Every bull market hides within it the seeds of a bear market. The market, as a whole, is mean reverting. So, a bulk of what goes up tends to come down, if not fully but to a large extent, wiping out all the temporary gains made in the process. And in between this going up and coming down investors make their reputation and fortunes.
By virtue of running an advisory, I get an opportunity to speak to a large cross section of investors. On Monday, I was speaking to one such person. He was extremely concerned about investing at “such all time high market levels”. He said that it had taken him many years to get to where he is today financially and he did not want to risk a large part of his networth should there be a large market crash. What was left unsaid was that he was also loath to let go of the opportunity in case the market kept going up. So, here is a classical dilemma.
This conversation got me thinking in multiple directions – the role of asset allocation, the need for a robust investment philosophy suited to oneself and of course where one is in one’s financial journey. All of this led to “financial resilience”.
Covid has taught us that resilience is crucial – whether in one’s physical or mental health or finances. So, how does one build financial resilience? As my guru Charlie Munger says, “Invert, always invert”. So, inverting the question and asking myself, how do we make our finances more fragile?
Here are some ways. None of this is rocket science. It’s mostly common sense but if you get it right it helps tremendously in building your financial resilience and will help you in facing a market downturn whenever it comes. These are as true for individuals as for families and also companies.
No savings
If you are working for some time and haven’t built up an emergency fund or some cash reserves that can cover expenses for a few months, then your financial life is fragile. The first thing to do is to build up some cash reserves for the rainy day.
Inadequate insurance cover
The biggest unplanned expense tends to be a medical emergency. You need to have adequate medical insurance for self and family to cover the costs. Having to pay for expensive medical treatment could derail, and at times completely ruin, your financial plans. The worst is if it happens during a time when you are otherwise financially weak.
Large debts
100% of all bankruptcies happen due to inability to service a debt. Basically, if your income (P&L) does not support your debt (balance sheet), then you are in trouble.
If you are taking a loan to create an asset like a home, it is still understandable. But you should have sufficient cash savings and medical cover before you take a home loan.
Taking a loan for consumption should be a strictly no-no unless you have a reasonable amount of savings to cover for the loans. The problem is people who need loans for consumption are the ones who should not take it and those who can afford to take loans don’t because they already have the cash.
Similarly in a market crash, the stories you hear of people going bankrupt are those who are leveraged. You can at most lose a large part of your capital in stocks but in derivatives, if you don’t know what you are doing, you can get wiped out.
Single source of income
If you are dependent on a single source of income you are fragile. If your job or business is your sole source of income then you are financially fragile. Try to diversify your income stream. One reason I started investing was to be able to have another source of income over time. This is true for nearly all part-time investors who have a steady job or business. If you keep adding to your portfolio, over time it builds up into a nice source of income through dividends and interest payments
Inadequate diversification
A lot of people have all, or large parts, of their networth in one single asset class or asset. Indians primarily have a house which dominates their networth. Others may have gold or fixed deposits or equities. At an extreme case, having investments in only one company like that of a promoter of a business, is also a cause of fragility. Adequate diversification into multiple asset classes, especially ones which are not correlated, and assets may reduce your returns sometimes, but has the definite benefit of enhancing resilience.
The challenge with personal finance is that it is personal. It cannot be generalized. You have to take a hard look at your financial situation and decide what you want. And then work out a plan to solve for it. What you want will also change over time as you age and life situation and priorities change. That is the way it is.
The important thing to remember is that you need to stay in the game for the long term. Resilience is key. Plan on every plan not going according to plan.
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