Risk management should be the core of investing and "not a small afterthought," writes John Cochrane in "Portfolios for Long-Term Investors." The senior fellow at the Hoover Institution adds in his recently published paper: "If this century has taught us anything, it ought to be that unexpected things will happen, they will be financially painful, and resilience is more important than a few basis points of alpha." (Alpha is the excess return produced by an investment relative to a benchmark index.)
The language of a finance economist is far removed from the signature folksy tone Warren Buffett uses in his annual letter to Berkshire Hathaway shareholders. But they share a similar outlook.
Reading the letters over the years, including the latest, Buffett advocates for the concept of a "margin of safety," (what Cochrane calls risk management). Buffett illustrated the idea at the company's 1997 annual shareholder meeting. "If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel OK, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety."
The pandemic recession exposed how many households were managed with thin margins. The strategy works most of the time until something untoward happens. People who kept their jobs during the pandemic — the lucky ones — have saved more and paid down debts. Cash in checking and savings accounts has grown by over $4 trillion in the past year, four times more than normal, according to Moodys Analytics.
Consumers have a lot of financial firepower to unleash as the economy opens up and COVID-19 retreats. There's nothing wrong with splurging a little. I'm looking forward to meeting with friends for drinks and a meal, as well as traveling to visit loved ones. But the savings hoard also means households have within their grasp the chance to lower household financial risks to the unexpected and funds to tap when opportunity strikes.
Much financial commentary deals with which mutual funds and stocks to buy and what role bonds should play in a portfolio. "The harsh truth is that the most important driver in the growth of your assets is how much you save," writes Burton Malkiel, "and saving requires discipline."
Take advantage of this unusual moment to set up an automatic savings program for everything from retirement savings to emergency funds. But put some money aside for fun, too.
Chris Farrell is senior economics contributor to "Marketplace" and a commentator on Minnesota Public Radio.
