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SURVIVING and THRIVING DURING CREATIVE DESTRUCTION Short-Term & Long-Term Financial Responses to the Current “Crisis”

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SURVIVING and THRIVING DURING CREATIVE DESTRUCTION Short-Term & Long-Term Financial Responses to the Current “Crisis” Certified Financial Services, LLC 600 Parsippany Road Suite 200 Parsippany, NJ 07054 Richard Aronwald Financial Specialist JANUARY 2009 SURVIVING AND THRIVING DURING CREATIVE DESTRUCTION Short-term & Long-term financial responses to the current “crisis” The consensus of the mainstream financial media is that times are tough, things are bad, and the future is bleak. And the adjective that most often precedes this pessimistic perspective? “Unprecedented.” That’s one way to look at it. But it’s not the only way. Financial crises are not new. Since the United States was established, its people have experienced at least 17 Panics, Crises, Recessions and Depressions (see list, what-goes-around-comes-around irony, the American page 2). And while it may take some time, things get auto companies may shortly find themselves victims of better; historically, every downturn has ended with a creative destruction. For those directly affected by these recovery. And often what arises out of the crisis is better realities, the impact can be financially brutal. than what was before. In fact, economists have a name But for the economy as a whole, creative destruction for this process of crisis and recovery. They call it is usually beneficial because it allows resources to be creative destruction. transferred out of older, less efficient industries and into newer, more efficient ones which produce improved Creative Destruction and/or less expensive goods and services. If understood Creative destruction is a term coined by Joseph and managed properly, creative destruction can be a Schumpeter in his 1942 treatise titled “Capitalism, catalyst to more productivity, higher incomes and better Socialism and Democracy” as a way to describe how standards of living. new businesses and technologies replace older, less When the prevailing psychological environment is efficient ones. It was Schumpeter’s observation that the pessimistic, it’s easy to forget that what’s being “process of creative destruction is the essential fact experienced right now is nothing new. With this about capitalism.” understanding of crises and creative destruction, When old technologies and business models are individuals should be focused on how to ride out the diminished because of creative destruction, there can be tough times and be prepared for the opportunities that significant economic distress for portions of the inevitably follow. Many of the details will depend on population. Carriage makers lost their livelihoods when your unique circumstances, but there are some financial Henry Ford began mass-producing Model Ts. Main- fundamentals that apply. The key is acting on what has frame computer companies were made irrelevant by proven to be productive, rather than worrying about Microsoft, Intel and the personal computer. And in a what might happen if you do nothing. F inancial Here‘s a quick quiz on a basic financial concept. Do you know the answer? L itera cy For Americans born in 1950, what is the average annual rate of return they can expect, in terms Q ues tion of retirement income, from their Social Security payments? ( See page 6 for the answ er.) a. 36.5% b. 15.3% c. 2.2% d. -.1% © Copyright 2009 Certified Financial Services, LLC *600 Parsippany Road Suite 200 Parsippany, NJ 07054™ [email protected] Page 1 Practically speaking, most people challenged by debt Is there anything of which it may be can’t simply sell their house, or tap into savings to pay said, “See, this is new?” things off and start over. And they might not be able to stop borrowing either, at least in the short term. (If you It has already been in ancient times don’t have the cash for a car, living without one might before us. severely restrict your employment opportunities.) But Ecclesiastes 1:10 people who don’t find ways to manage their debt will have a tough time surviving the downturn – and are less likely to participate in the recovery that follows. 1. Manage your debt. What is manageable debt? Two Rules Convinced (or deluded) that their homes and stock portfolios would continue to appreciate, a lot of Debt is manageable when the cost to service it Americans stopped saving and kept spending; for the doesn’t impact your ability to save consistently and past two years, the country’s savings rate has been substantially. If your income is $10,000 a month, you negative.* But the housing market turned pay all your monthly obligations, and find sour in 2007 and the stock market it easy to save $2,000 each month, you plummeted in 2008. In this current could make a strong argument that your financial environment, the biggest debt is manageable. On the other hand, if challenge for many Americans is finding a your mortgage, home equity line, auto way to continue paying for the debt they loan and credit card payments make it have accumulated – and finding a way to impossible to save, your debt is managing you. stop adding more debt to the pile. The easiest way to manage debt is not From another perspective, debt is to have any. While that comment might sound smart- manageable if whatever you owe is less than what you alecky, this was a prevailing point of view for many own. If your total outstanding debt is $300,000 including Americans that came out of the Great Depression. With your mortgage, and your total assets are $3 million, your the possible exception of a mortgage, many individuals debt is probably manageable – provided you could either paid cash or did without. From a personal finance liquidate some of your assets to pay the debt. standpoint, living debt-free certainly has advantages, and And this is where it gets tricky. Illiquid assets count many households would benefit from making it a on a balance sheet, but many times turning them into financial priority to be debt-free. If your spending is out cash would cause major financial disruption. You could of control, it may be time to cut up the credit cards or sell your business to clear your debt, but then what will have an intervention to get things under control. you do to earn money in the future? You could sell your home (probably at a discount), but where will you live? *Bureau of Economic Analysis, U.S. Dept of Commerce report (Nov. Thus, a better way to define manageable debt is if your 2008, released Dec. 24, 2008), Personal Income and Outlays. liquid assets are greater than what you owe. BRIEF HISTORY OF ECONOMIC DISTRESS IN Should you refinance? Two Reasons THE UNITED STATES. From a debt management perspective, there are two Event Duration objectives to refinancing. One is to secure a lower Panic of 1797 3 yrs. interest rate. The other is to lower your monthly Depression of 1807 7 yrs. payments. Particularly if you have good credit, now Panic of 1819 5 yrs. Panic of 1837 6 yrs. might be an opportune time to refinance some of your Panic of 1857 3 yrs. debt. Panic of 1873 6 yrs. While lending standards have tightened, interest rates Panic of 1893 3 yrs. are historically low, particularly for home mortgages. Panic of 1907 1 yr. Credit card companies are still looking for good Post WW I Recession 3 yrs. customers – the ones that have a balance, but pay their Great Depression 10 yrs. bills – so it may be beneficial to transfer balances to a Recession of 1953 1 yr. new institution. Recession of 1957 1 yr. Even if you can handle your current monthly Oil Crisis of 1973 2 yrs. payments, there may be value in extending your debt Early 1980s Recession 2 yrs. Early 1990s Recession 1 yr. over a longer period of time, especially if the lower Dot-com Bubble 2 yrs. payments would help you save money. Changing from a Crisis of 2007 ? 15-year mortgage to 30 years might seem counter- intuitive if the goal is to reduce debt. But consider the © Copyright 2009 Certified Financial Services, LLC *600 Parsippany Road Suite 200 Parsippany, NJ 07054™ [email protected] Page 2 possible advantages: A lower monthly payment will be got used to operating on skinny financial margins easier to handle. If the difference is saved, you are because they found they could spend more, save less, building a reserve to cushion against unexpected future and still come out ahead. Substantial cash reserves were challenges – thus keeping you from borrowing more or viewed as unnecessary or foolish. Oops. going broke. If not needed, the reserve can be applied Building cash reserves may not have the sex appeal against the outstanding balance to pay off the mortgage of some other accumulation strategies, but building and early. maintaining a financial cushion is an essential component for responding to times of creative Should you consider borrowing more? Two destruction. Cash reserves help you ride out the storm Scenarios and give you resources for new opportunities that will Even though the primary focus of debt management follow. for most individuals is debt reduction, there may be What Constitutes Cash Reserves? reasons to borrow more, depending on your personal circumstances and the reason for doing it. Cash reserves don’t have to be kept in a shoebox or If borrowing will allow you to acquire income- deposited to a bank savings account earning 1% interest producing assets, it may be worth taking on the debt. – there are other choices. But those other options should Typical scenarios might be borrowing to acquire include the features of a shoebox or a bank. income-producing real estate, or ownership of a First, the money should be liquid – i.e., accessible business.
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