Wednesday, January 11, 2012

If the Plan Is Right, Stick to It

Adjust, but don’t abandon a plan that isn’t broke.

It’s a little late: the annual reference to “It’s a Wonderful Life” is overdue. The first such reference in “Did the repeal of Glass Steagall create big banks and lead to the financial crisis?” was in reference to policy. The next year in “Investing Part 3: Setting the volume” the focus shifted toward personal finance and addressed a more subtle issue than the Henry Potter verses George Bailey confrontation.

This year’s first reference sticks with the focus on an individual’s financial management. The point is simple. If one has a good plan, stck to it.

Aficionados of the movie may recognize the scenes. Just as the run on the Bailey Building and Loan referenced in “Investing Part 3: Setting the volume” contained some subtle points, so too do these scenes.
Scene 1

In Scene 1 Potter is summarizing George Bailey’s current situation in preparation for offering him a job. Listen close and you’ll note that George at age 27 is setting aside (i.e., saving) over 20% of his earnings while paying his mortgage. While the dollar figures are quaint after the intervening seventy some years of inflation, it’s telling.

Potter doesn’t get it. He belittles George’s situation, yet acknowledges the George has “beaten” him and cites the bank run as an example. Potter’s explanation is that George kept his head during the panic.

It just doesn’t occur to Potter that keeping one’s head is a lot easier if one has been regularly saving. That’s a timeless truth. If one has a plan, external events like a panic aren’t what drives one’s actions. George’s plans change throughout the movie, but he changes them because his objectives change (e.g., save his father’s legacy in the building and loan, let his brother pursue “research,” marry Mary, save the building and loan from a bank run, etc.). Yet, those changes are a response to events, not a change in plans due to the latest news.

Fast forward to 2012. People who were saving 20% of their income were less likely to see 2011 as a year in which volatility forced them to adjust their portfolio in response to every shift from “risk on” to “risk off.” Similarly, they probably didn’t experience 2008 and 2009 as a reason to panic. While the dollar volatility of savers’ portfolios may have been bigger, their plans could stay the same. In fact, like Potter and George, they may have seen the recent events as a time to invest. Volatility certainly creates opportunities for the investor, but that’s a topic for another posting. It doesn’t require a new plan to capitalize on volatility.
Scene 2

In Scene 2 George is pleading for a loan from Potter. Many business owners invest everything they have in their business. We learn that George put everything into the Bailey Building and Loan. When Uncle Billy loses a deposit, George has no liquid assets. Concentration and focus are necessary in a business, but as an investment strategy, they create risks one ought to avoid.

Potter, who knows George’s situation, asks what assets George has that can be used as collateral for the loan. George isn’t broke. He mentions a life insurance policy. (It has some cash value. So, it’s what is known as whole life.) The cash value (surrender value) is well short of the amount George needs. Remember he has also been paying a mortgage. He has undoubtedly built equity through payments. It’s also worth remembering his home was bought during the depression and Scene 2 takes place post World War II, so inflation has added to his equity. His problem is the shortfall at the Building and Loan. George has assets, but not the liquidity of cash.

It’s interesting that treating home equity as a liquid asset is never even raised as an issue. Does that represent a difference in financial markets or a difference in how people planned? George put every penny into his business, but he didn’t “bet the ranch” (i.e., use a mortgage to raise capital), quite different from using an equity line to finance consumption. Having a home isn’t a part of George’s plan that he is willing to risk.

While pleading with Potter, George expresses a belief that Potter is the only person with the kind of money (liquidity) George needs. When Potter turns George down, George makes his big mistake.

Scene 3

In Scene 3, having been turned down by Potter, George contemplates letting events determine his action. It takes Clarence Oddbody, Angel Second Class, to show George the folly of letting events determine one’s plan. In the end, George realizes how foolish it would be to let events determine his life. That realization sends George on the path to the movie’s happy ending.

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