Make Your Balance Sheet Your Friend (Guiding Principle #1)
In this article, I will discuss what I call the first guiding principle for managing wealth:
Make your balance sheet, cash flow, and portfolio your friend
There is a critical distinction between possessing a high net worth and having a strong balance sheet, cash flow, and portfolio. Problems in these three areas can give rise to huge frustrations and mistakes. The predicament of a gentleman I’ll call “Harry” illustrates this point.
In terms of net worth, Harry was in an excellent position, with total assets valued at somewhere north of $60 million. I would have thought it safe to assume that his balance sheet, cash flow, and portfolio were spectacular, but that was not the case. A very high percentage of his assets was locked up in a private company he owned, or in his homes and other personal property. In fact, when I first met him, his liquid and semi-liquid assets were not sufficient to sustain his rate of spending for much longer. Though he had a $3 million portfolio, he was beginning to tap it at an unsustainable rate. Harry was wealthy and he felt wealthy, but he was heading toward an inevitable cash crunch.
Part of Harry’s problem was that he needed to be more cost conscious. A lot of his cash flow problems came down to over-paying for various goods and services. His mortgage payments were much higher than they needed to be. He was bleeding cash in the form of high brokerage fees. He was paying far too much for financial advice and services that were focusing on the 85% Trap and missing the Essential 15%.
Harry’s predicament showed how balance sheet problems can cause a domino effect. Because so much of his wealth was locked up in assets that generated expenses but no income, Harry felt that he needed to compensate for this problem through high-risk investments. If he had more control over his cash flow, he would not have felt so much pressure to pursue higher returns. But as it was, the strategy he was pursuing had a fatal flaw. If his high-risk investments suffered a sharp decline, the hole he was in would grow very deep in a hurry. His cash flow would have plunged below the level he needed to meet his financial commitments.
When that happens—when your cash flow becomes your enemy, not your friend—you find yourself forced to raise cash by selling assets you would much rather keep. This pressure can come at the worst of times, when assets are temporarily undervalued at distressed levels.
Even if that is not the case and you can still squeeze by, you may find yourself handcuffed and unable to take advantage of opportunities that arise in a distressed market. One of Warren Buffett’s most quoted recommendations is to “be fearful when others are greedy and be greedy when others are fearful.” But you can’t be “greedy” (I prefer the word opportunistic) unless you’ve learned to make your balance sheet, cash flow, and portfolio your friend. If you gain the financial strength such friendship provides, you will be well positioned to acquire the undervalued investments that abound in the depths of a bear market.
This principle raises a question: How do you know if your balance sheet, cash flow, and portfolio are your friend? What standard should investors use to measure the “friendliness” of their current position? The answer lies in the second guiding principle, which I will discuss in my next post.
Joseph J. Janiczek is the founder and CEO of Janiczek Wealth Management. This article is adapted from his book, Investing from a Position of Strength.