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URL:  http://boards.fool.com/the-cash-management-game-23564939.aspx

Subject:  The Cash Management Game Date:  1/16/2006  5:11 PM
Author:  imdajunkman Number:  14982 of 35834

Each investor will have her own reasons for creating savings, chief among which might be the psychological anchor that savings provide, as well as the financial discipline instilled. The growth of one's money is “A-Good-Thing” and certainly a tactical benefit of savings. But the more important benefit might those aforeward-mentioned, strategy ones of stability and discipline. So, I would claim that savings are “A Good Thing” just for their own sake. But that's for each investor to decide.

So, also, might the same things be said of reserves, which seem to serve two purposes. The first is an aggregation process, whereby small amounts of cash from disparate sources are gathered together into a quantity sufficient to be deployed as a single unit. Discussing that will be the main purpose of this post. But, first, I want to comment briefly on the second purpose and then take it up again at another time. Also, there are likely to be yet other purposes for reserves, and I invite everyone to share what he is doing.

The second purpose for creating and carrying reserves is risk management, whereby cash is always carried in one's portfolio in a sufficient quantity to overcome the maximum anticipated draw-downs to that portfolio such as might be caused by multiple simultaneous failures, or a sustained sequence of failures, of the individual positions in the portfolio. In other words, if the risks of a portfolio are properly managed, it is possible to sustain even significant losses without compromising the integrity of the program underlying the portfolio or the investor's will to keep moving forward with the program. But as losses mount up, at some point they begin to cripple both the ability and the will to make new investments. Therefore, the purpose of reserves is to ensure that point is never reached, much less the far worse one of destroyed the portfolio, which was exactly the failure of Long Term Capital Management. They failed to carry sufficient reserves, and the story is instructive.

Some smart-*ssed, Nobel-winning, financial whiz kids, classic academics everyone of them, who could admittedly price risk better than anyone in the whole world, failed to listen to their own traders who had an intuitive sense that LTCM was over-leveraged and that the fund was not carrying sufficient reserves. The academics argued to the traders that the feared event, all open positions failing simultaneously rather than an in an orderly and manageable way, was a statistical improbability. But, as financial history tells, “fat tails” do happen, and the academics blew up the account. Despite the efforts of the traders to unwind the risks, the losses, once they started happening, were cascading and unstoppable.

I keep hammering on the LTCM incident because Wall Street's whiz kids have done it again. They've once again created a leveraged situation that could take down the whole financial world, and you, the average, small investor, will be paying the costs of their arrogance. I'll post the links to some of the relevant articles separately. But they are in plain sight and easy to find on your own if you're making even half an effort to do the things a fixed income investor has to do in order to anticipate and avoid troubles. Despite's the White House cheerleaders who can point to a lot of positives about the US economy, those positives are like a sea gull who has momentarily landed on an iceberg. The tip of the iceberg seems like a stable perch, but the supporting mass of the berg is rotten ice and being rapidly eroded by the seas. The deficits and debts the US is running are unsustainable. Fixed-income investors are riding a train headed for a wreck.

The “average small investor” isn't likely to ever to find herself paralleling LTCM in scale or technique. But I would claim that she has no less of a responsibility to herself to anticipate the worst possible case and to defend her portfolio against it, which can be accomplished (among other things) by carrying sufficient reserves. What “sufficient” might mean will be for each person to determine.

OK, let's return to a fairly non-controversial use of reserves, which is Cash Aggregation. If you're an active fixed-income investor with even the most modest of portfolios, you are constantly faced with the task of putting ba