Plan and Invest Using the Same Advice You Give Your Kids

The other week I wrote about inflation and the uncertainty of predicting whether it is either temporary or here to stay. Fact: No one really knows for sure. So, how does one plan for a potentially disruptive force? Answer: By creating a margin of safety in our financial plans and our investments. Here are some ideas how to do that.

First, life is uncertain so we operate within margins of error all the time. Have you taught your kids to drive? One of the primary lessons I tried to instill with our two is to expect the unexpected. For instance, square your corners so your tires don’t hit the curb during a turn; keep an eye on that little kid with the ball in case she decides to chase it into the street in front of you; give that cyclist a wide berth in case he swerves into your lane to avoid a pothole. In other words, we create margins of safety all the time – our financial lives should be no different.

Room for error is sometimes viewed as an overly cautious approach used by those who aren’t confident of their opinions. In fact, room for error allows us to endure a range of potential outcomes so we can live to fight another day. Here are some examples of how we try to do just that:

• The absolute best way to prepare oneself for a variety of unforeseen outcomes is to save, save, and save some more. Living beneath our means and saving and investing the rest is a tried-and-true formula. Warren Buffett’s business partner, Charlie Munger, once said, “I did not intend to get rich. I just wanted to get independent.” Saving is the best way to achieve independence.
• When we create financial plans for clients, we project their portfolio produces an average annual return suitable for their circumstances. And then we can run a Monte Carlo analysis that simulates 10,000 different possible return scenarios to see the probability of achieving the desired outcome. If the probability looks low? Time to adjust expectations and recommend solutions. Probability looks high? Try running scenarios with higher expenses and longer lives to see if it still looks good.
• Maintaining an emergency fund in case your income evaporates is important. There are various rules of thumb – 3-6 months of your necessary expenses isn’t too far off. Having that cash when an unexpected expense arises – and it will – is better than selling investments and interrupting their multi-year compounding affect. And way better than paying a 10% penalty by withdrawing from your retirement account prior to age 59 ½;
• We diversify our clients’ portfolios – all their retirement and investment accounts put together – and invest them appropriately for their individual circumstances. As you know, we don’t try to time the market – that’s a fool’s errand. We invest so when one asset class zigs, hopefully another asset class will zag.

Overall, when in doubt, refer back to the first bullet.

Steve Byars, CFP®