Principle 4: Carefully manage liquidity
Updated: Oct 11, 2021
Adequate liquidity is both an investment function and a financial planning function. This marriage between investment management and financial planning is a key differentiator in the way Basepoint Wealth helps you reach your financial goals.
Aesop didn’t pull any punches. It is a tough lesson from a different time that sounds cruel to modern ears. Although it may feel like we have conquered scarcity, it is important to remember there are no guarantees that our social safety net will to continue to function indefinitely. It is therefore imperative that we maintain adequate liquidity to provide for our needs during good times and bad. There is a certain amount of freedom granted by having set aside ready cash so that during times of emergency we are not left to count on the kindness of friends or strangers.
In 1970, Warren Buffett was cleaning out his uncle Fred’s safety deposit box as part of settling the estate. In the box was an envelope containing $1,000 ($6,400 adjusted for inflation) in cash and a letter from Warren’s grandfather, Earnest:
“Over a period of a good many years I have known a great many people who at some time or another have suffered in various ways simply because they did not have ready cash. I have known people who have had to sacrifice some of their holdings in order to have the money that was necessary at that time… You might feel that this should be invested and bring you an income. Forget it- the mental satisfaction of having $1000.00 laid away where you can put your hands on it, is worth more than what interest it might bring, especially if you have the investment in something that you might not realize quickly.”
Liquidity can be thought of in two dimensions: first, a required amount of cash to provide for needs already known. This is especially important during retirement, because a large percentage of required cash flows can be anticipated years in advance. It is for these known expenses that we set aside a dedicated amount of cash that is placed to earn interest based on the “time to need” in a strategy called Asset-Liability Matching. Secondly, there are unknown needs for cash that can be related to things like a job loss, disability, medical emergency, home and auto damage, or other unforeseen occurrences. These unknown needs must be immediately available during an emergency, so must be placed in cash or cash equivalents for ready access.
Adequate liquidity is both an investment function and a financial planning function. This marriage between investment management and financial planning is a key differentiator in the way Basepoint Wealth helps you reach your financial goals. While many financial planners simply recommend 3-6 months of expenses as a cash reserve, we insist that more significant thought is required to help you determine the appropriate amount of liquidity for your unique situation. For instance:
Once an appropriate level of liquidity is determined, more emphasis can be placed on careful allocation of the remaining assets in securities that are likely to earn a sufficient return on capital. Adequate liquidity also allows us to make friends with volatility and purchase securities at compelling prices during a market downturn. It is important to note that we are not considering lines of credit or available debt financing as emergency reserves. These types of financing may be used for convenience during a need for cash; but debt financing should never be thought of as substitute for liquidity other than in its ability to facilitate a transaction (i.e. purchasing a home, vehicle, etc.).
While Warren Buffett’s grandfather recommended an envelope stuffed with cash, current circumstances have changed the recommended location for ready cash storage. First and foremost, the establishment of the Federal Deposit Insurance Corporation by the 1933 Banking Act, has prevented a single dollar from being lost as bank deposits for over 85 years. The original covered deposit amount was $2,500, which has grown to $250,000 today per depositor, per institution . Further, policy driven inflation has grown tremendously since the establishment of the Federal Reserve Bank in 1913 , and storing currency is a sure way to lose purchasing power over time. Our normal recommendation for placement of cash is to utilize savings accounts or money market assets for cash needed in the next 6 months, to utilize exchange traded Certificates of Deposit for cash needed in 6-24 months, and to consider short-term, high quality bonds for cash needed more than 24 months in the future. Of course, these are only rules of thumb, and you should work with your financial advisor to build a customized cash management plan based on your unique goals and circumstances.
Our core competency, and our duty as a fiduciary is to help you maintain adequate liquidity for both emergencies and for opportunities. We work with you to discover your personal liquidity constraints for known outflows of cash, and unknown risks that may require cash with limited notice. Our discipline allows you to be more direct with investment of non-reserve assets, prevents the need for sales of assets at disadvantageous times, and provides liquidity to purchase discounted assets during market dislocations. While we sacrifice a little return to maintain liquidity, we gain the ability to act in times of need, and to be calm in times of panic, further serving our goal to help you sleep well and eat well.
It is fair to say that our transition to Basepoint Wealth is now complete, yet our journey together has just begun. Our goal is to continue developing improved systems built to deliver additional value in the form of improved tax efficiency, reduced insurance costs, increased returns on cash, and better retirement savings and liquidation strategies. Thank you again for your continued trust, we never underestimate how important it is.
W. Allen Wallace
A., & Winter, M. (1919). The Aesop for children. Eau Claire, Wi.: E.M. Hale. This interactive book is presented by the Library of Congress, adapted from the book “The Aesop for Children: with Pictures by Milo Winter,” published by Rand, McNally & Co in 1919. This work is considered public domain in the United States. Milo Winter’s pictures were transformed for this interactive book, and now readers can interact with the charming illustrations to see and hear them move: a choosy heron eyes the fish swimming at his feet, a fox swishes his tail, a mouse chews a rope and frees a lion.
Buffet, E. (1939). Everyone should have a reserve [Letter to Fred & Catherine Buffet].
Federal Deposit Insurance Corporation. (2018, April 30). Retrieved May 3, 2018, from https://en.wikipedia.org/wiki/Federal_Deposit_Insurance_Corporation
Hallman, G. V., & Rosenbloom, J. S. (2015). Private wealth management the complete reference for the personal financial planner. New York, NY: McGraw-Hill Education.
Tuttle, D. L., & Maginn, J. L. (1985). Managing investment portfolios. a dynamic process. Boston: Warren, Gorham & Lamont.
Handbook of Labor Statistics, U.S. Department of Labor, & Bureau of Labor Statistics. (n.d.). Consumer Price Index (Estimate) 1800-. Retrieved May 3, 2018, from https://www.minneapolisfed.org/community/financial-and-economic-education/cpi-calculator-information/consumer-price-index-1800
The chart below was created by Basepoint Wealth to illustrate the correlation of the Creation of the Federal Reserve as well as the Leaving of the Gold Standard. It is based on data gathered from the aforementioned article.