Thursday, August 27, 2015

The Dilemma Created when Short Term money is invested in Long Term Investments

Many years ago, Warren Buffett told a story about “Mr. Market” being this wild and crazy business partner who suffered from bi-polar disease. The story was originally told by Benjamin Graham. I shared it with clients most recently in 2011.

“Mr. Market, is an obliging fellow who suffers from a severe case of bi-polar disorder. He turns up every day at the share holder's door offering to buy or sell his shares at a different price. Often, the price quoted by Mr. Market seems plausible, but sometimes it is ridiculous. Sometimes Mr. Market is wildly overly optimistic and is willing to pay a very high price. Other times, Mr. Market is in such a depressed state that he is convinced that the future is hopeless and that the value of your shares are ridiculously low. The investor is free to either agree with his quoted price and trade with him, or ignore him completely. Mr. Market doesn't mind this, and will be back the following day to quote another price. As an investor, you need to be confident enough in the value of your investments to be able to take advantage of Mr. Market rather than being affected by his disease.”

Given the recent market downturn, I thought a slightly different take on the concept might be useful.

Let’s assume you have $250,000 cash. Not wanting to bury it in the backyard or hide it under your mattress, let’s assume you have two “rational” choices.  Option A: You could put the money into a bank account and earn 1% per year interest, guaranteed by the government. Option B: You could buy a 50% interest in an office building as a Limited Partner.  The General Partner of the office building agrees to pay you a portion of the rental profits, if any. The General Partner also agrees to buy you out at any time you ask him to, but he gets to set the price. He agrees to quote you a “buy out price” or BOP on a daily basis.

You choose Option B and give the General Partner your $250,000. For the first few months, the General Partner sets the daily BOP at $255,000 each day. After the first three months, he even sends you a “rental profits dividend” of $625.00. You are told that you can expect $625.00 every three months.  You feel like you made a really good investment.

After a year or so, the General Partner begins raising the BOP.  Rental profits are rising. He offers you a BOP of $300,000. You think about it and decide to keep the investment since it is “doing really well”.

Several months later, the BOP offered each day begins to slip. The BOP declines to $285,000. The economy is slowing and it appears that a lot of new construction has flooded the market with new office space. Then something really bad happens. The largest tenant does not renew their lease and the office building is suddenly only 50% occupied. The General Partner claims to be unable to find any new tenants and the BOP falls to $240,000. You are afraid that the BOP might fall even further.  To make matters worse, the “rental profits dividend” is cut to $200.00 every three months.

What to do?

The problem for most people who are presented with this dilemma is the “right” answer is unknowable because the future is uncertain. It also depends on the financial situation of the person as well as all the “other” investments, if any, that the person owns.

History teaches that over time, it is reasonably probable that new tenants will be found, causing the “rental profits dividend” and the BOP to recover and rise over time.  It would be reasonable to assume that over a 10-15 year period, the value of the property would rise at least by the amount of inflation, and that the “rental profits dividend” would likely be about the same as the interest that would have been earned if the $250,000 had been deposited in the bank. (In other words, it might be best to just “wait” and hold on.)

A large dilemma exists for those who needed that $625.00 “rental profits dividend” to cover their living expenses. (Only a portion of that income should have been “counted on”.) An even bigger dilemma exists for those who figured that whenever they needed money, they could accept the BOP, sell out and use the money to cover their living expenses.
In other words a big problem here is when people assume that income from their long term investments will provide steady and consistent income in the short term. And, a bigger problem here is when people assume that the value of their long term investments will be stable in the short term.

Long term investments tend to fluctuate significantly in value.  It is wise to assume that they could easily rise by 20% or fall by 20% in the short term. And if they fall by 20%, it could take considerable time for them to recover.

In our example, the other point to consider is that making a $250,000 investment in one office building creates a concentrated risk. The $250,000 would have been “safer” if it had been “diversified” into several investments in different locales and different industries.
History teaches that diversified long term investments tend to provide double the long term value of shorter, less “risky” investments. But, that assumes that you hold them for the long term. During that long term period, often, the value of, and income from, the long term investment will fall below the value  of, and income from,  the short term investment. (In other words, when interest rates are only 1%, one should not expect an 8% return from equity investments in the short term. And, often in low interest rate environments, normal market fluctuations from equity investments may actually result in negative short term returns.)

Your short term investments (deposits) should always be sufficient to meet your short term (3-5 year) needs. Your long term investments should be meant for the long term so that fluctuations in their short term daily BOP does not matter to you. If your financial plan calls for a need to liquidate some of your long term investments to cover living expense, you need to sell, “in advance” when markets are “high” or undertake a periodic “averaging cost” plan to sell  regularly over time to average out market fluctuations.

Remember the story of Mr. Market: “you need to be confident enough in the value of your (long term) investments to be able to take advantage of Mr. Market rather than being affected by his (bi-polar) disease.”

PS.  I am sure that many clients are surprised that I remain so calm during periods of market turmoil. They often ask “Aren’t you concerned when we are losing so much money?. Shouldn’t we be doing something?” My answer is always, “All of this up/down is pretty normal. The daily value of long term investments only matters on the day we intend to sell them or the day we intend to buy them. Since we don’t intend to sell them for a very long time, the emotional bi-polar actions of Mr. Market with falling prices on a daily basis really does not matter except when we are buying. And when we are buying, we like it when prices go down. Investors need to remain confident that the long term value of their highly diversified portfolio of high quality investments remains intact, despite daily market value fluctuations.”