Divestor

In a lot of basic financial advice that I read, there is usually the mention of the concept of an “emergency fund”, which is a cash stash that can be deployed in the event of unforeseen emergencies (e.g. losing your job, medical emergency, etc.).

Maintaining a cash reserve to survive many months (ideally a year) in theory is good practice. It is very difficult to run a completely leveraged lifestyle (typically known as “paycheque-by-paycheque”) because it does not take many external circumstances to impact your financial situation. However, if you have cash-like assets that can be liquidated at a moment’s notice, then it makes the concept of an emergency fund highly redundant. You can be impairing your returns by having capital deployed in low-return products.

The question is a matter of resource utilization – keeping the cash literally stored as pieces of paper (hundred dollar bills) underneath your mattress surrenders any ability to gain interest, and present a security risk if you are robbed, or if your house goes on fire. So keeping the cash in a risk-free savings account (e.g. Ally offering 2%) is the next best alternative. For most people, this is probably the best option for the “emergency fund” since their decision-making abilities to invest the proceeds might incur negative expected value.

For most financially sophisticated people, seeing the cash stored at a fully-taxable 2% might be a bit unbearable, especially when one considers that it will be a below-inflation return. Where else could you put your emergency stash? You could move into short-term corporate bonds of stable companies, but in this low interest rate environment, would be unlikely to yield more than 2%. The next step up would be preferred shares, but that entails the risk of principal loss in the event of an untimely liquidation.

Finally, this leaves longer-term maturity corporate/government debt or even low-risk equities (e.g. utility companies with stable yields). You can see why “chasing yield” becomes dangerous – as long as bond/share prices remain stable and keep pumping out the coupon payments or dividends, you feel “safe” (a very dangerous feeling in finance if you are expecting a high reward for your “safe” risk). But it only takes a 2008-type event before everything gets flushed in the marketplace. Still, there were quite a few securities out there that were relatively unaffected by the financial crisis, and you can assume they will be an acceptable risk for emergency fund capital.

Giving a numerical example, let’s say your lifestyle requires you to save $25,000 to maintain a one-year operating cash cushion without drawing any subsequent income. If you had invested the money in a short-term savings account, and had your cash-requiring emergency at the same time as the 2008 financial crisis, you still would have $25,000 in principal to draw. A few button-clicks and you will magically have $25,000 at your fingertips.

However, let’s assume you wanted to reach for yield and invested the $25,000 in a TSX index fund at the beginning of 2008. The peak-to-trough amount the TSX dropped in 2008 was 42%. So had you been forced to withdraw proceeds at the bottom of the market, you would have had $14,500 left.

This would suggest that an emergency fund, if invested in a broad-based index of equities, should be about 1/(1-0.42) = 1.73 times larger than the amount you actually need to operate. So your $25,000 emergency fund, if you want to invest them in equities, should be around $43,000 if you want to be able to have a large degree of confidence of being able to withdraw $25,000 even in the middle of a 2008-style financial crisis.

This type of math suggests that people with about 1.73x the assets required to maintain their lifestyle in the event of an emergency should really have no emergency fund at all.

If your remaining assets are in safer securities, such as secured corporate debt, the impact of a 2008-type financial crisis is significantly less; there were plenty of corporate debt issues which barely budgeted during the crisis. As an example, the debentures of a company like Penn West Energy Trust (where their ability to pay out principal is never really in doubt) fell about 10% during the financial crisis. If you could structure a portfolio around such securities, then your ratio would be about 1.12x – or about $28,000 of the “emergency fund” invested in corporate debt.

Time Magazine had an article about two university economists proclaiming that young people should go on margin when investing in stocks. They came to this determination after mining the 130-year set of historical data, and taking into consideration 45-year investment periods. They suggested a 2:1 ratio.

So for example, if you had $5,000 sitting in the bank, you should go and purchase $10,000 in stocks. I would not suggest this.

David Merkel (who incidentally writes probably one of the best pages on the internet regarding real-life economics) blasts the argument for many reasons. I want to elaborate on the first counter-point, mainly that mining historical data is not sufficient to determine a future course of action.

Whenever you walk into the office of a financial adviser (salesman) person at a retail bank, the most frequent chart you will see on the back wall is the Dow Jones composite index, roughly from 1900, in non-logarithmic format (designed to make the 1929 and 1987 market crashes look like nothing). They will usually give you a pitch how the stock market, on average, has gone up 9% (in nominal, not real terms) a year since eternity and therefore, your money should be invested in some equity fund that the adviser will presumably make a healthy commission selling.

The assumption that the markets will continue going up 9% a year in the long run is incorrect. If you believe this, you will lose money.

Throughout history, markets in countries have a frequent habit of collapsing. Around 1900, the top three capitalized stock markets were in the USA, United Kingdom and Russia. Not many people would have guessed Russia, but we all know what happened after – they were utterly destroyed after the Bolshevik revolution in World War 1. In fourth place was British India, and that country looks completely different (consisting now mainly of Pakistan, India, Bangladesh) than what it was back during the dying days of colonialism.

It is very difficult to predict whether the USA will still be around in 100 years, let alone compound market gains by 9% a year.

The other comment I will make with respect to buying stocks on margin is that even if you know what you are doing, it is very psychologically difficult to watch positions go underwater when on margin. Typically you will be receiving a good (low) price during periods of very intense volatility, and it is very unlikely that you will be receiving the “best possible” price had you looked at a chart 6 months in retrospect. There are far too numerous examples of this in my own life, but one was during the middle of the financial crisis in March 2009, when ING Group’s hybrid debt was cratering:

Recall that par value on the above issue is $25, and the coupon is 6.125% given out quarterly. Looking at my own trading records, I see I purchased shares between $6.26 and $4.70, which would have equated to a 24.5% to 32.6% annual yield (assuming they do not default). The best price I could have received is $2.83, or a whopping 54% annual yield! Looking at the chart it is very easy to say “Sacha, why didn’t you put your life savings on margin into the thing at $2.83/share?” – in retrospect, I would have loved to, but there are a few complexities to take into consideration:

1. When you place your order, you implicitly acknowledge that it will likely go lower before it goes higher;
2. You have no idea how low the low will be.
3. If the issuer defaults, you are in deep do-do.

Now, I remember when placing my order that I thought I was already getting a good deal, but underestimated, by some 40%, the extent to which the market was willing to take this thing down.

Imagine if I had the snippet of knowledge that on April 16, 2010 that this would be trading at $18.91 a pop and went on 2:1 margin at a price of $4.70/share. I would have had my account liquidated on a margin call well before the bottom was reached. Even if I knew what the “true value” of something was, by using excessive margin, you are giving the market the ability to wipe out your investment before you can realize its true value. For stable asset pricing and stable yields, the argument to use margin is more coherent, but when you introduce volatility, margin will absolutely kill you.

This was a one-security case, but even when diversifying the portfolio a bit, you still would not have been able to avoid margin call issues simply because the whole market was being flushed in March 2009.

Telling young people to employ margin based on historical market data analysis is absolutely foolhardy and will only result in losses. It is difficult enough to be able to invest in equities and doing it on margin will just compound the agony even if you’ve done your research correctly and have a general idea that you are purchasing stocks below their fair value.

So for my final parting shot of the day, when a young person buys a condominium and makes a 10% down payment, and mortgages the rest, they are making a 9:1 leveraged bet on their concrete box in the sky. Does the past 10 years of Canadian real estate price history data suggest that you should be making the minimum 5% down payment and go on 19:1 margin?

The following quotation is golden advice:

One final note: when I wrote at RealMoney, I took a contrarian view that for average investors, no one should be fully invested. Even the great Ben Graham never exceeded 75% invested. My view is that average people must limit their risks or they will not be able to sustain their investment plans. A 50/50 or 60/40 balanced fund approach is best for the average person — they will never get scared enough to abandon it.

By always keeping some black powder in the keg, you will be able to pounce on opportunities that others cannot because of their leveraged circumstances. Late 2008 and early 2009 was a time to be doing this, and there will be times in the future where keeping a stack of cash will be of great benefit. I don’t sense that “now” is one of those times to be deploying cash, but certainly if we are in a 1970’s type market, we will be seeing 30-40% market gyrations both to the upside and downside.