Ultima Financial Planners - News

In these unprecedented volatile and uncertain financial times we often hear people say that they wished that they had rather invested in a risk-free investment, often alluding to money market funds as being risk free. The sad news is that “….there is no risk-free[1] investment.”

If we forget about the equity market for a minute and focus our attention on money market funds, I will look at the risks money market funds are exposed to:

1. Negative real interest rates
2. Credit risk
3. Liquidity risk

Negative real interest rates

This equates to the decline of purchasing power. If the rate of inflation exceeds after–tax interest rates, then the spending power of your capital in a money market fund will decline over time. This will happen even if you choose to reinvest your after-tax income. You might well say that you prefer to go backwards slowly and predictably rather than very abruptly as happened to equity markets in 2008. However, most investors probably do not want their capital to go backwards indefinitely.

When in trouble to meet their obligations, Governments around the globe might resort to printing money indiscriminately or engineer negative real interest rates. We would then end up being like Zimbabwe. If you had invested your money in an Zimbabwean money market you still would have had all your capital intact but unfortunately it would be worthless in terms of purchasing power.

Credit risk

Money markets invest in debt instruments or ‘IOUs’ which oblige the issuer of the IOU to repay a fixed money amount on a specified date within the next year. If the issuer were to go ‘bankrupt’ and default (in other words not being able to pay the full amount when it is due) the fund and the investors would bear a loss.

One way money market funds try to address credit risk is to invest the fund in a diversified portfolio of debt instruments issued by a range of issuers. This is done so that any potential losses arising from the default of any one issuer will be constrained to a limited portion of the fund’s portfolio.

The benefits of diversification will be tempered if the default of one issuer sets off further defaults by other issuers in a domino-effect crisis, as we saw happened globally in 2008. In the event of a systemic crisis like this, governments around the world have typically stepped in to shore up and stabilise the financial system.

Liquidity risk

Extreme circumstances can heighten liquidity risks. In most circumstances investors in money market funds can give one day’s notice of their intent to withdraw all their funds. All capital invested in a money market fund is not invested on a call deposit as the managers think it is unlikely that all the fund investors would suddenly want to withdraw all their funds on the same day.

By investing in longer dated paper fund managers can improve the yield earned by the fund and the investors.

Very importantly; in extreme circumstances (such as were experienced in the US money markets in 2008), withdrawals can be unexpectedly large, and this may force money market fund managers to sell its longer dated paper in order to fund the withdrawals. If this paper is sold at a loss (as there may be other money market funds all trying to sell the same paper at the same time), then that loss will be borne by the money market fund and the investors.

26 October 2008

I believe we are going through some of the toughest times experienced the past 80 years. Unprecedented volatility is experienced every day on the markets. Unlike previous down markets, this time the whole world is in turmoil. Many of us will definitely feel the urge to jump ship to what we believe is safer asset classes such as bonds and cash. I believe this would not be the correct strategy as the long term prognosis for equities is still good. I came upon a recent article written by Warren Buffett which I think will benefit all of us while we go through these trying times.

The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

Why?

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

You might think it would have been impossible for an investor to lose money during a century marked by such an extraordinary gain. But some investors did. The hapless ones bought stocks only when they felt comfort in doing so and then proceeded to sell when the headlines made them queasy.

Today people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value. Indeed, the policies that government will follow in its efforts to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities.

Warren E. Buffett is the chief executive of Berkshire Hathaway, a diversified holding company.