Tuesday, March 18, 2008

Surviving a downturn (2)

In part one on this topic I raised the possibility that the current financial difficulties, declines in the market values of many asset classes and some of my informal leading indicators could mark the beginning of a prolonged economic downturn. I identified three key points to focus on. This post addresses the first of those key points: financial survival.

By financial survival, I mean the ability to maintain my current lifestyle (more or less) without adversely affecting our future financial plans to any material extent. In a different context, I might be concerned with bankruptcy, a mortgagee sale of our home or other traumatic financial calamities. However, at this point such extreme outcomes can be disregarded. Instead, I can focus on preserving our current lifestyle and our financial future. I asked myself three questions:

Question 1: when would the cash run out?

This is the personal finance equivalent of a liquidity test. If I lost my job, for how long could I continue to meet monthly expenses without having to sell assets? In answering this question, I came up with three answers. The first answer looks at cash on hand only which would last us about 12-14 months. This is a worst case scenario. The second answer takes into account Mrs Traineeinvestor's income which extends the time line out to about 15-16 months. The third answer takes into account the fact that my employment is subject to a minimum notice period and that some of my remuneration is paid in arrears. Even if I was given a pink slip tomorrow, I would not have to start drawing on existing cash reserves for at least 6 months which means it would at least 21-22 months before we would run out of cash.

As a final point is my savings rate. Assuming I just put my salary into the bank, with each passing month, I can save enough money to extend the zero cash point by close to one additional month.

Question 2: what is the risk of permanent downside to my assets?

I considered the possibility that each asset had the potential to suffer a permanent or very long term diminution in value. Any assets which I consider have a meaningful potential to go down and stay down should be sold - regardless of whether they look attractive at these prices or not. This is a lesson which has been repeatedly drummed into me in 1987, in 1997 and at other times.

For index funds and diversified ungeared equity funds I have no concerns. History has shown that markets as a whole will bounce back. It's just a question of how much pain you have to endure while waiting. I have similar views on real estate as an asset class with the qualification that leverage has the potential to create a permanent loss of equity value. I do not see a Japan style extended deflation in property values or even a repeat of the Asian crisis based on current fundamentals.

This leaves my residual share portfolio and my commodities. I have seen plenty of stocks go to zero and the prices of commodities remain at depressed levels for very long periods of time. I will carefully review each of my individual shares (only two that matter) and my commodities over the next few weeks before making any decisions.

Question 3: what else could go wrong?

This always the hard question. We have medical insurance. There is not much I can do about defaulting tenants or vacancies at the end of leases. De-pegging of the Hong Kong dollar? Interest rates rising? Inflation running rampant? I have been running all kinds of economic and personal problems through my mind. The issue is that many of them would be best dealt with by contradictory courses of action. I am not planning to arrange my life around financial fears which, as things stand, I consider myself reasonably well placed to address if and when they eventuate.

In general terms I have concluded that we are in reasonably good shape to withstand a downturn lasting 1-2 years. Beyond that and conditions will be more uncertain, but our margin of safety will improve with each passing month.

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