Sunday, November 16, 2008

Reserve the Reserves

When examining the financial condition of wealthy people, I find it useful to them to determine the sources of their money. This is especially true when dealing with reserves of short term cash. There is a separate value attached to money from various sources, even though in truth, money is fungible. The difference of cash generated from the sale of non operating investments such as stocks and bonds is very different from cash that is left over from spending.

One could say that only those who are generating more cash than the amounts that they are spending are truly wealthy. The others are just rearranging their poker chips. Thus a family of limited means spending less than they are earning is on the way to becoming wealthy, in contrast to the family which is spending a couple of million dollars a year more than all of their income. Supporting their costly “life style” could result in becoming poorer either by intention or not. The mechanics of dealing with ultra high net worth investors (UHNW) is easier than the family on the upward trajectory, but the psychological factors are much more difficult and intense.

I find that excess cash generated has a very different psychological meaning than an equal or greater amount generated by the sale of securities. The excess cash generates a feeling of upward progress and can be utilized in any fashion desired without damage to the fortress of wealth. The cash generated from the sale of securities is either to fund spending, or in these trying days, to alter the asset allocation in one or more portfolios. (I advocate multiple mini-portfolios in my book MONEY WISE.)

My advice to all those who are fortunate enough to have cash is to drop your expenditure rate on your personal needs, and increase your support of charities. Remember that charity begins at home (or with your family - particularly a relative currently having an extraordinarily difficult time). To those holding cash/short term instruments, I recommend more than ever to be prudent, particularly if you are acting as a named or un-named fiduciary.

Recently I spoke to an executive MBA program who visits New York to be lectured by various “experts.” I was horrified to learn that a number of these so-called experts stated that they were all in cash and have been for two years. While one might congratulate them on their trading skills (if true), the advice was far from prudent. Limiting your investment to one type of asset not only requires the extreme confidence of being right, but also the vision to predict important trends and the discipline to get on before the train leaves the station. The long term penalty for being wrong can undermine the future of a family or a charity.

While I don’t know when a bottom price will occur, if it hasn’t already, I am confident that there is a bottom price for all surviving investments. History suggests that after a bottom, prices will irregularly move higher until the next top is achieved to be followed again by a decline of some magnitude.

In looking back from the next peak, a favorite technique of historians and analysts, one would find that there was a period of time to buy very inexpensive assets. However, the “cheap” period is relatively short in duration. Our increasingly efficient market perceives unusual value before prices move up to fair value on their way to fully priced value and beyond. Not participating in the ‘cheap’ period will produce mush lower returns for long term investors.

There are many reasons to adopt my mini-portfolio approach to investing toward specific long term goals and obligations, but one of the best is that one can set different reserve amounts for each goal. For example, one would have a different reserve level for next year’s college tuition than for a newborn’s senior year. When setting reserve levels for oneself and for your spouse/companion, actuarial assumptions adjusted for current health conditions are a good starting point for retirement planning.

Returning to the subject of cash reserves, I do not view reserves as an important part of income generation as the yields are currently too low. Unfortunately for prudent investors, top quality yields will have to rise to the high single digit levels before they become a major income generator. While there are intriguing fixed income credits in the marketplace today, they are not without risk and belong in the risk assumption portion of a portfolio. Some of these credits could be appropriate for one mini-portfolio but not others. For example the tenth year slice for retirement might be appropriate, but not for next year’s tuition.

In summary, one should analyze the amount and quality of reserves one has. Over-reserving for some of the portfolios can be as dangerous long term as under- reserving. Reserves are an important ingredient to the overall structure for each of your portfolios.

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