In Marvin Gaye’s cool jam, “Trouble Man”, he sings, “There are only three things for sure, taxes, death, and trouble, oh this I know.” Financial advisors help us avoid taxes, and life insurance policies protect our families’ finances from unexpected death, but how do we prepare for trouble? I start every financial plan with the Safety Net because it is the foundation upon which the rest of the plan is built, and it is also the foundation upon which we can confidently stand and take wealth-building risks in other parts of our portfolio. Let’s explore the appropriate size of the Safety Net and its potential components.
The general rule of thumb measures the size of a proper emergency fund as six to twelve months’ worth of expenses. For example, if your mortgage payment, car payment, utilities groceries, and miscellaneous spending add up to $10,000/month, your emergency fund should have somewhere between $60,000 and $120,000. Like all personal finance, determining the size of an emergency fund is a combination of mathematical formulas and personal reflection.
Risk-averse people may want twelve months or more whereas a risk seeker may only want six months. Investors should also consider how reliable and consistent their sources of income are. For example, a salesperson with little or no base salary and inconsistent commissions should opt for a much larger emergency fund. A federal employee with a steady paycheck and future pension may opt for a lower emergency fund.
Let’s assume you work with your financial advisor and together you determine that your emergency fund should be 10 months, or $100,000. That does not mean that you let $100,000 sit in your checking account earning zero interest. In fact, I recommend only keeping two, or three months at most, worth of expenses in a checking account to smooth out the variability in month-to-month spending. We would use the remaining $70,0000 to $80,000 to buy safe and easily accessible assets, such as short-term US treasuries and CDs, which, at the time of this writing yield over 5%.
Having sufficient safe, liquid assets in your Safety Net will cover unexpected expenses and losses of income when trouble inevitably comes. It will also give you the necessary cushion so you do not have to dip into your long-term investments, which will almost certainly be down when you face trouble personally. Now is a great time to get your Safety Net in order, and you may feel like Marvin Gaye at the end of the song, “Don't care what the weather. Don't care 'bout no trouble, got me together, I feel the kind of protection that's all around me.”
Tune in next month when we explore another component of the Safety Net, a HELOC!
In last month’s article, we explored the relationship between financial planning and investment management, and how any investment necessitates a well-defined financial plan to determine the investment time horizon. This time horizon dictates the ability to take risks, and this month we will talk about a saver’s willingness to take risks.
A person’s willingness to take risks is a personality trait just as much as agreeableness or openness. Although education and knowledge can demystify risky investments, a person’s willingness to take risks is deeply personal and often difficult to change. All people land on a spectrum from totally risk averse to totally risk seeking. Taking the time to determine where you land on this spectrum will help you build a portfolio that you can live with and will avoid unnecessary anxiety and sleepless nights in the future.
How do you know where you land on the willingness-to-take-risk spectrum? Some questions to ask yourself, what would you do and how would you feel if you woke up one day and your account value was cut in half due to a market crash? What would you do and how would you feel if the market was up 20% in a year and you were only up 11%? Given the choice between a sure $100 or the chance to win $0 or $250 in a coin flip, which do you choose? What if it were a sure $100 or the chance to win $0 or $195 in a coin flip? When you hear the word “risk”, what other words come to mind?
As a fiduciary, I would never recommend taking more risks than your time horizon would allow. However, if you are a more risk-averse person, then it makes sense to dial back your risk lower than what your time horizon would allow. The other thing to keep in mind is that if you do not have a lot of experience investing, you may be more risk-averse than you think if you’ve only experienced a bull market or more risk-seeking than you realize if you’ve only experienced a bear market. Given the multidimensional factors that determine a person’s willingness to take risks, it always helps to have an independent, unbiased, and experienced investment professional evaluate both your ability and willingness to take risks before making any investment.
Tune in next month when we talk about the foundation of every financial plan, the Safety Net!