The Art of Wealth Preservation

Mouton_Rothschild_2015OK, it looks like you made it to financial independence. Well done!

You’ve spent the last decade or two with your spending locked down and your saving rate up at 50+%.  You’ve amassed a Freedom Fund worth 25x or more your annual spending.  That will probably be enough.

This is sometimes known as “Fuck You Money”.  When you have nuclear weapons, you generally don’t need to use them. Similarly, when you have Fuck You Money, you generally don’t have to say “Fuck You”.

It’s an excellent state of affairs. So good that you are gonna want to give some thought to not screwing it up.

That’s because losing money hurts.

Losses hurt (more than gains feel good)

We are biologically hard-wired to feel the pain of losses more than we feel the pleasure of gains.

Money worries are worries about survival, resources, offspring and status, the things that mattered to our ancestors and still matter to us today. We feel the loss of 20% of our portfolio the same way that a caveman would have felt the loss of 20% of his food supply: emotionally.

loss aversion

The human race has spent most of the last 100,000 years with its nose pressed up against the limits of our food supply.  A 20% increase in food supply for a caveman would be nice but a 20% loss of food supply might kill them.  This explains loss aversion and is why our fear of loss feels real, deep and primal.

What we have, we hold

Wealth accumulation should be like a ratchet. In other words, if done right, it should only go forward, not backwards.

It sucks to be poor. But one thing worse than being poor is being poor when you used to be rich.  If you lose all your stash, putting hedonic adaptation into reverse is a bit like putting a Ferrari into reverse gear when you’re doing 100 miles an hour on the autobahn. Maybe you can do it, but it wouldn’t be pretty.

It’s great to give money to good causes. But the cardinal rule of wealth preservation is, by definition, this:

Once you’ve got rich, you must never be poor again 

Keeping it is different to making it

When you are young and poor, you need to hustle, take some risks and use leverage (if you buy a house).  This is all fine and normal and its what I did back in the day. But the game is different after you get to financial independence.

Many entrepreneurs take crazy risks in order to get rich. For example, property developers generally leverage themselves up to the eyeballs in expensive bridging loans and then run around like headless chickens trying to get the development done and sold before the bank pulls the rug and demands its money back.

Fine, those developers do what they need to do to get rich. But its insane when you see them doing this after they have already made enough to never need to work again.

The Meteorite Test

And its not just property entrepreneurs who do this. Anyone financially independent whose net worth lies wholly in their business or in shares in their employer or in one street of Buy To Let properties is doing it wrong.

That’s because their portfolio fails the meteorite test.  Your portfolio passes the meteorite test when an asteroid can come from outer space and land anywhere on earths surface and (as long as it doesn’t land on your head) you don’t care where it lands.

For the benefit of overly-literal readers, this is a metaphor.  The meteorite represents any unexpected event.

Brexit was a meteorite because it was a (mostly) unforeseen event that hit investors who were over-exposed to UK property (remember those open-ended UK real estate funds that were gated to prevent redemptions?).

Diversification is the best way to ensure that your portfolio passes the meteorite test. For investors in a global equities tracker fund, Brexit has (so far at least) meant a nice bump up in the £ value of their overseas assets.

Don’t lose money

According to Warren Buffet, rule number 1 is don’t lose money. Rule number 2 is don’t forget rule number 1.

noise and signalIt took me a while to figure out what Warren really meant by this. He didn’t mean don’t invest in the stock market. He didn’t mean that your investments should never go down in price.

Price volatility is just numbers going up and down on a screen and, most of the time, that doesn’t mean anything…its mostly noise rather than signal.

No, real risk is the permanent loss of capital…its where something goes down and it ain’t going back up again.  Like The Titanic or shares in Enron.

Don’t borrow money

Once you get to financial independence, you should aim to remove all debt from your life.  Yes, I mean ALL debt.  Not necessarily overnight in one fell swoop…but over time you should remove all debt from your life…even if you are a buy to let landlord and the debt interest is tax deductible.

It should go without saying that, if you are financially independent, you will have long ago removed all consumer finance, hire purchase, credit card debt from your life.

But whenever you owe the bank money, you owe them an explanation. You have to fill in their silly forms.  You’d still be answering to The Man. You are gonna want to stop that shit.

Live off your income

If you can live off the income from your investments, then you have just eliminated sequence of returns risk.

What is sequence of returns risk? If you spend 4% of your portfolio a year and the portfolio is only producing 3% in dividend and interest income, then you have a 1% shortfall that you need to make up by selling a small chunk of your portfolio each year.

That’s a mild administrative inconvenience in a bull market. But being a forced seller in the trough of a bear market is a disaster.

Your whole financial set-up should be designed so that you’re never a forced seller of risk assets in a bear market. If you are unclear on this point, tattoo it on the inside of your eyelids.

Review your asset allocation

People that give up the day job / business when they get to financial independence should consider changing their asset allocation.

Jim Collins, the elder statesman of US financial independence bloggers, offers a neat rule of thumb for this.  Imagine 2 phases in life. There’s the accumulation phase and, post financial independence, there’s the wealth preservation phase. Jim suggests that people in the accumulation phase have 100% of their portfolio in shares (plus an emergency fund of cash). That’s because when you are working, it doesn’t matter if your investments fall in price.  In fact, its an opportunity to get more for your money each month.

If you are not working, not having access to cash is like not having oil in your car engine. Everything seizes up. So, once you’ve quit working, you include a 25% bond / cash allocation.

The main benefit of the bond / cash allocation is that you can ride out a 5 year bear market without selling equities (shares, stocks) when they are too cheap.  Instead you can spend from the cash (or bond) part of the portfolio.

Don’t take dumb risks

So income is a good thing. But its best not to compromise on quality in order to “reach for yield”. That’s a turkey move.

turkey

Take those P2P lending platforms that offer you 10+% interest on your loans (at a time when safe savings earn ~1%). You do realise that P2P is often just sub-prime lending, right? You know, the sort of thing that led to the last financial crisis?

What would the Richest Man in Babylon Say About that? He might say its like picking up pennies in front of a steam roller.

And don’t even mention Bitcoin and the whole crypto thing.  If something seems too good to be true, then it probably is.

Safety is an expensive illusion

But wealth preservation is not about trying to avoid all risk….because avoiding all risk is impossible.

There are hidden risks with all “safe” investments.  The problem with cash is that its melting like an ice sculpture at a party. The problem with index-linked gilts (TIPS) is that they’re expensive and offer poor returns.  The problem with gold is that it never grows and it pays no income.

What if equities, the asset class that went up and down the most in the short term, was actually the safest in the long term?

Be flexible 

Real world flexibility is far more important than endless spreadsheet bashing or internet debates about the “correct” safe withdrawal rate.

The ability to adjust is very powerful for wealth preservation.  So be ready, willing and able to cut (or delay) some spending. Obviously, the less you spend, the safer you are in terms of wealth preservation. But one metric that’s worth thinking about is the % of your annual spending that is fun money rather than essential for survival.  The higher the % that’s discretionary, the safer you are. The Escape Artist’s model spreadsheet shows this metric.

Even better, be ready to earn a bit more money either in a flexible job or a side hustle.  Generally the safe withdrawal rate studies don’t reflect this ability to flex your withdrawals in response to market drawdowns and I think this scares a lot of people unnecessarily.

The answer to the “how can I be sure that the 4% rule is safe?” question is the same as the answer to the “what would I do with all that surplus time?”…get a fun & flexible part time job or a side hustle.

Side hustles should only ever contribute

A great way to jeopardise your financial independence would be to start a business where you risk capital.  This is totally unnecessary if you follow The Correct Way to Start A Business.

Financial independenceIf your new business requires significant capital to get started, that’s God’s way of telling you that your business model is wrong.  You should not be starting a capital intensive business such as an oil company, that requires drills, oil rigs, refineries, factories, offices and shit like that.

You should start by taking money upfront….pre-selling your product or service. If people really want it and trust you, they will pay upfront, thereby creating a business with a negative working capital requirement.

Focus on your health

Once you are rich, the biggest risk is doing something stupid.

Apply own mask first

An excellent way to do something stupid is to allow yourself to get run down physically and mentally. The most common triggers for getting run down are: sleep deprivation, watching / reading The News, lack of exercise, alcohol, eating processed carbs (cake, bread, noodles, crisps, biscuits) and other junk food.

Some FI-seekers do this to themselves when they’re trying to get to FI too quickly. I did a bit of that to myself back in the day and its an understandable rookie mistake.

But not prioritising your health after financial independence is madness and there’s no reason to ever do that.

Apply own oxygen mask before helping others.

There is no de-accumulation

There are no guarantees.  But if equities generate returns of say 8% (eg 5% real plus 3% inflation) then you can see that a 4% safe withdrawal rate means the value of your portfolio will be growing.

One of the hardest concepts for me to understand as I transitioned into financial independence was that, if I did all the stuff above, I almost certainly wouldn’t run down my stash.

I don’t mean that the market value won’t ever fall…obviously it will some days, some months, some years.

But the number of units / shares that I hold has gone up since I quit. Not at the same rate as before…but enough to get that warm feeling that you are moving forward financially… as well as hopefully growing in other areas of life.

 


Reminder: The next London FI meet up is Thursday 2 August from 5.30pm onwards outdoors at the Anchor Pub, Bankside SE1 9EF. We’ll be joined by special guest Brad Barrett of the popular Choose FI podcast. More details here.  All welcome. Hope to see you there 🙂


Further reading:

fin-coaching-widget

  1. The Ice Sculpture and The Turkey
  2. Financial coaching

20 comments

  1. I have just read a really good book on the safe withdrawal rate – Beyond the 4% rule by Abraham Okusanya. I think it should be required reading for all those who attempt to live off their Investments whether by doing Drawdown or living off the capital. His conclusions are backed up emperical evidence which shows the worst scenarios that have been encountered for over 100 years and some of the best explanations of Bengens model for SWR and other elements to add to the strategy of living off your investments.

    I would highly recommend this book to anyone, whether they are financially literate or not. I have been investing for over 20 years and approached the book with some scepticism, but took awa some new learnings and tweaks that i could apply to my own strategy

  2. Hi there. Thanks for the article. Just a quick question, if you have time:

    I’m considering entering a phase between the “accumulation” and “wealth preservation”. Specifically I’m about 3/4 of the way to being fully financially independent and I’m considering quitting my job and contracting for 3 or 4 months a year to cover my expenses for the next few years. I’ll not need to touch my investments, but I’ll not be adding to them either. I’m planning on staying 100% in equities for this, however I wonder if you’ve any thoughts to the contrary.

    1. Wouldn’t recommend it unless you are willing to risk postponing FI all together for a few years and have a multi year cash backup stash in place already to ride out the bear market. I expect a sharp market correction in the next 18months – specifically hitting equities. We saw a first correction in Feb – a preview on what’s coming. I have zero allocation in equities for the moment.

      1. south_bound · · Reply

        My plan has some similarities – initially reduce the working week to cover living expenses so I am neither in accumulation or decummulation, then gradually reduce more while maybe picking up some side income from other more interesting sources (more like leisure activities that pay for themselves). I am lucky that I found a career that I enjoy but just getting to the point of realising there are so many other amazing things to do with my time. I came late to the party on the investment side of things so don’t have enough in equities and nervous about putting too much in right now. Same for real estate as the markets I know are all expensive but I do have a slug of cash ready for when the opportunities present themselves.

        1. Exactly, wait for the right opportunity. Long term u get ahead much further I believe even if you need to hold cash for a little while. A notion of caution however: the dollar is volatile at the moment and who knows if trust in it will hold given the sell offs of US treasury bonds by foreign powers and the lack of true growth in the US. I reduced my cash reserves in dollars to a bare minimum: 20k.

    2. OgreNoseGrid · · Reply

      I’m 100% equities and plan to keep it that way, even though I plan to pull trigger on FI soon.

      Why? My reasoning is: 40% of my portfolio is equities, but fixed interest banking debt. These are essentially a coin flip on whether the company remains solvent or not, and unless they all go tits up, all my expenses are generously covered up to 30k pa so I can ride out a prolonged equities price dip. Unless a combined global equity drop plus wipeout of my senior debt prefs, does me in. At which point I think we’d all have enough else to worry about.

      I will try that out for a couple of years. Plan B, is that if during that time catastrophe emerges – Brexit Trumpageddon – I will return to work as a contract business analyst, assuming Regulatory Change is the nuclear proof cockroach of the contract IT world.

  3. Great summary. I’m trying to take pretty much this approach now I am FI, but health is the area I need to concentrate on a little more I think. With young kids, it’s all too easy to make excuses. Once I have stopped lifting toddlers, I’ll need to do some proper weights!

    Would have liked to have met Brad next week but alas will be away. Hope we get some more UK folks on the Choose FI podcast as a result of his visit.

  4. Urban F. I · · Reply

    Thank you as always , real talk I love it

  5. I think its wrong to associate P2P with the financial crisis. Although the borrowers may be what would be called sub-prime, most (responsible) asset-backed lenders are relatively conservative in their LTV ratio’s and undertake due diligence around affordability.

    Who knows what will happen if there is an economic shock or lenders come under pressure to adjust their lending criteria (in an effort to grow the business) but history has shown that in an economic downturn all asset classes suffer.

    I don’t work for a P2P lender and neither do I play one on TV.

  6. Barn Owl · · Reply

    Another useful post.Thanks.

    I am struggling with how the number of units is going to grow post FI. With your numbers 8% growth, spend 4%, lose 3% to inflation fund value on average rises 1% real.

    Assume the stash is 100% in a global equity income fund, then income is less than 2%. surely you have to sell units to get to 4% spending?

    If you have 25% in cash with -3% real return that means selling more units.

    Am I missing something?

    Also any preferences between cash , 1-5 year and 10 year gilts for the 25% needed to hold over a 5 year dip?

  7. Hi All

    Lots of interesting comments and observations. I would like to suggest points that I think would be helpful to the discussion.

    1. Most of us set a target of an amount of money that we think we would need to secure our FI i.e provide an income that secures our living standards going forwards until we die, whether it be £1m, £2M or £3M or more if we our fortunate.
    2. The chances of us reaching that before 55 (currently) are not that high as the most efficacious way to achieve that is to invest in pensions. If you do hit it before 55 then you will have to live off it longer and all the research is based on drawing an income from no earlier than 60 and living off it for 30 years.
    3. So when we have hit our target of an amount of money that will secure an amount of income, we are then in the De-accumulation phase. Yes we may like to leave a capital sum to our next of kin over and above the value of our house (and the most tax efficient way to do that is through a SIPP, can’t currently be taken before 55) if we do not need to use our capital to provide for care in our old age. Although only approximately 16% of the elderly population end up in care homes this is what tends to destroy the chances of leaving money to the next generation.
    4. We have had a good run of 10 years without any major issues in the market so the Sequence of Returns (SOR) has been in our favour.
    5. However, for others that may not be the case. If you get a 10 year run at the worst possible returns you will not see your portfolio increase over that period; if the SOR is not in your favour in the first 10 years, it can decimate your portfolio.
    6. The next 10/20/30 years may help it to recover, but you are unlikely to do as well as someone who has had a good run in the first 10 years and you need to stick to your equity allocation through the worst possible times.
    7. The Safe Withdrawal Rate for the UK is 3.1%; dependent upon the amount that is allocated to Equities versus Bonds/left in cash & a few other factors (3.8% if you go 100% UK Equities, plus some other variations)
    8. The evidence is clear that the first 10 years after accessing your portfolio is the most important, together with the % allocated to Equities i.e. the less that is allocated to Equities versus Bonds the lower your return will be and the chance of growing your capital to provide an income.
    9. Even if you have secured more capital than you require to provide an Income, the chances are that you will want the level of Income that the capital will initially provide (plus inflation) and still want to leave an amount to your family.
    10. Yes you can live off Natural Yield, but you will have to accept variable income and capital growth, fine if you are happy to do that and have sufficient stable income to provide the essentials.
    11. Working on average returns is not the way to approach a portfolio to provide a standard of living, if you want to secure a growing income and capital from it (all the research on drawing an income from a portfolio proves this, call it Drawdown or what you will, SOR is the biggest issue).
    12. De-accumulation exists.

    Just my thoughts, happy to discuss!

    Gareth

    1. OgreNoseGrid · · Reply

      Nicely put set of points. Pretty much agree.

      Yet, I’m staying 100% equities: My way to handle SOR risk is: to have selected enough investments with a high natural yield so as not to be forced to sell down in a prolonged dip; to be doing OMY now to increase my Disaster Buffer; and have plan B of going back to work if it goes tits up in the first couple of years.

      Having got the basics of FI somewhat covered – big capital sum, somewhat sensibly invested – I find that what I am thinking about, are entirely different though not I think untypical concerns:

      I have kids at and about to go to Uni. It will be very handy indeed to have a low income for the next few years, for maximising the Student Loan (arts students, 4 year courses, so makes sense). So that’s what I am arranging: FI from next April, so both get maximum maintenance loans.

      I have a house in London with a mortgage at 2% for the next 11 years or until base rate rises above that. I could pay it off in a year’s time with the 25% lump sum from SIPP. But I won’t: basically I fancy my chances and can bear the risk of not beating that interest on my investments. A punt I know, hence existence of Plan B.

      I want to minimise tax paid in retirement. My partner and self both have full state pension entitlements: she has a SIPP and a DB pension (though v obscure as to how much it will be) – so I think we can juggle where the income comes from to effectively get 45k tax free by taking it from SIPPs (untaxed below the personal allowance) and ISAs, while being low SWR.

      I’m pretty happy with a book a bicycle the internet and my kitchen, so I don’t have much of a lifestyle to maintain at minimum, so if the market is decimated (or ahem, triple decimated as decimation only means 10% reduction, I point out pedantically) I think I can just scale back the yachts and racehorses without much worry.

  8. Love the post. Great summary. Enjoyed reading through the risk mitigation pieces of thought albeit doing it differently. Personally I have a solid, safe, and fast growing FI foundation, albeit completely not meteroid proof as 95% asset allocated in real estate in one city. So I liked your thought’s on this. I disagreed on equities is always good completely. I have just started work few years before the global financial crisis and saw my retirement fund almost evaporate. I was forced by law to pay into that managed fund against my own preference. Even till today that fund has only generated a mediocre return, whilst the fund manager’s and company were paid a (very good) living. So there is a time an place to invest. I believe one should pick the safest asset class with a safe return even if they are small compared to luring crypto and housing developer investments. I’m not prepared to go into equities in 2018 at the peak of a record long bull market, when all we saw grow this year predominantly FAANG and the rest of the market floated due to corporate buy backs of stocks. Banks down 20%, Deutsche Bank surviving on a shoe string thanks to ECB, Chinese market in bear mode -23%. Shit is about to hit the fan in my view. Hard assets are the was to go right now for wealth preservation. I will go into equities after the next major correction to diversify and grow. Meanwhile sidehustling with focus on health and saving, being paranoid, and growing the war chest.

  9. Great Post!

    I like the meteorite test idea – it certainly resonates with my feeling that a lot of news is just noise (be it financial news, political news or whatever). The more I think about investing, the less attention I pay to the market news – and moving away from investing in individual shares (from a time when I knew that my skills at picking winners were better than others) to ETFs just reinforces that.
    Investing should be simple – earn money, spend less than that and invest the remainder and keep it simple.

  10. Julie Knox · · Reply

    Loved this one!! Though I am far from FI and in that place where it all looks impossible so I might as well look the other way.

    Sent from my iPhone

    >

  11. FI Warrior · · Reply

    P2p is a broad church to be fair, so while some is definitely subprime, there are better models and better-run operations, the trick is to educate yourself enough to know the difference. I welcome it because the more investment options we have, the better (if they are voluntary) and we live in times where there is a dearth of decent choices.

    Having said that, given the pressure to hunt for good returns, even at the expense of higher risk, I’ve recently been burned with p2p; but it’s important to clarify that the end result was still no worse than with a conventional portfolio asset spread. ( just be realistic with expectations and have a plan B) I went in a little greedily with p2p-property, figuring there’d be a margin of safety as it was asset-backed, but given flat-lining sale prices, any firesales on the defaults didn’t cover original capital investment. This has taught me a good lesson on risk, it doesn’t matter what the claimed LTV is, or how great their alleged staff competence or recovery strategy, if the original property value is no longer valid. (irrespective of whether it was honestly ascertained in the first place)

    Currently I consider anything linked to property as linked to shares in that we’re overdue a crash and it could take over a decade for the value to recover, so very illiquid and medium to long-term.

  12. SurreyBoy · · Reply

    Good post as ever. For those fearing an imminent crash then its clear equities are not for you. The time worn problem here of course is the time is unlikely to ever be a right time for you, so you need to invest in something else.

    So if you want £20k a year for 40 years, you probably need > £500k shares. Or double that in index linked gilts. You pays your money and takes your choice.

    FWIW im aiming to live primarily on dividends from investment trusts yielding between 3% and 5%. These dividends can fall but probably not 40% across a basket of trusts in 18 months. They probably won’t get me the highest return but that’s ok. My plan will work or it won’t. My crystal ball is as useless as anyone else’s.

    On SWR I think too little recognition is given to the fact that after 75 you will probably spend less. Im sure there are cruise ships filled with high rolling 90 year olds but the older pensioners in my road barely leave the house six months of the year. I doubt they spend their days online gambling thousands a month. The flip side is also we don’t talk enough about care home costs. Presumably because it’s a ghastly thought and the spreadsheet will tell you to conjure up another half a million quid at the age of 80 which rather spanners the FI dream for many.

    The EA makes some good points about don’t blow the FI life with daft decisions. The FI world also needs to think how to safeguard people from impulse selling in the event of a crash. Or, and this is worse, how to stop people being talked out of their fortune when they are in their dotage.

    The closer I get to FI, I think the risks are less about the money and the markets and the more about unwise actions and being exploited in old age.

  13. This post is great, so many quotes to enjoy in ones head whilst imprisoned. Is the author appearing in Choose FI podcast?

  14. i like the cash/bond cushion idea. i’ve been flirting with the idea of building my own annuity type ladder of fixed income with better rates than you can get from those annuity sales thieves. i want to spend it all in the end, having eaten the crumbs and the cake.

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