While I do not follow much of the advice that CNBC's Jim Cramer offers, there is one nugget of wisdom that he has offered to investors that I think is spot on: "You should never put any money into the stock market that you may need within the next five years." You have to have an emergency fund. That's the backbone of everything. I can think of very few ways to destroy years and years of hard work faster than experiencing a liquidity crisis at the worst possible time.
It usually takes a lot to tick me off. But this scenario would frustrate me immensely: Knowing that stocks were getting cheaper and cheaper during 2008 and 2009 but having to sell stocks to meet short-term needs. Not only would that destroy wealth, but it would take an emotional toll as well.
I've heard from some investors that are new to investing and looking to get started. They have "the itch," so to speak. I've heard many of them say something to the effect of "I'll just buy the low beta blue-chip stocks that you usually write about, and I'll be fine."
Please don't think like that. Very few people in 2007 predicted the kind of price declines that we saw during 2008 and 2009. Even though I think companies like Coca-Cola (NYSE:KO) and Johnson & Johnson (NYSE:JNJ) are excellent, there is no telling how fast stock prices can fall when investors get in a fearful mood. Even if the operational results of a business remain excellent and promising over the long term, this does you no good if you have to sell and the other stock market participants do not recognize the full value of your stock at that time.
If you had to sell a blue-chip stock in 2008 or 2009, the results would have been nasty:
ConocoPhillips (NYSE:COP) fell from a high of $90 in 2007 to a low of $34 in 2009.
Procter & Gamble (NYSE:PG) fell from a high of $75 in 2007 to a low of $44 in 2009 (or slightly below $40 in 2010 if you want to include the flash crash).
3M (NYSE:MMM) fell from $97 in 2007 to $41 in 2009.
IBM (NYSE:IBM) fell from $130 to $70 all in 2008.
Reynolds American (NYSE:RAI) fell from $36 in 2008 to $16 in 2009.
General Electric (NYSE:GE) fell from over $38 in 2008 to under $6 in 2009.
PepsiCo (NYSE:PEP) fell from a few cents below $80 in 2008 to a low of $44 in 2009.
Chevron (NYSE:CVX) fell from $104 in early 2008 to $55.50 in late 2008.
Even Coca-Cola fell from $32 in 2008 to $19 in 2009.
Johnson & Johnson fell from $72 in 2008 to $47 in 2009.
This is what you are exposed to. This is what a realistic worst case scenario looks like. Even though these companies are all excellent businesses with great historical records of churning out profits, you cannot always count on others to recognize this. Heck, even Berkshire Hathaway (NYSE:BRK.B) has fallen by at least 50% on four separate occasions since Buffett and Munger took over. This is why you need a buffer.
The first key to successful investing is the easiest one to dismiss: you must have a cash buffer in place that allows you to make investing decisions solely in regard to fundamentals and opportunities. To the best of your ability, you want to prevent external factors from messing up your investing strategy. Sure, there are some unavoidable situations where "life happens" and you have to sell stocks at inopportune times. But I hope you reduce that risk as much as you can. In the world of investing, almost nothing is worse than having to sell a stock at a time you don't want to. Take active and preventative steps to keep yourself out of that situation.
In his 2010 Letter To Shareholders, Warren Buffett told the story of how his grandpa Ernest prized liquidity. When Ernest passed away and Warren was the executor of the estate, he came across a letter that Ernest wrote to his son Fred (this would be Warren's uncle):
Dear Fred & Catherine,
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 money that was necessary to have at that time. For a good many years your grandfather kept a certain amount of money where he could put his hands on it in very short notice.
For a number of years I have made it a point to keep a reserve, should some occasion come where I would need money quickly, without disturbing the money that I have in my business. There have been a couple of occasions when I found it very convenient to go to this fund. Thus, I feel that everyone should have a reserve. I hope it never happens to you, but the chances are that some day you will need money, and need it badly, and with this thought in view, I started a fund by placing $200 in an envelope, with your name on it, when you were married. Each year I added something to it, until there is now $1000 in the fund.
It is my wish that you place this envelope in your safety deposit box, and keep it for the purpose that it was created for. Should the time come when you need part [of it], I would suggest you use that you use as little as possible, and replace it as soon as possible. You might feel that this should be invested and bring you an income. Forget it - the mental satisfaction of having $1000 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 could not realize quickly…
I consider that passage brilliant. I've probably read it a dozen times since I first came across it in the 2010 Letter to Shareholders. It rarely gets mentioned, but liquidity is the most important thing about investing. It's easy to ignore because it is so boring and seemingly uninspiring. No one wants to spend hours of their labor toiling away for money whose intended function is that it will never be used (and, in fact, it will slowly rot away due to the effects of inflation as time passes). There are so many temptations that can entice an investor into lowering his liquidity threshold. Don't do it.
A lot of investors may think, "…but yeah, General Mills (NYSE:GIS) usually isn't that volatile. I'll be fine." The problem with that line of thinking is the fact that stock market investors in 2007 probably thought the exact same thing. Preparation for success cannot be compromised. Running a marathon is not the only thing that is important. You also have to train well and diet right in the days before the race. Likewise, investing itself is not the only thing that is important. You also have to focus on structuring your life in such a way that you will encounter minimal interferences with your investing.
It's hard to get excited about liquidity. But in many ways, cash has to be your first investment. You gotta set some money aside, and hopefully, you'll never need it. Yes, it will slowly rot away with time due to inflation, and you'll have to gradually add cash to your emergency fund over time for it to maintain the same amount of purchasing power. It's not particularly inspiring. But this is why Benjamin Franklin said things like, "An ounce of prevention is worth a pound of cure." The pain of setting aside cash today is nowhere near the pain of having to sell during a stock market low.