Business - Can you withstand market fluctuations and spikes?

(Part 9 of a series)

I understood what you were saying in your last piece but isn't liquidity an issue only if we have to worry about trading the instrument before maturity? For investments that we intend to hold until its maturity date, should we even worry about liquidity at all? --- Reggie

Liquidity isn't supposed to be an issue for fixed-term investments that we hold until their maturity date. For an asset under “Held-to-Maturity” (HTM), we reflect its value at historical cost plus accretion or minus amortization. People expect that the daily swings in the asset's value in the open market has no effect on the accounting treatment of the HTM investment. Asset liquidity also has no impact because there is no intent from the start to trade the instrument before it matures.

Now, what if some unexpected expense comes up during the next four years? Then we draw against our savings. If savings is not enough though, other assets like our 4-year bond need to be sold off to generate the needed cash.

Think of what happens when we buy a bond with four years remaining tenor. From an investment standpoint, we have to be fixated with a specific date 48 months into the future because that is when we regain the principal we invested 48 months earlier (plus the discount or minus the premium). The 48 months between now and the maturity date matter because of the expected coupons but the relative size of the par value will be the most significant of all the expected inflows.

An issue's liquidity profile allows us to respond to unexpected expenses.

We know that markets fluctuate and our personal conditions change with the passing of time. We also know that the only surprise with unexpected expenses (medical bills or major price escalation) is its timing, form and amount. Unfortunately we do not have the talent for foretelling these market swings or fully anticipating changes in our personal circumstances.

This human reality is the most compelling reason for preparing for the unexpected. This is why we need to always think of our liquidity position. This is especially true when we commit our resources to a long-term asset. When push comes to shove, can we sell the long-term asset even if our initial intention was to hold on to it until its maturity date?

Borrowing a phrase from the vernacular, investing is as much about the math as it is about “pahabaan ng pisi” (loosely, one's ability to have a long rope before the noose tightens around our neck).

A high income or extensive wealth will allow a select few the option of holding onto assets irrespective of market swings. Indifference is a clear clue that they have judged themselves to be liquid enough to either withstand the market spikes or remain focused only on the maturity date. This is the privilege of having a “mahabang pisi”.

For most retail investors though, our pisi is much shorter. We are much more prone to a liquidity squeeze and more likely to react when the day-to-day value of our long-term assets are fluctuating. The irony is that when investors sell when prices are already falling, values drop even further. Panic begets large losses and large losses beget further losses.

We saw as much during the unit investment trust fund (UITF) situation in 2006. Yes, UITF investors who held their ground more than recovered the initial paper losses while those who withdrew only guaranteed their losses. Hindsight though is 20/20 vision. Could anyone have guaranteed the UITF investor that the meltdown was only a “temporary” aberration that would eventually reverse? Would that person be willing to bet his own resources to cover any loss suffered by the UITF investor?

This brings me back to our investment pisi (rope). Markets change in ways we do not expect. Since we cannot see the future, our response can then range from panic (selling even at a loss) to total indifference while a few are in a position to welcome the opportunity to make money out of the fluctuations. The crux of it is the flexibility to sell when I need to, even though I initially had no such intention.

Among institutional players, the current rules require that they must make a distinction between HTM and assets classified as Available-For-Sale (AFS). AFS is in-between HTM and Trading Account Securities (TAS) and the difference in accounting treatment is quite material.

For retail investors, however, we do not draw such fine-line distinctions. We probably should but in practice we really do not. Even when we invest in long-term assets (bonds, mutual funds, UITF, stocks) purely for the long-term benefit, there is always the possibility that the position may be liquidated earlier than anticipated.

Just as when we remind new investors not to invest money that they cannot afford to lose, there is good reason to caution against going too far out on your investments when your financial rope is much shorter. This is not to say that long-term investments are a bad idea. What it does say is that our financial “pisi” dictates on which side we can err.

(Have a question for Dr. Noet? Email personal_finance@inquirer.net.

(Noet Ravalo is a macro-financial economist by practice and profession. He was chief economist of the Bankers Association of the Philippines until 2002 and has since been doing consulting work. Since 1994, he has been asked to provide technical inputs to both the Senate and the House of Representatives on various economic and financial legislation, some of which will have big impact on Filipinos' personal finances.)

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