Every investor eventually faces setbacks caused by disasters, natural or man-made, regardless of whether each disaster could or should have been foreseen.
We have compared disaster recovery plans to earthquake kits, but the metaphor only goes so far, because such a kit contains only items necessary for survival during the likely amount of time one might be isolated and without water or power following a temblor. A comprehensive disaster recovery strategy includes both the survival kit and the tools for rebuilding.
To limit damage and speed recovery from an investment disaster, pay attention to liquidity (both market and personal), cash reserves, and the timeliness of your market intelligence.
Liquidity
On December 10, 2008, the Wall Street Journal profiled Bill Miller, formerly “the era’s greatest mutual-fund manager.” As manager of Legg Mason’s Value Trust, Miller outperformed the market every year for fifteen years, only to lose 58% of the fund’s value in 2008. Like many value investors, Miller boldly bought distressed stocks he believed were undervalued. When financial industry stocks sank, Miller went on a buying spree. According to the Journal, “What he saw as an opportunity turned into the biggest market crash since the Great Depression.” Miller offered a frank assessment of his error: “The thing I didn’t do, from Day One, was properly assess the severity of this liquidity crisis.” According to the Journal, he failed to consider “that a whole group of once-stalwart companies would collapse.” For investors, liquidity refers to the ease with which you buy or sell assets. How fast can you get out of a stock or a real estate investment if you need to sell it? Usually, when heavy selling pressures an asset, eager buyers pick up the slack on the cheap and maintain market equilibrium. But liquidity is not guaranteed, and prices drop quickly when sellers cannot find buyers. When prices drop rapidly, buyers retreat to wait for the bottom, or become reluctant to buy something they may be unable to sell. When nobody is buying, liquidity disappears. This proves extra harmful to assets that were relatively illiquid in the first place. For most long-term investors, a temporary loss of liquidity isn’t too much of a problem. By temporary, we do not necessarily mean “short-term.” Even a long-term illiquid investment presents little trouble for someone with liquidity elsewhere. The market historically shows tremendous resilience and those who can ride out the storm for a few years need not turn temporary losses into permanent ones by selling during a liquidity panic. Wall Street panics affect individual investors differently depending on their goals and timeframes. Consider a sixty-year-old with a thirty-year-old 401(k) and a twenty-year-old with a brand new IRA. The elder may have lost 50% or more of his nest egg in 2008, whereas the new investor lost little and has been presented with rare bargains and an opportunity for significant future appreciation. Liquidity means little to the twenty-year-old, and can mean everything to the investor approaching retirement. For both individuals and managers, illiquidity reduces our agility when better opportunities arise. But illiquid investments are typically cheaper because they reflect a liquidity discount, and are often attractive to value investors as part of a broader portfolio. So liquidity can be a double-edged sword, but the financial meltdown of 2007-2008 reminds us to better respect both sides of the blade.
Cash
Whether we call it “saving for a rainy day” or “keeping your powder dry,” most people intuitively understand the importance of keeping reserves available for emergencies. Sometimes, people get a little carried away with the desire to be fully invested and view their good credit as a reasonable substitute for cash reserves, but the recent credit crunch should disabuse people of that notion. Your good credit may not always be available.
Asset allocation means more than finding the right level of portfolio diversification – it also requires that we understand how much we should NOT invest, because we appreciate the importance of liquidity, and there’s no asset more liquid than cash. Cash reserves not only ensure our “survival” after a financial disaster, but also provide the basis for recovery. Every market crisis creates opportunity, but investment opportunities only matter to those able to act on them.
Knowledge
The entrepreneurial investor prioritizes intimate knowledge of his or her investments, but one must stay current. Even a significant margin of safety can erode over time.
A concentrated portfolio of 10-20 stocks offers the advantage of concentrated vigilance. We recommend that investors sign up to receive automatic news alerts through Google or Yahoo whenever a company in their portfolio appears in the news. This helps investors make sure each asset continues to meet their criteria for ownership. At the same time, one should ask of every headline, no matter how unrelated it may seem, “How might this affect company XYZ? What new opportunities does this create?” Whether caused by a volcano eruption in Iceland or a debt crisis in Greece (which we’ll discuss in a future article), economic ripples spread far and wide, so consider the possibilities.
This three-part series is not about predicting disasters, but preparing for them. Your bank, your broker, and your investment manager have disaster recovery plans. Shouldn’t you?