I wanted to take a minute to write about why having a financial reserve is important.
Levered Income is about creating and managing multiple income streams. It is about creating different income levers and pulling those levers to generate income and cash flow. The reason for the income stream diversification is to protect against one business going wrong, or losing money without affecting your main business, which is you.
When you work for one company and get one salary, and that is your primary source of income, your income streams are not diversified, and it is a precarious proposition. What if you lose your job? What if your employer goes bankrupt? That single income stream is gone, and you have nothing else to keep your cash flow coming in.
Why Having a Financial Reserve is Important – The 100 Year Event
In the COVID-19 pandemic, a once in the 100-year event (Spanish Flu was in 1918), every type of business has been affected. Even people who have diversified income streams have seen all of their income streams affected.
If you’re a dividend investor and you have created an income stream of dividends with investments in multiple companies, you’ve seen these dividends reduced or even eliminated. It might be a temporary thing, but still, it affects your current cash flow.
If you started a small business running an Airbnb, governmental agencies might have shut you down and stopped you from renting, forcing you to cancel reservations. Also, by not having a comprehensive overall plan and changing the rules weekly, these governmental agencies have brought your rental business to a standstill.
If you’re an oil investor, the oil price wars and lack of demand due to COVID have wiped you out, especially if you have been investing in high-cost oil production areas (Permian Basin, for example). Not only are your wells shut-in, but you’re also probably paying to maintain those oil wells.
Long-term property renters have tenants now that can’t pay the rent because they’ve lost their jobs. If you are a landlord, you are prohibited from evicting tenants in some instances, but you still have to pay your mortgage to your lender. If you hold triple net lease property and your commercial tenants are closed by government order, they have no income and can’t pay their rents either. But, you’re still on the hook to pay your lender.
Some businesses have seen business explode during the pandemic. Some of our favorite online, digitally-based businesses such as Affiliate Marketing, SaaS solutions, e-commerce, and all of the associated support businesses (such as digital marketing) are examples of digital businesses exploding in growth.
Overall, if you look past the Amazons and Apples and larger technology companies that are doing well, other businesses, the economy, and especially the consumer have been wrecked by the pandemic. Subsequently, most of your Income Levers have all been “broken” or at least “cracked.”
How do you deal with a 100-year Event?
Experiencing a 100-year event is where having financial reserves comes into play. A financial reserve gives you the flexibility to weather downturns in your business. So how are people approaching the economic destruction of the pandemic?
What individuals are doing.
An individual version of “financial reserves” is sometimes called an “emergency fund” or “rainy day fund”.
Typically, individual consumers don’t plan for the future. According to Bankrate, 28% of US adults have no emergency savings, and 25% have a reserve fund that doesn’t even cover three months of living expenses.
Interestingly there’ve been many articles about how the American consumers have saved (or paid off debt) with their Government stimulus checks, versus spending it. Of course, this is bad for businesses that are designed to extract all the money out of the American consumer that they can (think retailers). Still, it shows an exciting shift to having a financial reserve versus debt spending.
What large companies are doing.
Large companies have credit lines on which to draw down, to help them get through tough times in business. Since the start of the pandemic, you have seen these companies:
• increasing their cash position by drawing down their credit lines down to zero,
• reducing or eliminating dividends,
• selling more stock,
• and issuing bonds to the credit markets,
all to get the liquidity to carry them through what they see as a longer, slower economic recovery.
As an owner of some of these larger companies (via stock investing), I view this as a very smart move. The goal is to protect that future income stream and to protect that business. If this is a short-term catastrophic effect and doesn’t impair the long-term future of business, “short term pain is long term gain.” I view temporary dividend reductions or suspensions as something necessary for business survival and future growth.
What I am doing.
I take the Warren Buffett approach and keep a healthy financial reserve (relative to my situation – I don’t have 120 billion in cash like Berkshire Hathaway), and also retain “dry powder” for opportunities that pop up in economic downturns.
It is challenging to carry $50,000 a month in overhead and salaries when the business is not bringing in any revenue (been there and done that). A strong business cash position can deteriorate quite quickly when the revenue spigot is turned completely off. Because of this, I have been focused on moving to lower “carry cost” businesses (low-employee, automated businesses) and to online businesses like Affiliate Marketing, online services (Digital Marketing), and SaaS builds. I also keep an eye out for other business opportunities, both in the public and private markets.
Why Having a Financial Reserve is Important –
What Are Your Goals?
Keeping a large cash position is typically viewed by the investing community as reducing your rate of return (cash is paying almost zero interest). However, I view it as a question of personal goals.
• Are you a money manager, paid to extract the last percentage from the assets under your management?
• Are you trying to make a short-term profit on a trend?
• Are you developing businesses to create multiple streams of income for the long-term?
• What do you want your businesses and other investments to do for you?
My number one goal is to not be affected by gyrations in markets, governments, pandemics, civil unrest, interest rates, inflation, etc.
How do you do this?
Keep a financial reserve. That is why having one is essential to me.
How Much Should I Keep in Financial Reserve?
The amount varies from person-to-person and business-to-business.
My approach is to look at the length of previous downturns as a starting point, knowing that every recession is different.
Looking at the modern era, The Great Depression was three years and seven months, and the Great Recession was one year and six months. There were some shorter recessions (the 1980 recession was the shortest at only six months).
The average duration of the 13 economic downturns since the Great Depression (and including the Great Depression) is 13.29 months.
28% of all Americans have no financial reserve at all, and 25% that do have a financial reserve has less than a 3-month reserve. In other words, over half of Americans do not have a financial reserve large enough to get them halfway through the shortest recession, or a quarter of the way through an average recession.
Also, consider that the Great Depression was AFTER the Spanish Flu pandemic of 1918, and plan accordingly.
These statistics should give you a starting point on why having a financial reserve is essential, and in determining the reserve amount that fits your situation.
Warren Buffett’s 120 billion dollar cash reserve will last longer than three years and seven months; how much do you think YOU will need to feel comfortable?
Let me know in the comment section.