Proceed with Caution
Mind the gap.
A tagline about as memorable as, “Just do it.” A simple reminder to passengers to be careful when exiting the subway.
Even as I am writing this, you probably have that image of the red circle, blue rectangle, and white block letters that read, “MIND THE GAP.”
Why? Because even something as simple as stepping off the train contains an element of risk, and caution is warranted. Humans are a cautious bunch, and many are simply allergic to risk.
Today, I’d like to discuss my version of Mind the Gap and highlight that many investors are distracted by what they perceive as short-term risks while ignoring a more meaningful long-term risk.
So, off we go…
The Key Metric
Let’s start with what I often refer to as the most important metric in financial planning: withdrawal rates.
If you had to review the health of a financial plan with only one data point, withdrawal rates would be a good place to start. Many white papers have been written on the topic of “safe withdrawal rates.” People are eager to know what percentage they can “safely” withdraw from their investments on an annual basis without the risk of outliving their assets. The math here is simple: your annual withdrawals (spending) divided by the size of your portfolio gives you your withdrawal rate. The industry has traditionally accepted a 4% withdrawal rate from a well-diversified portfolio as something sustainable and reasonable (for further details, see “Four Percent Rule” research by William Bengen).
Now that we’ve got the math, let’s discuss how we can influence those withdrawal rates. Essentially, safety here would be defined by lower [withdrawal] rates. So, what drives lower rates? Either (1) lower spending or (2) higher asset levels.
From my experience, it’s typically difficult for an investor to change their spending habits and the lifestyle they’ve become accustomed to. Not to mention that inflation is driving up this spending year over year. This means the more likely solution here would be to drive higher asset values, increasing the denominator in our withdrawal rate equation and, in turn, driving lower withdrawal rates.
Growth is Key
Insert discussion around driving higher asset values, which has everything to do with compound interest.
The two most important variables for compounding asset values are (1) rates of return and (2) time. A long time horizon accompanied by above-average returns has a parabolic impact on asset values.
This is where my Mind the Gap principle comes into play. It’s simple: the gap to mind is the gap between your annual spending and the value of your assets. In most cases, an investor’s spending is increasing at a predictable rate, which can be explained by inflation. So, growing assets at a greater rate than spending builds that gap I am referencing.
Imagine a visual of one’s expenses being graphed over time. Now, add a second line on your graph to represent the growth of an investor’s assets. If, and this is a big if, an investor can create a portfolio generating above-average returns, then the slope of that asset line will be steeper than that of the expenses line. What you get is a growing gap over time between these two lines – asset levels and expenses. Said another way, you get a shrinking withdrawal rate. Hence, my advice is to Mind the Gap.
Yet, investors tend to be shortsighted and overly anxious about what’s going on in markets today. This shortsightedness leads to heavier allocations in short-term investment instruments. An approach that is antithetical to growing that gap between assets and expenses over time. It’s almost like the distraction of short-term volatility drives long-term allocation decisions, which then become detrimental to long-term outcomes, which is why one must Mind the Gap.
The Psychology of Investing
Last week, we discussed the importance of taking inventory of one’s cash. As discussed, this excess cash is often driven by (1) a lack of awareness and (2) a lack of strategy. I am not encouraging investors to throw caution to the wind, and I think being cautious is both wise and prudent. Strategy is key, though – strategy defines what you are doing and why you are doing it.
When it comes to personal finances, most people desire one thing above everything else – a sense of security. So, when it comes to the psychology of investing, you need to devise a plan (a strategy) that helps to both instill that sense of security in the short term and drive that gap between assets and expenses via growth in the long term. There is a point of tension here: investments that instill that sense of security look and feel much different than investments that drive long-term growth. As I often say, when it comes to investments, you can have stability or growth, but you can’t have both.
This leads me back to my framework of Expense-based Planning, which I have discussed here on TOM on multiple occasions. One satiates that appetite for security with layers of safety nets in cash, high-quality bonds, access to credit, and portfolio income (dividends and interest). Each of these layers of safety is measured as a multiplier of annual expenses, which is psychologically comforting to an investor when they know they have quick access to 3 or 4 or 5 years of expenses if an emergency or need were to arise. In turn, this allows an investor to allocate a majority of their assets in a diversified portfolio of investments focused on attractive long-term growth rates. Again, to Mind the Gap, shrink withdrawal rates and build a nest egg that dwarfs and overshadows one’s annual spending.
Recap
I know that the concepts I have introduced today are simple, but they are also powerful. When adopted and applied, a focus on Mind the Gap will result in long-term wealth accumulation and optionality. Optionality is one of the most freeing concepts in finance – the options one avails of when a surplus of wealth exists. Options around charitable gifts, legacy planning, personal experiences, supporting loved ones, and much more.
I hope today’s discussion was helpful to you, and I hope it helped to stretch your paradigm when you assess your long-term approach and strategy to portfolio design.
With that said, I will be back next week to share more of my Thoughts On Money…
