On the dryness of powder

I sometimes come across a moderately sophisticated intuition, and find that while I don’t strictly speaking agree or disagree with it, I do find it basically meaningless without additional context. This intuition says, “anything that can be done in an urgent situation can and should be done before the situation becomes urgent.”

So, for example, if you would need to tap your home’s equity in order to pay for a medical bill of a certain amount, that’s a sign that you don’t have adequate cash available and you should take out the home equity line of credit now, before you have a medical emergency, rather than wait until you actually need the cash.

When it comes to investing, people are often willing to accept a permanent drag on their portfolio in the form of less volatile short-term and intermediate-term bonds in order to preserve so-called “dry powder” should the equity markets tumble and put stocks on sale. The premise underlying this behavior is that people invest 100% of the income they have available to invest, and then they decide how to allocate that investable income according to their meticulously-calculated “risk tolerance” (or some other metric, like age or target retirement date).

My sense is that people both have more financial resources at their disposal then they generally think, and that waiting to tap those resources until a promising investment opportunity arises makes perfectly good sense.

Sources of cheap liquidity

Many people have sources of cheap liquidity available they aren’t aware of and spend no time thinking about:

• if you make more than the minimum payment on your student loans, you have excess liquidity;
• if you make more than the minimum payment on your mortgage, you have excess liquidity;
• if you replace your phone before it stops working, you have excess liquidity;
• if you buy food or drinks in restaurants instead of at retail merchants, you have excess liquidity;
• if you replace your wardrobe more often than necessary, you have excess liquidity;
• if you replace your car more often than necessary, you have excess liquidity;
• if you buy new cars instead of used cars, you have excess liquidity.

Now, unlike your average moralizing personal finance blogger, I don’t see any virtue or sin in any of the above. I don’t think debt is terrible and that you have to get rid of it as soon as humanly possible, and I don’t think new cars are terrible and that you have some kind of moral obligation to never buy another one in your life.

Deciding when and where to deploy excess liquidity is hard, but everything is hard

My point is that spending behavior which may make sense in the low-expected-return investment environment we have today may not make sense in a future, high-expected-return investment environment. Today, accelerating payments towards loans in order to secure a modest but guaranteed investment return may make sense. After the next financial crisis those excess payments may be better used to load up on cheap equities. Today, eating out and networking with colleagues may offer a better return than the modest expected future gains of the stock market. Tomorrow, plowing that money into high-yield corporate bonds may offer a better prospective risk-adjusted return.

If your project is to reach a million dollars, or two million dollars, or ten million dollars, in net worth before any of your friends, then sure, you should strip away all your excess expenses today and invest entirely in an aggressive-but-well-diversified portfolio of stocks. But life is more than a net worth statement, and spending more and investing less this late in a bull market makes perfect sense to me.