My Coping Mechanism: Cash

In this second of a series on coping with a plunging stock market, Kiplinger's Personal Finance Senior Editor Bob Frick urges you to build up your reserves -- even if it means investing less to do so.

The last straw for me during the Crash of 2008 came when I bumped into a friend who works for the Federal Reserve Bank. We shook hands, and he asked me with a little smile and a massive slice of irony, "Time to buy?" With that bit of gallows humor, I finally had to admit to myself that we have gone from the subprime to the ridiculous.

The Crash, which chopped 18% off of the Dow Jones industrials during the trading week that began October 6, is serious business, and I have what I think is a good investment plan for coping with it. My strategy is simple: Strengthen your credit first. Specifically, pay down your debts and build up your cash reserves, and do it quickly.

If that means slowing contributions to your 401(k) to build a fat cash cushion, so be it. How fat? Given the uncertainty, six months' worth is a minimum, and a year wouldn't be a bad idea. And if your credit and cash situation is already shipshape, keep following your investing program.

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The sad fact is that we've all been swept up in a speculative bubble. Savings rates are way down and household debt is way up. Princeton economist Robert Shiller, who recognized the tech bubble in his 2000 book Irrational Exuberance, puts it simply in his latest book, The Subprime Solution: "In a climate of excessive optimism, people tend to take full advantage of a strong economy instead of protecting themselves from the possibility of a major correction -- an eventuality that seems to them utterly remote."

We -- myself included -- have forgotten that maintaining a reserve fund and holding down debt come before investing in the market. Based on the numbers and recent interviews with financial planners, I know Shiller's statement is right on the money.

Why is a strong personal balance sheet so important now? Those who have one will be able to get credit more easily and cheaply. That's always been the case, but it will be especially true in the coming years as lenders make it harder for Americans to get home-equity lines, car loans, credit cards, you name it.

More importantly, the credit bubble has burst, and the "great unwinding" has begun. Assets from stocks to homes to capital goods are becoming worth much less now that the credit binge that puffed up their prices has ended. Unemployment could soar, consumer spending could plummet and our standards of living could suffer. And that pile of cash and lack of debt may come in handy.

The cash strategy became clearer when I edited Live Debt Free, the November cover story for Kiplinger's Personal Finance magazine. Its theme is that middle-class people who thought they had their finances in order were blindsided by problems such as unemployment, divorce and housing issues. They sure wish they'd kept more cash on hand.

Here are two other reasons I think keeping cash high and debt low are so important now:

First is psychology. A strong cash position acts as a financial Valium and calms our nerves. And in times of financial stress, we need clear heads.

In particular, the pain of losing money, and the desire to get back what we've lost, makes long shots seem like good bets. If you're sitting on the sidelines just waiting to jump in and invest when you think things can't get any worse, now you are timing the market. Do you really think the market has bottomed, or are you just wishing it were so? In any case, market timing is a loser's game.

At the other extreme, we may go into avoidance mode. This means we ignore our investments and avoid doing such crucial things as rebalancing our portfolios and taking advantage of exciting opportunities. For example, a friend of mine was so distraught after the tech bubble burst that he essentially ignored his portfolio and kept his investments mainly in a fund that tracks Standard & Poor's 500-stock index. But for most of the period since 2000, we've seen great gains in real estate investment trusts, small-company value stocks and overseas stocks. My friend missed all of these.

By having a fat cash cushion, we will sleep better at night and not be so stressed that we succumb to head games when the markets go nuts. Planners have told me that the clients they have to calm most are the ones who have insisted on very aggressive portfolios that are low on cash and bonds. They have fallen into the trap of overconfidence Shiller warns against, and they realize now that they need more balance.

The other reason for my high-cash/low-debt strategy: This ain't your average bear market. Last spring, I profiled David Tice and his Prudent Bear fund, which is designed to rise in value when stocks fall. I met Tice at his Dallas office for two days' worth of horrific doom-and-gloom credit-bubble predictions. So far, I'm sorry to say, this market mess has played out pretty much as he predicted. I spoke with Tice a couple of weeks ago and asked what he recommend investors do.

"Buy gold," he said.

"What do you mean? Gold stocks? A gold mutual fund? A gold exchange-traded fund?" I asked.

"No, coins," was his ominous reply.

Yikes. I don't believe the U.S. is on the verge of collapse, as Tice's advice seems to imply. And I certainly don't suggest that you run out and buy gold coins (and keep them in a spanking-new safe bolted to your basement floor and surrounded by an electric fence). But there is a possibility -- not a probability -- that Tice's best case scenario is correct and that the current recession could be long and deep. (To get an idea of what a prolonged bear market feels like, see Diary of a Bear Market a story I wrote in 1997 on the tenth anniversary of the 1987 crash.)

And if you feel that by saving more and avoiding investing more in the market you're somehow not doing your patriotic duty, I would beg to differ. Peter Schiff, president of Euro Pacific Capital and author of the Little Book of Bull Moves in Bear Markets, put it this way: "Barney Frank, chairman of the House Financial Services Committee, said, 'We have to prop up consumption.' He has it backward. The government has been propping up consumption for far too long, and the best thing it can do now is remove the props so spending can be replaced by savings." That will provide banks capital they need for more lending and help loosen credit for consumers and businesses.

When the recovery comes, your carefully tended portfolio will rocket up. (And don't be fooled by spikes -- as Tice told me, "There will be ferocious rallies on the way down.") You may spend a day wishing you'd put that cash cushion in the market sooner, but that's a small price to pay for the security and peace of mind it will have brought you.

Bob Frick
Senior Editor, Kiplinger's Personal Finance