The first rule of compounding is to never interrupt it unnecessarily
Charlie Munger
When I look back at my investing career, with everything life has thrown at me, I’ve realized that one of the key reason for my investing performance so far has been something so basic – keep extra cash in the bank.
Wanted to buy a new car and had to make the downpayment- No extra cash, sell some stock to fund the downpayment.
Annual vacation – again sell some stock to generate some cash.
Everytime I promised myself – that I would replenish those stocks asap – reality check – never did so.
I was always fully invested. So whenever there was a need for extra cash, I was always dipping back into my portfolio and unnecessary tinkering with it. I never built up enough cash resources or an emergency fund.
I’ve been through 3 important significant downturns in the equity markets. Dotcom crash – I was to young with very little investible surplus, however subsequent couple of events, both times I was lucky enough and gutsy enough to invest in the markets. I had learnt my lessons well from the great books – be greedy when every one is fearful
While many of stocks in my portfolio turned multibaggers, my inability to hold on to them just because I needed cash – has been the biggest downfall in my investing career so far.
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The Psychology of Money
I recently read this fantastic book by Morgan Housel – “The Psychology of money”. Throughout the book, there was one recurring theme that resounded with me very deeply. That was about ensuring that we don’t interrupt the compounding engine unnecessary and plan for things to go wrong.
I want to read and re-read these few paragraphs from this book -till they create an indelible impression on my mind.
More than I want big returns, I want to be financially unbreakable. And If I’m unbreakable I actually think I’ll get the biggest returns, because I’ll be able to stick around long enough for compounding to work wonders.
No one wants to hold cash during a bull market. They want to own assets that go up a lot. You look and feel conservative holding cash during a bull market, because you become acutely aware of how much return you’re giving up by not owning the good stuff. Say cash earns 1% and stock return 10% a year. That 9% gap will gnaw at you every day.
But if that cash prevents you from having to sell your stocks during a bear market, the actual return you earned on that cash is not 1% a year – it could be many multiples of that, because preventing one desperate , ill-timed stock sale can do more for your lifetime returns than picking dozens of bi0time winners.
Compounding doesn’t rely on earning big returns. Merely good returns sustained uninterrupted for the longest period of time- especially in times of chaos and havoc – will always win.
The Psychology of Money – Morgan Housel
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Second Order Thinking
This is classic – System 2 thinking or Second Order Thinking as Daniel Kahneman noted in his seminal book – “Thinking Fast and Slow”
I have been a victim of First order thinking while not wanting to hold cash – as it gave such minimal returns.
I did not get to the Second order thinking on the lines that holding cash enabled me to meet all of life’s other small and large emergencies and left my equity portfolio untouched and compounding at a healthy pace.
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Lessons learnt
I’m in the process of building a large enough fund, something that I still feel uncomfortable about. Seeing that level of cash sitting idle in my savings bank account still makes me so uneasy. Hence I am writing this post as a reminder as to why I am doing this.
Morgan himself keeps close to 20% of his assets in cash outside the value of his home. He himself admitted that it’s a very high threshold and he doesn’t recommend it to all. I don’t think I may get to 20% ever as I don’t think I’m mentally wired that way although it was be interesting to get close to that and see how it feels.
The follow excerpt from the book tells you Morgan’s reasons for doing so
“We do it because cash is the oxygen of independence, and- more importantly – we never want to be forced to sell the stocks we own. We want the probability of facing a huge expense and needing to liquidate stocks to cover it to be as close to zero as possible. Perhaps we just have a lower risk tolerance than others.”
The Psychology of Money – Morgan Housel
So what percentage of your assets are in cash? Would love to hear about it in the comments.
Signing off now to add some more fund to the cash account.
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