There are a number of folks who have been talking about a potential stock market crash over the weeks, so I thought I'd start gathering up the accumulated wisdom of 25 years of trading and investing. The working title for this piece is
"Are you prepared for the next CRASH?"
I'm going to try to "pre publish" this overall piece in sections here.
The first part is related to the most important basic--securing your cash. My philosophy is that "cash" is not an investment. It's a parking place for money before it finds a proper investment home. I do not advocate keeping most of one's assets in cash for extended periods of time.
Part 1: Cash is King
In the event of a market Crash, huge sums of money will be made and lost. It's entirely possible that a massive liquidity crisis could be triggered. Those who are positioned incorrectly could loose much or even all of their net worths, and financial hardship could even befall relatively conservative investors. Meanwhile, those who are savvy and prepared will be sitting on fat profits and ample cash to take advantage of whatever opportunities might be presented.
The first thing to remember is that in a market crash, Cash is King. A substantial portion of your investable assets must be kept as close to 100% safe and 100% liquid as possible. The exact percentage is for you and your trusted advisor to determine--the important thing to note is that many cash parking places aren't nearly as safe and as liquid as they seem. It is imperative that you do your own due diligence, because there are any number of hidden risks. Let's take a look at a few:
Banks- Bank deposits are only Federally insured up to $100,000. Anything above that amount is, at least theoretically 100% at risk. Moreover, if there is a failure, it is entirely possible that $100,000 amount might not be fully available to you for some time. The worse the crisis, the longer it may be. My conclusion is that in a crisis, a bank is not where you should keep your liquid investable assets. Certainly modest sums should be kept in more than one bank, or savings institution, but nothing too large. Bank runs have occurred--not just in the Great Depression but in 2007. That can greatly interfere with any asset protection strategy you might have.
Money Market Funds--This is the biggest, most unappreciated risk that otherwise savvy traders take. Most folks think that there is no risk in investing in a money market fund. In normal circumstances, of course, they are pretty much right. The problem is, the ONE TIME when you need absolute security --a Crash-- is the one time that the risk is highest. Money should be placed in the Money Market fund for absolute safety and liquidity. The real money is supposed to be made when we deploy the assets. Most money market accounts are not guaranteed by any government entity. They typically maintain their net asset value at $1, but it is entirely possible for that NAV to fall below $1. In fact this has happened just recently!
(see http://www.creditflux.com/digest/2007/08/03/axa+im+shores+up+money+market+funds+invested+in+subprime.htm ) With the sub-prime mess and mountains of ill defined derivatives risk, the risk of holding a standard Money Market fund during a crash is much higher than perceived. If you doubt it, ask Florida teachers (see: http://www.bloomberg.com/apps/news?pid=20601087&sid=aSkgscULJ6Tk&refer=home )
Cash in Your Futures Account -- This isn't a big issue for many but it is important to note that cash in most futures accounts is not guaranteed by the government or even necessarily held as a segregated asset (separate from the brokers assets). If the futures broker fails, you may be an unsecured creditor. Don't leave large sums of idle cash in your futures account.
Cash in your Brokerage Account-- Most brokers insure cash balances up to 1,000,000 or more through outside insurers and SIPC. In a crisis, however, we don't know how well this will work. It's probably not a good idea to have large balances simply held by brokers and especially not just one broker.
I say, if you want to take a little risk to get more return, buy some of those closed end bond funds trading at a deep discount, or pick a target maturity zero coupon fund (though this would be better when the government bonds are down). Otherwise, don't go for above market returns with "safe" money.
In a credit contraction, when folks have been using leverage and massive derivative plays, there's all kinds of unexpected risk, including counter-party risk that could easily come home to roost at a Money Market fund that was positioned a bit too heavily in the wrong commercial paper, SIV, or other debt.
To my eye, an investor is not getting paid enough to analyze that particular risk and they won't be paid enough justify to taking it.
There's an old saw often trotted out by seasoned investors: Never reach for yield. It's the biggest (and oldest) sucker bet that there is. History is littered with the fiascoes of widows and orphans and retirees lured by supposedly "safe" high yielding bonds and deposit accounts. It is incumbent upon you, the investor, to evaluate the true risk of any investment. Don't take someone's word for it and don't be blinded by a big stated return. There's no such thing as a free lunch, so if the return is higher than average in a "safe" investment, then chances are the risk is also higher than average--probably much higher than average.
So, when Cash is King, diversify where you keep it so you don't have too much money at any one institution, and make sure that it is largely guaranteed and/or insured. U.S. Treasury securities are a good bet, as are government money market funds and modestly sized deposit accounts with Federal deposit insurance. Rember, this money needs to be available to you when there's panic and "blood in the streets". You don't want to wait until the markets have recovered to invest your cash, so it needs to be 100% liquid and secure during the worst case scenario.
Future articles will address various strategies and trading instruments to generate profits from a Crash or Bear market, how to identify a possible Crash scenario, how to reduce risk and the costs of errors, and how to identify a turning point and what to do about it.