In the financial realm, the term dry powder is a euphemism that primarily refers to the cash reserves an individual company proactively maintains so that it can meet its obligations during times of economic stress. A company may step up its campaign to build up its dry powder levels if it anticipates difficult conditions on the proverbial horizon.

Key Takeaways

  • The term dry powder refers to cash reserves that are maintained in the event of economic stress.
  • Dry powder may refer to the assets companies maintain so they may cover their financial obligations, or it may refer to individual investors, who are frequently encouraged to segregate significant portions of their portfolios away from the stock market.
  • Investors may also maintain dry assets so that they can take positions in stocks, after their share prices dip to low levels.
  • The phrase dry powder was co-opted from the 17th century, when wars were fought with guns, cannons, and other firing weapons that relied on loose gunpowder, which had to be stored dry to maintain its efficacy.

Dry powder may also apply to individual investors. In this context, the term similarly refers to cash reserves, but may also encompass other liquid assets, such as money market funds that an investor may set aside for investment purposes.

Financial advisors often discourage their clients from investing 100% of their assets in the stock market, stressing the importance of maintaining a healthy percentage of dry powder, as a preemptive measure against potential market corrections. Not only can dry powder reserves offer emergency funds during periods of steep market decline, but investors may also funnel these funds towards purchasing devalued stocks, capturing them at bargain-basement prices. This latter usage enables the strategy of dollar-cost averaging, an investment model where investors make fixed dollar amounts of periodic stock purchases--regardless of share price. When prices are low, more shares may be purchased. Which prices are higher, fewer shares may be purchased for the same dollar amount invested. This strategy eliminates the temptation to time the market, in an attempt to lock in the best prices of equities, which is viewed as a losing prospect. Dollar-cost averaging, which fundamentally reduces volatility, depends on liquid reserves of investible assets that dry powder provides.

Etymology of Dry Powder

The origins of the phrase “dry powder” hearken back to the 17th century, when military battles were fought with guns and cannons that utilized loose gunpowder in combat. In order for it to remain effective, the gunpowder had to be kept dry. Consequently, having stores of dry powder readily available was essential to keeping weapons functioning optimally. Hence, equating dry powder with reserves that can keep companies solvent, or position investors to stay financially sound in down markets, entered the financial lexicon.

Although company's of all types maintain dry powder, private equity investors and venture capitalists particularly favor this practice because the fledgling startups they invest in are more vulnerable than established companies.

To learn how to create your own emergency savings, see "Build Yourself an Emergency Fund" and "Are You Living Too Close to the Edge?"

(This question was answered by Tony D'Altorio.)