Risky Business

It’s been a strange year. So, what’s next?

November 19, 2020 | Insight

AbsolutVision

It’s been a strange year for investors so far. Strong markets after the New Year were followed by a precipitous drop on COVID fears in February and March which was then followed by a confident recovery to new highs by August. The anticipated second wave of COVID infections seems to now be upon us and the spring and summer market enthusiasm has waned somewhat. So, what’s next?

There are lots of risks that could be realized in the coming months. Will there be a second downturn to rival the first quarter plunge? Will inflation begin to return as governments continue to print money at an unprecedented rate? Will the economy fall into a prolonged recession with the resultant high unemployment and reduced business activity? Or worse, could there be a return to the “Stagflation” of the 1970s featuring a stagnant economy combined with high inflation?

Our intent in stating these risks is not to heighten your stress levels but rather to make the point that even in uncertain times, there are certain truths that underlie the management of one’s wealth. The first thing to realize is that all of the stated risks have happened before and will happen again at some point, often with little or no warning. Trying to guess if or when these might occur is a losing proposition. Our objective is not to try to avoid the immediate consequences of a market downturn or recession or inflation but rather to try and ensure that whatever the immediate impact is, it will be temporary and that our clients’ wealth will not be permanently impaired.

A second truth is that there is a difference between wealth and money. Although the terms are often used interchangeably, they are not the same. Money is simply a medium of exchange and has no value by itself. Wealth on the other hand, is made up of productive assets that are capable of producing more wealth. An easy way to think of this is that owning a few baskets of apples would represent having money since you could trade them for something else but owning an apple tree (or an orchard) would represent having wealth since it will continue to produce more apples year after year. Now, substitute a bag of hundred-dollar bills for the apple basket and a portfolio of successful businesses for the orchard and you’ll get the point.

While the price of any productive asset will fluctuate, sometimes significantly, the price of productive, well-managed and well-financed businesses will recover from a downturn eventually. Such businesses should be able to produce a return well in excess of the rate of inflation over time and will often have the ability to raise prices in order to maintain productivity, even in inflationary times. For that reason, negative price fluctuations for shares of successful businesses tend to be temporary rather than permanent. The temporary loss can become permanent however, if shares are sold at the temporarily lower price. A permanent loss can also be achieved by paying more than the shares of a successful business are worth. The “loss” is the excess amount of price paid and is reflected in the lower or possibly negative return on investment over the period of its ownership.

On the other hand, the purchasing power of inflation-depreciated money is permanently lost. Our preference therefore is to invest that portion of a client’s portfolio that is in excess of near-term spending needs in shares of productive businesses. There are times however (and we’ve been in one for a while), when we are stuck between overpaying for a good company or leaving funds in cash. In those times we will choose cash. Even though cash is depreciating from inflation, it is currently a slow process. Until the cash is deployed, we enjoy a low-cost option to buy any company at the price of our choosing at any time.