OK, 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.
Losses hurt (more than gains feel good)
Losing money hurts. 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.
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.
It 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.
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.
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 offers a neat rule of thumb for asset allocation. Imagine 2 phases in life. There’s the accumulation phase (working) and, after financial independence, there’s the wealth preservation phase. Jim suggests that people in the accumulation phase have 100% of their portfolio in shares (plus a cash emergency fund). That’s because when you are working, it doesn’t matter if your investments fall in price…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”.
Investors who reach for yield are like turkeys on a farm. They get fed until they don’t.
High income investments such as P2P lending, high yield bonds or emerging market debt combine an obvious but limited upside with a hidden risk of total wipe out.
Take those P2P lending platforms that offer you ~10% interest (at a time when safe savings earn ~1%).
You do realise that P2P is mostly sub-prime lending, right? You know…the sort of thing that led to the last financial crisis?
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?
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 4% 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.
If 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. This is WAY more likely if you 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. There’s no reason to ever do that.
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 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.