The COVID-19 public health crisis has taught us several important financial lessons. This pandemic has highlighted the importance of having cash reserves, the risks of borrowing to invest, and the unpredictable nature of financial markets. We can better prepare for future economic challenges by learning from these lessons.
One key lesson from the COVID-19 experience is the necessity of having cash reserves. While it may be difficult for many to maintain a six-month emergency fund, aiming to keep 10% of your net worth in cash is a more achievable goal. For example, if you have $10,000 in liquid assets, it’s wise to keep $1,000 in cash. Similarly, with $100,000 in assets, having $10,000 in cash is wise. For those with $1 million in investable assets, excluding the primary residence, $100,000 in cash is advisable. This strategy helps avoid the need to sell investments at a loss during economic downturns, providing a financial guard to cover essential expenses. History shows that significant economic disruptions occur roughly every decade, reinforcing the need to be prepared. Acceptable cash reserves can turn market downturns into opportunities to buy undervalued assets.
Another critical lesson, demonstrated in past financial crises, is the danger of borrowing to invest. Using margin in investment accounts, essentially borrowing money from a broker to purchase securities, is risky.
When banks issue margin calls (a demand for additional funds or securities), investors are often forced to sell their holdings at significant losses. Without margin leverage, investors can hold their positions through downturns and wait for the market to recover. During the COVID-19 crash, many investors using margin had to liquidate their portfolios at significant losses, highlighting the risks of borrowing to invest.
The COVID-19 pandemic has also emphasized the unpredictability of financial markets. While markets generally rise more often than they fall, downturns are inevitable, and their timing and causes are often unpredictable. The sudden stop of the global economy in early 2020 due to the pandemic caused even traditionally "safe" investments to drop significantly. Preferred shares, municipal bonds, and Real Estate Investment Trusts (REITs), which are typically less affected in recessions, experienced significant value losses. This crisis demonstrated that all investments could lose value, emphasizing the importance of maintaining a balanced portfolio.
Balancing a portfolio involves managing the proportion of cash and investments:
Holding too much cash can reduce long-term growth potential.
Acceptable cash reserves provide security during downturns.
Diversification across different investment types can reduce risk.
Annuities can be suitable for part of one’s portfolio, as they transfer investment risk to the insurance company. However, they come with reduced flexibility.
In summary, the COVID-19 pandemic has underscored the importance of financial preparedness. To weather future crises, it is essential to maintain cash reserves, minimize debt, and recognize the unpredictability of markets. When faced with portfolio declines, the best course of action is often to do nothing or, if possible, to add to investments at lower prices. Striking a balance between stocks for long-term growth and cash for near-term needs is crucial for financial strength.
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