During the 2008-2009 financial crisis, approximately 1 out of 7 millionaire households liquidated 20% or more of their portfolios. The rest either stayed the course, refusing to part with their acquired assets at firesale prices or recognized the bargains that existed and bought more.
How is this possible? There are quite a few causes, and one of them is cash.
Compared to the middle and upper class, millionaire households have the liquidity to endure crises at an extremely high level.
In fact, devotion to high cash balances is one of the few major differences between households of professionals and entrepreneurs.
In the Brookings white paper “The Wealthy Hand-to-Mouth”, author Greg Kaplan points out that an astounding 83% of professionals earning salaries between $85,000 and $215,000 have less than one month’s cash available. The rest is spent or invested. The advantage is that money gets put to work and started compounding quicker, but the downside is that any loss of employment will almost immediately require the sale of assets on whatever terms Mr. Market is willing to offer. Considering that job loss correlates with recessions which correlates with stock market declines, the loss of employment may very well occur at a time when assets are selling at a discount.
Entrepreneurs, specifically the owners of local businesses, keep on average 27% of their wealth in cash. Hyper aware of how profits fluctuate at their own business, this segment of society knows how devastating a liquidity crunch can be to personal finances.
Psychologically, think about how much different the process of an economic recession–both in the employment and the investment markets–plays out when you enter it fully equipped with a large stash of cash.
First, the stock market itself takes a more limited toll on your net worth.
If you have a $1,000,000 portfolio at the time a recession hits and takes away 36% of the stock market’s value, like we saw from the summer of 2007 through the spring of 2009, you have to stare at a $640,000 balance. This is the experience of the professional living hand to mouth.
On the other hand, imagine you’re the business owner sitting on the 27% cash position–you enter the recession with $270,000 in cash and $730,000 in a broad distribution of equities. When the recession strikes, the stock portion is cut down to $467,200 while the cash position remains unscathed. Their net worth low is $737,200 rather than $640,000. If their money is collecting interest, the figure is $742,600. The cash position acts as a shock absorber that makes your net worth a tenth higher than what it would be under the full investment scenario.
But more importantly, the difference between the two arises in the degree of offense you’re able to play when opportunity strikes.
If you are the professional in the hand-to-mouth scenario, there is not much you can do to increase your capital available for investments when bargains present themselves. You can only take advantage of the deals in a limited way–whatever surplus you collect from your salary every two weeks.
But the entrepreneurs that fall within the 27% cash position in ordinary times have the ability to really ratchet up their net worth by leaning on their cash hoard. A $270,000 investment during the recession would be worth $950,000 today. If that money were instead fully invested in the hand-to-mouth scenario and never sold, the $270,000 would have grown to $513,000. Of course, the $950,000 figure should be regarded as a theoretical maximum because I am not suggesting that the entirety of a cash hoard be deployed during a recession, but it is a demonstration how the savvy use of cash can ward off the full extent of volatility while also goosing long-term total returns.
It is an underreported aspect of financial planning because it is behaviorally focused. Generally speaking, the white papers published in-house at Credit Suisse or JP Morgan are correct when they point out that lump-sum investing as soon as capital is available will lead to a higher net worth. The glaring exception is when a recession follows shortly after the lump sum investment or cash is deployed judiciously during a period in which asset prices are distressed.
But these studies also ignore the behavioral satisfaction that occurs when you have cash available to deploy. If you are fully invested, you have to crouch a bit and hunker down to wait for the bad times to pass. When cash is available during these circumstances, the question for the family is: “What opportunity do we want to take advantage of next?” Large cash positions enable you to stand up straight and strut a bit in a way that illiquid households cannot fathom during economic distress.
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Originally posted 2017-02-01 10:20:28.
