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Chapter One
The Three Commandments
What You Should Inscribe
Upon the Stone Tablets
of Your Portfolio
THERE ARE THREE CENTRAL RULES for keeping your money safe. We will come back to them again and again throughout this book. I call these rules the Three Commandments; they are simple but universal enough to cover virtually every challenge you will face in managing your money.
(Thatās why there are only three, instead of ten.) If you obey them, you will have a purer investing heartāand better resultsāthan many professional investment managers, who stray constantly from the true path of righteous safety.
I will express the Three Commandments in Biblical language, because they are that important.
All the rest is commentary.
The First Commandment
Thou shalt take no risk that thou needst not take.
Always ask yourself: Is this risk necessary? Are there safer alternatives that can accomplish the same objective? Have I studied the pros and cons of each before settling on this choice as the single best way to achieve my goal?
Unless you ask, do not invest.
The Second Commandment
Thou shalt take no risk that is not most certain to reward thee for taking it.
Always ask yourself: How do I know this risk will be rewarded?
āMost certain to reward theeā does not mean that there is zero chance that you will not be rewarded. It does mean, and must mean, that you are highly likely to be rewarded. What is the historical evidence, based on the real experience of other investors, to suggest that this approach will actually succeed? During the periods in the past when it hasnāt workedāand every investment in history has gone through such dry spells, regardless of what the hypesters might tell youāhow big were the losses?
Unless you ask, do not invest.
The Third Commandment
Thou shalt put no money at risk that thou canst not afford to lose.
Always ask yourself Can I stand to lose 100 percent of this money? Have I analyzed not merely how much I will gain if I am right, but how much I can lose and how I will overcome those losses if I turn out to be wrong? Will my other assets and income be sufficient to sustain me if this investment wipes me out? If I lose every penny I put into this idea, can I recover from the damage?
Unless you ask, do not invest.
Safe Bets
ā¢ Never invest without thinking twice and consulting the Three Commandments.
ā¢ Answer the questions that accompany the Three Commandments above whenever you invest; they will help you shape an investment policy, telling you not only where to put your money but Why.
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Chapter Two
Solid, Liquid, or Gas?
Taking to Heart the
Central Lesson of the
Financial Crisis
THE IDEAL PORTFOLIO is solid and liquid at the same time. Perhaps because this principle defies our normal notions of physics, itās easy for investors to overlook it.
An investment is solid if decades of historical evidence indicate that it is highly unlikely ever to lose the vast majority of its market value.
An investment is liquid if you can transform it into pure cash any time you want without losing more than a few drops. If you canāt, then we say that its liquidity has frozen, dried up, or vaporized.
Some investments are solid without being liquid. Unless you borrowed far too much against it, your house is probably worth several hundred thousand dollars even after the recent plunge in real-estate pricesābut good luck if you need to convert it to cash in a hurry. Thereās nothing inherently wrong with having some of your money in illiquid assets; they often have higher returns in the long run. But it is absolutely mandatory for you to keep a reservoir of liquidity in your portfolio at all times. Just as travelers in the wilderness die without water, investors perish if they have no liquidity.
The flip side, of course, is that many investments can appear to be liquid without actually being solid. And they will stay liquid only for as long as everyone continues to pretend that theyāre solid. These assets offer merely the illusion of liquidity. The mortgage-backed securities created in the credit binge of the past decade were a form of this illusion. In 2006 and 2007, they traded in immense volumes. That made them seem liquid. But the assets underlying these securities-underresearched loans on overpriced homes that were overleveraged by underqualified owners-were not solid at all. So the liquidity was not sustainable. It was an illusion, like a mirage of water rippling over a patch of sand in a desert.
Just as it would never occur to you, as you step to the kitchen sink to fill up your water glass, that nothing might come out when you turn the faucet, investors never imagine that a previously liquid investment will suddenly turn out to be illiquid. But it can, and it was this shocking discovery, more than anything else, that accounted for the panic among investors in 2008.
The biggest risk of all to your money is the risk that many investors never think about until it is too late: namely, the chance that if you need to turn an asset into cold, hard cash right away, you might not be able to do it. This chapter will help you understand safety in a new way and build a portfolio that should never run dry.
How Leverage Dries Up Liquidity
An investment is liquid if, and only if:
ā¢ at least one person is willing to sell it,
ā¢ at least one person is willing to buy it,
ā¢ at the same time,
ā¢ for close to the asking price,
ā¢ the costs of completing the trade are low,
ā¢ and the buyer and the seller have a secure way to complete the trade.
More often than not, the culprit in a liquidity crisis is leverage, or borrowed money. Miss a few car payments, and the repo man will show up in your driveway with a tow truck. Skip a few mortgage payments, and the bank can lock you out of your house. Borrow to buy stocks that go down in price, and your broker will seize the shares as collateral.
If you owe, you do not really own.
We all would borrow a lot less if we realized that what leverage really means is āgiving someone else the right to take my ownership of something away, at the worst possible time for me to lose it.ā If you lose liquidity in one part of your portfolio, you may suddenly find yourself unable to pay the interest on your debts elsewhereāturning your lenders into the owners of your most coveted assets.
If many people or institutions all leverage up in the same way, the ripple effects can rise into a tidal wave. When Lehman Brothers, the investment bank, collapsed in September 2008, trillions of dollars in complex securities could no longer trade. Billions of dollars in prestigiously rated AAA mortgage bonds could not be priced at all. Leading American companies suddenly found that no one would lend them money even for as little as 24 hours.
And cash itselfāthe very essence of liquidityāturned out to be frozen. The Reserve Fund, a money-market mutual fund with a sterling reputation, held so much Lehman Brothers debt that it ābroke the buck,ā informing its investors that their money was no longer worth 100 cents on the dollar and denying them daily access to their accounts.
We tend to think of our most valuable assets as the safest, because their total value is the farthest away from zero. A house worth hundreds of thousands of dollars seems like a safer investment than a bank account with a few hundred dollars in it.
But the central lesson of the recent financial crisis is as plain as the nose on your face: No matter how valuable an investment may be or appear to be, itās of no practical value to you unless itās liquid when you need to cash out. Your house may have been appraised for $1 million in 2006, but if so few people now want it that you might need two or three years to find a buyer at $699,000, then that $1 million is a fantasy. So, for that matter, is $699,000 if you have to wait two or three years to get it.
By definition, no asset can ever be worth more than someone is willing to pay you for it. Without buyers, there is no liquidity; without liquidity, so-called securities have no security.
Gan You Tap Liquidity Elsewhere?
Liquidity risk is not hypothetical; it is real. Whenever we invest money now, it is always in the expectation of being able to turn it into even more money laterānot money that exists only in our imagination, but actual cash we can spend to fund our future needs. Since life is full of surprises, tomorrowās needs can be swamped by todayās emergency. Lose your job, get divorced, fall ill, become disabled, or simply suffer the rising costs of family tifeāand suddenly you may need to turn your assets into cash not decades down the road, but right now. Then, without a momentās notice, you will lose the luxury of being able to sell your investments at exactly the right time and price. You will, instead, be forced to get rid of them in a fire sale.
Thus, for safetyās sake, you must erect the foundation of your financial future not on bedrock but on a reservoir of liquidity. And the only sensible way to do that is by determining the personal liquidity risks in the portfolio you already have. For the simplest starting point, measure your own portfolio against the national average. Exhibit 2.1 shows, in descending order, the percentage of total assets that the average American family holds across 16 categories.
And now we can review, in simplified form, how liquid each of these assets will beāespecially when combined with the others. Exhibit 2.2 shows four measures of liquidity for each major asset: how long it may take to sell, how costly it can be to sell, how much its market value may decline, and how much money people typically borrow against it. The less time it takes you to sell an asset, the lower your expenses in selling it, the less its market price fluctuates, and the less leverage you used to ...
