3 questions to ask yourself before the next financial crisis

By Brian Tycangco

No one's ever ready for a crisis… even if everyone knows that "it's time".

In 2008, bankruptcy filings in the U.S. jumped 31 percent to 1.1 million. There were 3.1 million home foreclosure filings. Household wealth declined almost US$17 trillion from in mid-2007 to early 2009.

Is a crisis around the corner now? I have no idea. But the world's biggest stock market is in the midst of an epic bull run that history suggests has to end soon.

With the S&P 500 at record highs and stock market valuations at their second highest level in recorded history… it's a good time to see if you're ready for next time when "it's time".

A three-way test for your portfolio

Being ready for a financial crisis isn't complicated. Start by asking three simple questions.

Are you diversified? Holding a small number of assets allows you to reap outsized gains relative to the overall market when the sector or asset you are heavily invested in does well. But this exposes you to heavier than normal losses when the market turns against you.

One of the biggest mistakes investors made during the previous financial crisis was having too much exposure to just a few investments, namely real estate and financial stocks (which lost more than 80 percent from October 9, 2007 to March 9, 2009 – the peak to trough of the crisis).

Those who also invested in defensive sectors like consumer staples, health care and utilities mitigated their losses as these sectors outperformed the rest of the market. And those who also diversified into precious metals and government bonds and Treasuries (safe havens during financial turmoil) were spared from the brunt of the declines in stocks and real estate.

We've written previously about the importance of diversification (here, here and here). So if you have the majority of your assets allocated to one particular type of investment, it's time to rethink your holdings.

Are you financially liquid? Being financially liquid means having enough easily disposable assets to pay for your day-to-day expenses and any potential emergency situations that may arise.

This includes holding cash (the most liquid of all assets), having money in the bank and assets that can be easily sold, like shares, government bonds (i.e. U.S. Treasuries), mutual funds and money-market funds.

If needed, any of these assets can almost always be sold almost immediately at or near face-value. That's an important quality to have during a financial crisis.

Being financially liquid increases the likelihood you'll be able to maintain your lifestyle and pay the bills without having to dispose of assets at below-market prices (although if you don't sell soon enough, the market value might decline sharply, and quickly).

More importantly, being financially liquid lets you take advantage of once-in-a-lifetime opportunities that might emerge as a crisis unfolds.

But how much financial liquidity do you need? The short answer is: it varies.

How much you need in liquid assets depends on your spending habits and existing financial commitments.

For example, let's say David has a net worth of US$500,000 but also has a mortgage, car loan, credit card debt and living expenses of US$15,000 per month. He'd do well to have at least six months of expenses (US$90,000) in liquid assets.

Meanwhile, John has a net worth of US$1 million, owns his house, doesn't drive a car or use a credit card and spends just US$2,000 per month. John needs just US$12,000 (six months of expenses) in liquid assets.

So your net worth doesn't dictate how much financial liquidity you need. People who are less wealthy can have higher liquidity needs than people who have more.

Do you have too much debt? In rising markets, leverage – that is, borrowing – can vastly increase your wealth-creating potential. But it can also work horribly against you in weak markets – and especially during financial crises.

For example, just before the housing bubble burst in 2008, it wasn't unusual for people to have two or three mortgages on different properties – despite holding relatively low-paying jobs and having no savings. When the crisis came many of these people had no way to make their mortgage payments when they lost their jobs.

It's also important to watch margin debt – the practice of buying shares in listed companies using borrowed money.

With margin debt, an investor usually offers up owned stock as collateral. But when the market falls, margin debt will almost always be sold (even at a loss), and so will the collateral to make up for the difference. This is not something you want to have when the next crisis hits.

In short, make sure your portfolio is ready for whatever's coming by asking yourself these three questions today.

 

Brian Tycangco
Brian Tycangco is an Editor and Investment Analyst with Stansberry Churchouse Research, an independent investment research company based in Singapore and Hong Kong that delivers investment insight on Asia and around the world. He's been working in the financial world since 1995 and has carved out a reputation as "Master Stock Picker". He's seen just about everything there is to see in these markets, met with the leading CEOs of every industry in Asia, and knows the ins and outs of doing business and making money there. Brian has been a stock broker at a large Asian trading house, an equities analyst for a major European investment bank, as well as editor and chief investment strategist for one of the longest-running Asian investment newsletters in the world. Click here to sign up to receive the Asia Wealth Investment Daily in your inbox every day, for free.

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