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How much?

How much should I invest in stocks?

How much should we hold in liquidity?

These similar questions arise from different sources. One personal the other corporate.

The key ingredient is attitude to risk.

For an individual who can’t tolerate losses stocks aren’t the thing. For those who want some diversity in their investment the question is one of how much can you lose on a series of bad days? As a rule of thumb 50% is probably a reasonable place to start. How would you feel?

As for liquidity that’s something that banks “model”. And under scenarios 8%-15% of liabilities may suffice.

But there is a difference between personal and corporate risk.

At a personal level, it’s unlikely you are leveraged. If 20% of your wealth is in stocks you won’t be wiped out (but you may be leaving money on the table by being cautious).

However in a really ugly scenario banks take more risk than both their capital and liquidity allows. In truth to cover such eventuality would be prohibitively expensive. That’s why they don’t do it.

The saving grace (for banks) must therefore be action. When things get rough, unlike the personal investor, banks can’t afford to sit back and wait. If they call it wrong and things go from bad to worse they are done.

That’s why scenarios are so important. It’s not about predicting what will happen (things don’t happen as planned, ask any economist) it’s about deciding when and how to act to ensure you say in business.

The key point. Stress testing doesn’t tell you how much you can lose. It allows you to develop action that deals with adverse consequences thereby staving off failure.

Ironically in the real world behaviour plays a big role. Personal investors respond to big market falls by selling at the bottom and banks often sit on thumping losses hoping it will all come right in the end.

Is this because collective board responsibility reduces the perception of individual risk whereas the average investor is scared witless?

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