IT is intellectually rewarding to discover how disparate concepts spanning curiosity, space, time and economics may fuse together to achieve a common goal: serious wealth.
Therefore, today we’ll look at three terms starting with the letter “E” which dovetail together to grant us powerful insights into the world of money.
1. Equities
2. Emergency Buffer Fund (EBF)
3. Entropy
EQUITIES
The annual World Wealth Report analyses the asset allocation preferences of the world’s wealthiest individuals.
A chart found in most yearly WWRs tracks the percentage of their investment wealth spread across five primary asset classes: cash, fixed income (bonds), equities (stocks), investment real estate, and alternative investments (like private equity, structured products, hedge funds, derivatives, foreign currencies and commodities).
Diversification across asset classes is wise. However, over long periods, say, from a decade to a century, equities tend to outperform all four other major asset classes.
This is not surprising.
When we buy directly listed stocks or even equity funds, we are investing in business ownership. It is through owning and operating a business well that enormous wealth is created and then consistently compounded over decades. Yet there is a trade-off:
Equity investors accept sizeable risk when they opt to part with a portion of their nest egg to try and grow their money faster than they might using the other four primary asset classes.
In exchange for accepting equities’ higher risk, they demand — and sometimes receive — outsized gains through dividends and price appreciation.
The trade-off for high potential returns is the acceptance of large levels of investment risk.
That doesn’t mean we should avoid equities, just that we should invest gradually and intelligently.
Equity funds grant us broad-based diversification while directly owned stocks carry the potential for enormous gains (but also gargantuan losses) in exchange for accepting huge asset price volatility. I own both forms of equities in my portfolio.
For my financial planning clients, though, I adopt a more prudent approach and advise them on asset allocation plans implemented through funds spanning up to five asset classes.
It is a helpful way to mitigate single-stock-selection concentration risk when investing in the exciting equity space.
EBF
The EBF or Emergency Buffer Fund is a cushion of cash or a reserve fund that protects us, quite literally, from the “slings and arrows of outrageous fortune”, as the unparallelled William Shakespeare wrote in Hamlet Act 3, Scene 1.
Emergencies arise; that’s life.
Intriguingly, having a fat EBF — comprising pure cash of our own, not borrowings — not only helps us deal with real life emergencies but also calms our nerves when investment markets, especially tumultuous equity ones, nosedive at the most inopportune times.
Our personal EBFs should cover between three and 12 months’ normal monthly expenses, depending upon our circumstances. I recommend holding EBF cash in bank accounts and pure money market funds.
As this GVC or Great Virus Crisis gathered momentum in Malaysia (and, of course, globally) from mid-March this year, the individuals and businesses that survived the best — economically speaking — were those with obesely-funded EBFs. For them, this crisis was a mere inconvenience.
But those without fully-funded EBFs experienced this economic implosion as a crushing calamity.
ENTROPY
There is a thermodynamic quality of physical systems, which arises because energy always spreads or thins out as we move from the past to the future.
It is called entropy and is a physical system’s inherent tendency to move from order to chaos or from high energy density (at the Big Bang) to the projected HDU (Heat Death of the Universe) at the so-called end of time.
On the much smaller time scale of our wisp-like lives — spanning, give or take, a brief century — if we wish to grow fitter, wiser or wealthier, we need to cause localised entropic reversal by proactively choosing to eat better and exercise harder, study more intensely and ruminate more deeply, or save sacrificially and invest intelligently.
The benefits which accrue from financial planning are enormous. But they will never happen by accident. We can wander into debt. We can’t wander out of it.
Doing so requires a solid plan, discipline, patience and persistence.
In every area of life, valuable hard-won victories arise not by going along effortlessly with the flow but by swimming against the current to raise our levels of orderliness.
In doing so, we battle and successfully defeat life’s entropic tendencies to plunge us into chaos.
Great ways to reverse our financial entropy is to commit to the financial planning process; invest widely using several asset classes, including well-chosen equities; and building up EBFs for our lives, our families and, possibly, our businesses.