Sunday, December 19, 2010

Investing Part 3: Setting the volume

Lyrics to the song “Money” by the Kingsmen, the Beetles, and others

“Money, that’s what I want. That’s what I want,” but for heaven sakes let’s hope it isn’t all you want. That’s true of life, and it is equally true of investing. So, how much is enough? How much money to hold is quite different from how large a portfolio? We’re talking about liquidity. Cash is the usual portfolio term.

It’s that time of year again, so here’s a reference to that seasonal movie classic “It’s a Wonderful Life.” There’s a scene where shortly after getting married, George Bailey has to try to save the Bailey Building and Loan. The run is on. The first depositor wants to withdraw his entire balance. (We’ve seen that recently.) Then, however, things settle down. At this juncture, a subtle point surfaces. Subsequent depositors start making smaller withdraws. The amounts are quaint. But, the point that is easy to miss is that they, the classic “man on the street,” know how much money they need to live. You should too.

Further, you should keep in mind that money represented total cash flow requirements at the time the movie was made. In today’s terms, it represented total ATM withdrawals, automatic payments, checks written, cash, and debit or credit card purchases. In short, it was everything they would spend between banking cycles, probably paydays for most of them.

To hearken back to previous discussions, especially “Wall Street Doesn’t Run the World,” you have a big advantage if you know how much money you need. To illustrate, poor George Bailey doesn’t know how much money he’ll need to make it through that day. By contrast, his customers, who aren’t bankers, can put a dollar figure on what they need.

Indirectly, George avoids the clutches of the evil banker, Mr. Potter, due to the astute financial management of Miss Davis who only withdraws $17.50 rather than the $20 withdrawals of the customers before her. That she knew she could get by for $2.50 less than the previous customers. That she leaves that $2.50 in the Bailey Building and Loan is crucial. George squeaks by with $2 left at the end of the day.

Now $2.50 then isn’t $2.50 today, but could you make an estimate of your needs to within the current dollar equivalent of $2.50. If you can get close, you have a handle on your liquidity needs. If you can’t get close, work on it. It’s essential. If you can’t do better, take your after tax income from your w-2 last year and divide it by 12. Use that as monthly cash needs. Once you get a figure, all that remains to do is decide how long you would want to be able to leave everything else untouched.

You’re probably thinking: “That’s no help. I don’t know how long that should be. Are we talking until next payday?” Well, at this point things get personal. Personally, living payday to payday never appealed to me. Plus, I realize that next payday is only as reliable as my employer and my continued employment. I’ve experienced time when I skipped a payday and meeting payroll meant payroll for everyone except owners. (That, by the way, isn’t unusual. In small businesses it is usually the owner’s choice. In large businesses, dividends usually disappear before a payroll can’t be met).

The issue becomes: how long are you willing to go without a payday? For most people it means: how long will you allow yourself for a job search if you get canned, laid off, downsized, right-sized, etc.. I once heard a “rule” that went “Have one month of rainy day funds (i.e., cash) for each year you’ve worked. The logic is the longer you’ve worked the more specialized your skills and the higher the pay; thus the longer it will take to get a comparable job.

If you follow the practices in these and subsequent posting on investing, and follow a few simple rules like not borrowing to consume, you’ll find that employment becomes far less financially important than what you do with your investments. Then the “money” issue becomes a little more complicated. Yet, one principal remains the same. You still have to address the question: “How much money will you need to hold in order not to be forced to make decisions you wouldn’t make otherwise?” From this perspective the question becomes: “How long can you live comfortably without touching your portfolio?”

For investors, that means you need to know where a few years of cash flow will come from. If you doubt it, just talk to anyone forced to liquidate much of their portfolio during the recent crisis or the internet bubble’s aftermath. The complicating factor is cash flow generated by the portfolio. That can’t be taken at historical rates since the very nature of the risk you’re addressing will have an impact on the cash flow (dividends get cut, bonds default, etc.). Add to that the fact that earnings even continued employment can be called into question and you see what I mean by “complicating factor.”

Note that the basic logic of this approach puts rebalancing in overdrive. Instead of reducing cash to keep the portfolio balance, it forces actively reducing cash to pay living expenses or to avoid other portfolio adjustments. That tilts the portfolio toward the depressed, non-cash assets at the very time they are under stress. It also treats cash as what it is, a sterile non-productive asset.

The overdrive can be enhanced by monitoring cash flow from the portfolio. As mentioned, during periods of depressed asset prices, cash flow from a portfolio usually declines. Use cash to restore the cash flow from investments also encourages asset purchase when prices are down. But, that assumes not all the cash will be needed to get through the hard times. The final consideration is particularly relevant if employment related earning are depressed.

But, money isn’t wealth and generally doesn’t contribute much to efforts to generate wealth. It’s a sterile asset. When you hold cash equivalents, you're usually paying someone else to take your money and generate wealth with it.

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