How to best allocate scarce resources to get the best return is always a challenge for investors. In turbulent economic times like we're in now, a solid practice would be to have the goal of keeping our money by letting it sit in a safe place, or to tighten up stops to protect from catastrophic losses we aren't in for the long term.
Those are good strategies, but there's a better one in my opinion, evidenced by the response of consumers to the low price of gasoline which has plunged along with oil prices.
Some pundits are blaming U.S. consumers for some of the slowdown of the economy because they decided to do something with their money that surprised them, which was in general, to pay down debt rather than spend it on goods and services.
After following consumer behavior for years and being a financial adviser in the past, it is a pleasant surprise to see people understand the important of reducing debt because of the safety and flexibility it gives with their finances. The same concept is true with investors, who would be able to position themselves for underpriced stocks by taking the defensive measures mentioned above and reducing debt. These actions will result in more capital available to pour into stocks that lost their value from momentum trading as a result of fear, rather than weakening fundamentals.
The simple financial secret U.S. consumers are using
This particular financial practice isn't sexy or get the rush pulling the trigger on buying a new stock, ETF or other investment vehicle, but it probably will do more to move us toward our financial goals than any other thing we do. What is it? The boring practice of paying down debt.
Not only has it caught a lot of the industry and media by surprise, but it's caught me by surprise too. It gives me hope that Americans are finally catching on to the value of living life on a lower debt basis. Unfortunately, it could also mean the individual and family debt loads have climbed so high they're not being given a choice. Either way, if it becomes a long-term discipline, Americans will be a lot better off financially for it. So will investors.
On the financial management and investment side, low debt or no debt provides a cushion for the unexpected crisis life always seems to hand us, and being able to deal with those circumstances from a strong financial position provides a lot of peace of mind because problem we're facing can be our focus rather than the additional challenge of having the money to deal with it.
I'm not saying by this we shouldn't have a stash of cash on hand to deal with things, but when you combine our emergency cash with little or no debt, it's a powerful means of dealing with financial surprises that pop up from time to time.
I literally can't remember the last time I had any long-term debt. Occasionally I will go into short-term debt in order to acquire an item like a computer I use for my means of generating revenue, but my no-debt situation allows me to pay it off in a few months and go back to having no debt.
Not only does this give me peace of mind, but it also provides me with a lot more investment money, which in the end, is what it's all about once we have our defensive measures in place - meaning cash on hand for at least several months if we lose a main income source, along with no or low debt.
If you do have high debt the key is to start doing something to pay it down as quickly as possible. Since it can be a frustrating catch-22 situation, where you have to pay the debt but have little left to build your cash up, it's best to do a little of both so the feeling of despair doesn't come upon you; financial management is both psychological and practical strategies.
Even on the consuming side it offers us a lot. If we have no debt and we need to buy something, we can just pay for it right on the spot and have nothing else to be concerned with. Not only does this not generate more pressure from increased debt, but over time, it helps us to build up a cash base for our investment capital to use to build our long-term positions.
I have a strong cash foundation, no long-term debt, and the ability to invest in whatever I want to at the most opportune times. I don't mean market timing here, but being able to take advantage of a market correction or downward trend that I have no doubt will reverse direction over time.
Another value I get out of being debt-free is it puts in a frame of mind I don't have to panic or make rash decisions if my investments temporarily go south. Even if I lost all of my investment capital, I would still be in a strong financial position I would start to rebuild with.
For those investments I have a position in that aren't convincing as to long-term viability, I do keep my stops very tight and limit the downside. With those I am convinced will do well over the long haul, I keep my existing positions and add to them when they are going through a period of correction.
The point I'm getting at is this is the type of flexibility and opportunities arising from having more capital available because it doesn't have to be allocated to paying down debt.
For that reason, in our current economic environment, I see reducing or eliminating debt as one of the best ways to use our extra capital. Actually, I see that as one of the top uses of our capital in any economic environment, especially if our debt load is very high.
One thing having no debt has also done for me is give me options of paying off certain purchases before the interest rate kicks in. I did that recently with a specific product, which gives me 6 months to pay it off. Having a wide monthly cash cushion to work with, it will be easy for me to pay it off before I have any interest on the item. The combination of these factors provides more capital to work with for the things we want to invest in.
A discipline to use now
Since consumers (which includes investors) are enjoying a low-price oil environment that should last for at least another year, one thing we can do to produce a disciplined approach to this would be to calculate how much we're saving on gasoline, and apply that to our debt. Or as mentioned earlier, if there is a need to create the sense of making some asset growth progress, take some and start building up a cash reserve at the same time debt is being reduced.
This is simple and easy to understand, and once that road is traveled, there is a growing sense of relief and satisfaction progress is being made. Under these conditions financial control is being asserted, along with the sense of taking charge of our lives.
My thought is if a person has the choice of paying down debt or building up cash reserves, paying down debt is the superior strategy. Building up a cash reserve is vital, but if every time a stash is built something comes along that requires the cash to be spent, it's very disempowering. That's why under heavy debt loads, it's better to pay it down and use the gradual savings in payments coming from lowering debt to build a cash reserve. That way even if cash had to be used, at least the debt is shrinking and there is extra cash to use in the near future once a unforeseen crisis arises.
If there is a cash reserve on hand but large debt, then an investor can use the extra capital to add to positions or open up a new position in whatever investment vehicle being targeted to build wealth and eventually provide for retirement.
When considering the best use of available capital, how much debt and the interest being paid on it is important to evaluate. Some store cards can ask for almost 30 percent interest, and we all know the various interest rates asked for by credit cards.
With gas costing less, with the result of releasing more capital to consumers and investors, it is a terrific time to take inventory of our financial strategies and consider paying down debt as the best option for our extra capital at this time. Not only does it reduce or eliminate catastrophic risk, but it further releases capital for other uses as the debt is paid down.
The goal of investing is to provide a solid financial position for the rest of our lives. Thinking in terms of reducing or eliminating debt is just as valid and important as taking a position in a stock or other security.
I think under these market conditions and having possibly a once-in-a-lifetime reduction in gas prices for a prolonged season of time, there is an opportunity to strengthen our personal financial position and prepare for a future that provides a lot of opportunities to boost investments because we have access to more capital on a consistent basis because it's not all being drained by a huge debt load.
We may not get close to a better return than paying down high-interest debt.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.