriated gentleman searching for something under a street lamp. The cop stops and asks the man what he is looking for. He answers he has dropped his keys. The cop asks where he dropped them, the man points to the other side of the street away from the lamppost, saying “over there.” The cop asks why he is looking under the streetlight if he dropped his keys on the other side. “The light is better here,” is the reply.

As silly as this tale is, it may say something about finding alpha in the markets of 2008 and 2009. We’re still used to looking under the streetlight and finding our keys with ease, just as we easily found investment performance for much of the last three decades. There were a few pauses when the light flickered around the 1990–1991 recession and a momentary blackout in the 2000–2002 bear market. But now, when we need to look where it is pitch dark, why do we insist on looking under the streetlight?

A recent piece in the Financial Times hints at the changed times. It commented that in 1932, GM managed to show a scant profit of $165,000 and paid out $63 million in dividends from its cash reserves even though sales were 78 percent below their peak level of a few years before. It wasn’t that GM had anticipated the Great Depression; far from it. Rather, Alfred Sloan, GM’s chairman, remembered that the recession of 1920–1921 ended the career of GM’s founder and almost bankrupted the company. In response, GM had been hoarding cash ever since. Moreover, in the four years prior to 1929, fixed assets doubled, two-thirds of earnings were paid out as dividends and the cash hoard still grew.

For many companies, times have changed. Not only isn’t cash hoarded, cash on the balance sheet is seen as a sign of unimaginative or even lazy management. Debt is embraced. Even as investment banks were converting to commercial banks, accepting more regulation and looking forward to getting deposits (more liabilities), a common refrain was that their leverage would be forced down, reducing their profits and lowering their stock prices—although those same stock prices had already collapsed. Cash hoards were old-fashioned, unnecessary and irrelevant; besides, they were inimical to profits. Think one more moment about the American automobile industry: Until recently, no one seemed to see why Ford started hoarding cash as best it could beginning in late 2006. Two years ago it seemed like a silly idea. Last summer’s credit crunch changed opinions.

Leverage may have its place, even in the pitch-dark investment world we find ourselves in now. But it is not a guaranteed route to higher profits. We need to remember that leverage means taking on real risks that include a real chance of failure. One thing to look for in the dark might be less leverage. While searching, consider the impact of cash on a portfolio. While pension funds are often modeled with allocations of 60 percent equities, 30 percent bonds and 10 percent cash, recently, not enough attention was paid to the impact of the cash portion. Raising the cash proportion can substantially lower the volatility of the overall portfolio: The annualized standard deviation of a portfolio that invested 100 percent in the S&P 500 on Nov. 30, 2007, and sold on Dec. 22, 2008, was 40 percent; had that same portfolio been 50 percent S&P 500 and 50 percent cash, the standard deviation would have been 16 percent.

Note that I am carefully not referring to the standard deviation as “risk.” Market volatility is certainly a form of risk, and one that, under the street lamp, we were confident we understood. But risk is far more than market volatility; just ask Bernie Madoff’s investors, who discovered that the $50 billion they invested with Madoff simply wasn’t there.

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