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Be Cash Rich and Debt Poor During a Recession

Why Liquidity is Important in Times of Economic Stress

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In times of economic stress, liquidity is king. That's why during a recession, you want a lot of cash, cash equivalents, or access to money in some way at your disposal in the event that you lose your job, the stock market crashes and you don’t want to sell your shares at depressed prices, you suffer a pay cut of some sort, are disabled, or you own a business and sales start to drop.

Many of the best value investors in the world, including Tweedy Browne and Third Avenue, have routinely kept cash on their balance sheet to serve as “dry powder” for when markets fall. Although the greenbacks can serve as a drag on returns when the markets are exploding, they can offer very large benefits when stock prices begin to fall. In the meantime, you’re likely to collect at least a few percentage points of interest or money market dividends, possibly keeping pace with inflation.

Tax-free municipal bonds can be a good choice for the right type of investor. So can Treasury bill, bonds, notes, saving accounts, checking account, and money market funds. Professional investors and institutions might get into some of the more esoteric instruments such as commercial paper or repurchase agreements, but that’s not an area for the inexperienced to tread.

… and Debt Poor

An important part of reducing your risk during a recession is lowering your fixed payments. Debt can be a terrible thing if not handled properly because it introduces payments that include interest, which is really nothing more than the cost of “renting” money. Your goal is simple, and you should never forget it: You need to conduct your affairs so that if you were to lose your job or suffer a sudden, unexpected cash need, you would not be on the brink of disaster. If things get extraordinarily difficult yet you have a reasonable expectation for them to return to normal within a short time, you could even use your expanded borrowing capacity to help temporarily tide you over on items such as groceries.

Typically, low-cost, consolidated student loans and home mortgages are the least worrisome. There are always exceptions – you are probably in real trouble if you make $25,000 per year and have $90,000 in student loans (it’s still possible, so don’t despair!) but because of the tax advantages and relatively low interest rates, you are more likely to get in trouble by having high credit card or car loan balances. Not only are the interest costs potentially enormous depending upon your credit rating, but they aren’t tax deductible, making their true cost relative to other forms of debt substantially more expensive. The good news is that you can find tons of great resources out there to help you pay down your debt in order to strengthen your personal balance sheet.

Maintain Your Asset Balance

Investing is all about rationality. Many of the traditional portfolio models make very little sense for the experienced business leader with extensive accounting knowledge and financial experience. For the average person, who might not really understand what a stock is or why he or she owns shares of an S&P 500 index fund, lowering volatility (the rate and severity of price fluctuations) can be an important goal. That way, they are going to be less likely to dump equities when they are cheap out of fear.

This topic is known as asset allocation and was covered in the special article Introduction to Asset Allocation. In short, the practice is nothing more than moving an investor’s money into different asset classes such as stocks, bonds, mutual funds, real estate, gold, other commodities, international firms, fine art, etc. The theory is based on the idea that not all markets are correlated – that is, when one goes down, and other might remain untouched or even increase. Thus, the investor is less likely to panic, dividends can be reinvested, dollar cost averaging plans followed, and the wealth manager has protected the client from their psychological urge to “conquer” the market by trading trends.

A perfect example are members of my own extended family who, in the aftermath of the September 11th stock market crash, sold the stocks in their 401k plans at dirt cheap prices because they didn’t want to “lose more money.” While that may make sense for a day trader speculating on the short-term direction of lower quality stocks, it doesn’t hold water for long-term investors that are buying blue chip companies, reinvesting their dividends, and continuing to work. They moved into money market funds at a time when rates were lower than they had been in nearly half a century, only to earn anemic returns while Wall Street ultimately recovered and skyrocketed. For this type of investor, a balanced portfolio can reduce your fear because you aren’t going to see direct correlation with any of the major areas of the financial world.

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