Economic recoveries and bull markets move slowly; recessions and downturns move fast. So, be prepared...
Do you think that once a recession looms on the horizon, you'll be able to make preparatory moves to sustain your financial investments and your portfolio? If so, you're probably wrong. You're taking on too much risk and not effectively managing the risk within your portfolio and your financial life if you naively think that pre-recession prep isn't necessary.
Recessions come too quickly for most people - it'll probably be the same for you
Too often, people fail to take prudent steps to prep for recessions, market corrections, or economic downturns - they think they'll see the signs close to it and will be able to make the needed financial adjustments. This is incredibly hard to do, however, and most people fail at it.
The main reason it's hard to do is that, unlike economic recoveries and expansions, recessions come quickly and don't tend to give warning signs until after things are already bad (so, they're not really warning signs in this case).
There's too much prep work to do pre-recession
There is too much to be done to prep for a recession, and there might not be enough time to do it if you wait for some sort of warning sign to begin. These things may include the following:
The above items are essential if you want to both protect your financial and non-financial worlds during a recession. It's also important if you're going to thrive post-recession because of recessions, market corrections, and economic downturns bring asset prices down. The smartest investors are those who are eagerly awaiting a recession with a list of quality firms and other assets to buy up at low prices.
It's hard to find great firms at any time
Generally, quality firms are those who have healthy balance sheets, strong and growing earnings, proper management, and are engaged in businesses that are not readily open to competitive entrants. This is an entire field of study, however, and there isn't enough room in a single article to even begin to delve into this topic.
1. Wealth allows you to obtain more comfort: Wealth and money allow you to have more things, better things, and get them faster. We all know that money doesn't buy happiness, but money can definitely buy you a lot of physical comfort(s).
2. Wealth allows you to make those you love comfortable: More important than making yourself comfortable, wealth allows you to improve the physical circumstances of those you love, whether that means helping your kids with a down payment, providing a good home for your family, taking care of your ailing parents, or giving a much-needed gift to a friend. Making the lives of those you love better is one of life's greatest joys.
3. Wealth allows you to affect the world: You can affect the world without having much wealth – some of the most influential people throughout history didn't have much in the way of resources, wealth, income, or power. But, having wealth does help make an impact on the world. If you've got a ton of money, you can help strangers by leaving large tips, or you can help college students by funding scholarships. With wealth, the options are almost endless.
4. Wealth allows you to demonstrate your value-creating abilities: If you're able to create value for other people, businesses, or organizations, you'll end up having money come your way most of the time. If you don't have any money, it's hard to argue that you've created a lot of value (of course, you could be a big spender). Real wealth, obtained in morally correct ways, is a big sign that you've done some things right.
5. Wealth opens up more opportunities for you: You surely don't need wealth to succeed, but having it helps a ton. If you have the money, a lot of doors open for you - they might be professional doors, they might be social doors, or they might be health-related doors. Wealthy people are able to utilize far more of this world's resources in getting the thigns they want:
Devastating portfolio declines and what it takes to recover from them – the math isn’t in your favor
Everyone thinks about gaining money when they invest, but too often we neglect how important it is to not lose money. Not losing money is so important, in fact, that one of the greatest financial investors in history (and very likely the greatest one alive today) espouses the following as his Rule No 1:
Don’t lose money.
What’s Rule No 2?
Remember Rule No 1.
Rule No 2 is obviously meant to be a little humorous, but Buffet is a serious man when it comes to investing and his rules are meant to illustrate a fundamental truth about investing – that truth is that it’s very hard to recover from a loss and that it gets harder and harder the deeper the loss.
This is all best illustrated with examples. Sometimes, a good set of examples can do more for contributing to understanding than pages and pages of text. So, let’s go over three examples, each with increasing levels of severity of initial losses.
In each example, we’ll break things down into 3 time periods – Time 0, Time 1, and Time 2:
A 25% Loss – Somewhat severe, but recoverable
With a 25%loss, your $1000 declines to $750 – this represents a one-quarter decline in your portfolio and would obviously be an unwelcome occurrence. Now, let’s take a look at what sort of returns you’ll need to recover by Time 2; let’s see what sort of returns in the subsequent time period you’ll need to make you whole again.
As you can see from the table, a 33.33% gain is required in order for you to recover and get back to the initial $1000. A 10% return, 20% return, or even a strong 30%return in one time period simply won’t do it.
That means if each time period is 1 year, even a 30% return in the year subsequent to your 25% loss won’t be enough. 30% is a solid return. The fact that it’s not enough should be the first hint that getting back to whole is a lot harder than dropping, from a mathematical/percentage perspective. It’s only going to get worse.
A 50% Loss – Very severe, but you can recover if you stay prudent over the long term
With a 50% loss, it’s a lot harder to recover. Now, it takes a 100% gain (doubling your post-loss portfolio value) to get back to whole again. If you halve your portfolio, you’ll need to double it to bring it back to its original value.
So, if a time period is one year, you’ll need to double your post-loss portfolio value to get back to your Time 0 initial value. That’s very hard. You’d be far better off having avoided such a decline because it’ll be an uphill climb getting back to baseline again. This is what Warren Buffet’s Rule No 1 points to.
A drop of 50% in your portfolio value is very severe and detrimental to your long term investing goals. It will take a 100% increase -- doubling your portfolio -- to recover from a 50% loss. This is tough, but it's doable - it might not happen in a single time period but over time a prudent and disciplined investor stands a chance at recovery.
A 75% Loss – A devastating blow to a portfolio that will take some time to recover from
With a 75%, things get really bad. Now, in order to get back to whole, you’ll need a 300% gain. A 300% gain is the same as quadrupling your money (4x return). As any investor knows, a 300% return is very hard to get – it usually takes years to achieve such returns in a well-diversified portfolio.
Let’s think about this some more. As we keep increasing out Time 1 losses by 25% increments, the return needed to get back to whole by Time 2 goes up by way more than 25%. This is based on the underlying mathematics of portfolio returns, but we don’t need to get deep into that here. The above examples should clearly show how each time the loss gets more severe, the needed gain to get back to baseline gets more and more astounding.
If you lose 75% of your portfolio’s value in a single year due to a very severe recession or, far worse, due to investing blunders, you’re going to have to make some incredible returns (300%) to recover. What makes you think you’ll beable to do that? It’ll likely take a number of years and some serious investing discipline to be able to recover in this way.
A 75% portfolio decline is devastating to any portfolio. It will take a 300% return (quadrupling your money; a 4x return) to get back to whole again. This is very hard to do in a single time period. It might take years of prudent and disciplined long term investing to recover. This demonstrates why large portfolio declines are so detrimental and should be avoided.
A bit more mathematical, for the mathematically inclined
For those that are more mathematically inclined, let’s dig a bit deeper into the portfolio maths.
Let’s assume an initial portfolio value of a – this is your Time 0 value
For any portfolio change (decline or increase) d, where is greater than -1 but less than 1, the portfolio value in the immediately subsequent period (Time 1) will be a x (1 + d)
To get back to the initial portfolio value by Time 2, we’ll need to do something to the Time 1 value to get it back to a (which we stated above was our initial value)
We can simply divide the Time 1 value by (1 + d) to get back to a – that’s [a x (1 + d)]/(1 + d)
Dividing by (1 + d) is the same as multiplying by 1/(1 + d) – that’s the amount, no matter what our initial a is and what the change d ends up being, that we have to multiply the Time 1 portfolio value by
Now, notice that if d is less than 0, 1/(1 + d) will be larger than 1. So, if d is -0.25 (corresponding to a 25% decline in our first example above), then 1/(1 + d) is 1/(1 – 0.25) which is 1/0.75. What’s 1/0.75? It’s 1.3333. That means you’ll need 1.3333 times the Time 1 value – this exactly represents an aprox 33% increase.
Let’s do a 75% decline as in the third example above – now 1/(1 + d) is 1/0.25. That’s equal to 4, which represents a 300% increase over the Time 1 value.
We can see that as d approaches -1 (moving towards a total loss), 1/(1 + d) gets bigger, but by a disproportionate amount.
Can we derive a simple way to see how our 1/(1 + d) factor changes with changes in d? Yes – it’s easy using Calculus:
d/dx[1/(1 + d)] = d/dx[(1 + d)^-1] = [-(1 + d)^-2] x d/dx(1 + d) = [-(1 + d)^-2] x (0 + 1)
so, the derivative is -1/(1 + d)^2
Calculus can be applied to lots of situations to better understand how things change. F
We can see that by squaring the (1 + d) term, we’re increasing the effects of both positive and negative portfolio changes. If d < 0, then squaring (1 + d), which will be less than 1, will only make the factor smaller. By making that factor smaller, the entire factor gets bigger because dividing 1 by smaller and smaller numbers makes the result bigger and bigger.
This should be very discouraging – the numbers tell us that negative effects are magnified when we think about the returns needed to recover.
In Antiquity, Family and Community Provided a Safety Net in Retirement
Throughout most of human history, the idea of retirement as we know it today didn't exist. People simply worked their entire lives either hunting and gather or farming (after the Agricultural Revolution) -- if they were lucky enough to survive into adulthood -- and when they were too old to work, they relied on their families to take care of them. An old person might rely on younger siblings, children, and nieces and nephews within the family or community to take care of them. While doing this they probably still had to do some work - the idea of not working at all is a deeply modern notion and even very old people in ancient times still likely cared for children, did chores around the house, and performed other familial duties (eg. arranging marriages, representing the family to other communities, and advising younger family members).
Although life was incredibly harsh with humans having to face both natural disasters and man-made dangers in the form of banditry, war, pillaging, or abandonment, most human societies operated in a way where the elders and those who were unable to work were taken care of by family. As time moved forward and as humans settle down this was more and more true - while a hunter-gatherer tribe might leave an old person to die, a farming community would likely be able to provide for the elderly because life was calmer and a bit more stable in terms of movement and physical danger.
Obviously, no one in their right mind living in the first-world should want to go back to a hunting and gathering lifestyle and especially a farming lifestyle (as farming was likely worse than hunting and gathering for overall human well-being). However, we can't deny that the family bonds that existed in the past that effectively created an organic safety net for the elderly no longer exists today.
Safety Nets Such as Welfare Provide Retirement Security in a Changed World
As the world moved forward modernized, nations around the world began creating public, centralized welfare systems to take care of those who were too old to work and had to enter a stage of retirement or diminished income-earning capability. In the United States, during Roosevelt's New Deal during the Great Depression, the Social Security system was created - this was a system where old people who were no longer working could receive income from the government (meaning from those who were earning income). In effect, this wealth-transfer mechanism sought to replace the old traditional familial and community retirement safety nets that had long since been eroded over the centuries following the Industrial Revolution.
It is difficult to argue that a safety net for old people who can no longer produce income through their labor and who don't have a large enough retirement nest egg to live on is a prudent idea - it is deeply natural to humanity to take care of one another. The difference is that instead of taking care of each other locally, we started taking care of each other on a grand national scale. This creates its own problems and perverse incentives, but it fundamentally is in line with our human nature. If done in a prudent and conservative way (something that is far from guaranteed), such a retirement safety net can at once benefit the economy through stabilizing things and benefit society through creating a better and healthier moral landscape by taking care of retirees.
Retirement Saftey Nets in Jeopardy - Self-reliance is Key
However, today the Social Security system -- a system that hasn't even been around for a century -- seems to be in jeopardy (it is projected that in 2037 Social Security trust fund reserves will be exhausted and where 100% of payments will no longer be able to be made). A system designed at a time where there were few retirees living into their 60s and 70s compared to the working population is under stress in the world where Baby Boomers are aging rapidly with access to world-class health care that will allow them to live into their 80s and 90s reliably and in good numbers. Many believe this system will not be able to sustain itself. This will be further exacerbated if unemployment increases over the coming decades due tot he rise of artificial intelligence. Young people today should not rely on Social Security to be around when they are old and gray - that is now a foolish proposition.
For young people today, the idea of retirement is different than for almost all past generations. For the first time in history, neither (1) the familial/community structure that effectively provided retirement benefits for the old nor (2) the retirement benefits provided by welfare systems like Social Security is likely to be around when today's young men and women reach retirement age.
So, we're now in a world where the old family and community structure have long since been almost totally wiped out and where the retirement safety net that came in to replace that old structure is itself in peril. We are facing a troubling and dark world when it comes to retirement - we have neither one nor the other, we only have ourselves at this point. Although a fix might occur and things might turn out well, in the end, any prudent person who is under the age of 40 should discount Social Security and only rely on himself/herself to provide in old age and retirement. This requires changes - it requires a discipline that might not have existed in the last century for most of the population in term of saving. Young people must be diligent and disciplined savers and investors if they are going to be able to amass a nest egg large enough to support them through what could be decades of retirement.
This means that saving 5% or 6% in your 401k to get your employer match, putting $5000 a year into an Investment Retirement Account (IRA), or simply having a nice cash cushion in the bank is not even close to enough. Saving rates must far exceed 10% and should approach 25% if young people today are going to be able to comfortably retire. Additionally, effort and energy must be put in to invest the savings in a smart way - saving cash will not be sufficient as growth is going to be needed over time in order to build up a nest egg.
And now, given the rise of cyrptocurrencies and crypto assets to quasi-mainstream financial assets, we're dedicated to providing quality, relevant, and interesting material on cryptocurrencies and cryptoassets. Articles on Bitcoin, Ethereum, Ripple, Cardano, and many more cryptocurrencies and cryptoassets can be found on Pennies and Pounds - all that in addition to a plethora of information on what cryptoassets are, how the entire crypto industry came to be, blockchain/immutable ledger technology, mining, proof of work, proof of stake, and how to prudently invest in crypto if you are so inclined (based on your risk tolerance and ability to withstand the volatility that will come with a crypto portfolio).