The interaction between your assets and your life context is different for every investor. Not just for what investments you choose, but also for what risks to hedge in the first place.
By “context” here I mean the particular life circumstances of each investor. For example, a 25-year-old with a good income but few assets should choose a different risk-return blend than a 75-year-old with no income but high assets.
Even within incomes, there are differences. For example, if you make a lot at something you hate — lawyering, for example — then your risk-return profile would differ from somebody who makes a lot at something they love. The lawyer is saving up for a change, while the “I can’t believe they pay me to do this” person can spend more of what they earn.
So far so good. What’s less intuitive is that these two investors should also be hedging for different risks. For example, the fact that recessions eventually recover, even if it takes a decade, is more comforting to the 25-year-old than a 75-year-old. In fact, a high-earning but asset-poor 25-year-old may not even bother hedging for recession. Just set it on autopilot, only peeking at your brokerage account if the zombies actually show up in the driveway.
The key characteristics here are how long an asset takes to liquidate, and how much it costs to liquidate. For example, if all of your assets are in a brokerage account, you can liquidate or change your holdings in a matter of minutes. On the other hand, if your main asset is a house or, more broadly, real estate, then it will take you months or more to liquidate the asset.
This means the brokerage investor only cares about fast risks — risks that take weeks or months to emerge. They don’t care about risks that take years to mature. For example, hyperinflation doesn’t shoot out of the blue; it normally takes a year or more to even start to appear (more on hyperinflation’s lead-time in this month’s AIM). Meaning that a typical brokerage-account investor may as well completely ignore hyperinflation until annual inflation hits, say, 10%.
As important as duration of liquidation is costs of liquidation. Again, with a brokerage account it might cost you $50 to liquidate your entire life savings. Meaning you can “pull the trigger” without needing too much confirmation. And also meaning that you can easily reverse a mistake.
On the other hand, a more illiquid asset like real estate might cost you $10,000 or more to sell. And thousands more to buy back in if you made a mistake. The very fact that mistakes are costly means you’ll tend to wait too long.
This, of course, was a problem in 2008. It’s one thing to say that brokerage investors should’ve gotten out in time. After all, it takes minutes to liquidate a stock portfolio. But it’s hard not to feel for people who were stuck in illiquid and expensive-to-sell assets. Those people needed strong confirmation before selling, and strong confirmation tends to come too late.
The rule of thumb, then, is the more illiquid the investment, the more likely you’ll wait too long to sell. You want to build this in to your “stress test” of what a crisis will do to your finances. So, for example, if you’re heavy on real estate, or if most of your assets are in a cycle-dependent business, than the rest of your money should be in something low-returning that’s insensitive to the cycle. Like any insurance, it’ll cost you — you’ll be leaving money on the table in the form of low returns on your liquid assets. But the insurance is covering your overall financial health.
Of course, not all of us have the luxury of steering clear of illiquid investments. For very valid reasons — holding illiquid investments are the only way to, say, run a business or own a house. Indeed, the vast majority of Americans’ net worth is tied up illiquid assets such as businesses or houses.
If you’re already invested in such illiquid investments, this means that you do indeed need to keep an eye on longer-horizon risks. And it means that the rest of your portfolio, the more liquid part, has to do the work of shielding you from financial risks. It might feel silly if your business is work-hard-play-hard shoot-for-the-moon while your money’s in bonds, but that kind of mix is the right way to go if your assets are necessarily illiquid.
Subscribers to the Austrian Investment Monthly know that I generally address the one-to-three month horizon. The reason is that I’m usually analyzing publicly-traded securities, meaning the typical investor has a short horizon and low transaction costs. I have gotten feedback that a lot of subscribers are entrepreneurs, so I’ll do a bit more mentioning of longer-term risks.
For the record, despite my short-term optimism, the Piper will eventually be paid — we will eventually get a recession. And that recession is likely to come within the 2-3 year timeframe relevant to business-owners. We’ve got awhile yet before the rain comes, but as long as they keep making cycles we investors will have to keep dodging busts.
Summing up, the first step is laying out your own income, assets and spending profile. Any financial advisor worth their salt will start this in your very first meeting.
Second step is to be aware of the liquidity horizon and liquidation costs on any investment. Keep in mind that longer horizons and higher costs will both introduce new risks, and both will push you to always stay too long.
The time to repair the roof is before the rain, so today’s a good time for the prudent investor to “stress test” their most illiquid holdings. Meaning estimate the hit and ask if you can take it. If you cannot, reduce your exposure to the asset — bring on financial partners, say, or shift from owning to renting your business resources.
And if the exposure can’t be limited? Then it’s time for your liquid assets to step up, effectively “insuring” your core, illiquid, investments.