If your savings are growing, you tend to feel safe. And if they’re declining, you tend to worry. That’s truer than ever as you get older, and the options for replacing wealth via a job disappear. But your money lives in a fickle financial world, subject to a variety of risks. Your tools for reducing those risks are your ongoing financial behavior, and your asset allocation.
My last article presented seven categories of financial risks: It explored ignorance, bad information, rigged game, confiscation, depression/deflation, inflation, and devastation. And it concluded with some thoughts on the probability of those hazards. You need to assess the likelihood of a threat, before spending time and money to avoid it.
This article continues the discussion with a look at the tools, tactics, and costs for defending your wealth against the various financial risks. We’ll start with internal risks, and personal financial behaviors that will help you minimize those. Then we’ll explore external risks, and touch on the major asset classes that will help you to diversify away their potential consequences.
Use these tools and techniques to keep your hard-earned assets as safe as possible….
How do you counteract ignorance — being out of touch with reality? Answer: Lifelong learning in critical subjects, like personal finance. Even if you ultimately choose not to manage your own money, you need a minimal understanding of how money works, to delegate and protect your wealth. The best learning always stems from hands-on, real-world experience. When it comes to your money, you want to learn with small sums, keeping risk low until you understand the game. Betting a non-trivial portion of your life savings on a single, unfamiliar investment is a recipe for loss and heartbreak. Until you fully understand investing, a few universal principles can serve as your guide: low cost, diversification, and patience. You are far less likely to commit a major financial blunder if you avoid high-cost products, if you don’t put all your eggs in one basket, and if you buy and hold for the long term. When possible, make your mistakes in a virtual world rather than the real one: Use one of my recommended retirement calculators to plan and simulate your financial life. That will give you visibility into your future, with no risk. The cost of banishing ignorance is a bit of your time for continuous learning.
To avoid bad information, you need to rely on trustworthy sources. Personal recommendations are invaluable. Beyond those, I favor impartial, real-life personal finance blogs written by people who have “walked the talk.” When I need to make a major financial decision in my life, I’m more interested in what a 50- or 60-something self-made millionaire has to say based on experience, than what a 20- or 30-something bank or brokerage employee has to tell me based on their firm’s latest sales training. I strongly prefer a do-it-yourself approach to personal finance whenever possible, because it avoids layers of expense and conflict of interest. If you can’t do it yourself, talk with USAA, Vanguard, or AssetBuilder. Finally, keep your financial life as simple as possible. Bad information often leads to financial complexity, confusion, expense, and missed goals. Much of the best personal finance information is free: See Bogleheads for just one example.
To stay as safe as possible in the rigged game, seek out transparency and low costs. You want to live your financial life in the sunshine of broad index funds holding conventional stocks and bonds. Avoid dark niches such as options, commodities, and sector stock picking, where the professionals play. Active trading is a high-risk full-time job. If you’re a part-time, recreational investor, don’t climb into the ring with the pros. Remember that expenses have proven a highly reliable indicator of whether you’re in a rigged game. Low costs are a reliable measure of value and integrity. The overall expense ratio on my portfolio is just over 0.2%. That’s a good target. With a little effort, you can do even better. Lastly, if you must rely on external advice, vet any financial advisor to understand conflicts of interest. The cost of staying safe in the rigged game is your ongoing vigilance.
The essence of avoiding confiscation/taxation is to reduce your taxable income. The best route while still working is to maximize tax-sheltered savings plans and associated employer matching. Since none of us can predict the future tax environment, tax diversification — holding a mix of taxable, Roth, and Traditional retirement accounts — is a wise strategy. Once retired, we can live in a low tax bracket, and enjoy a zero percent long-term capital gains tax rate. Beyond that, there are many schemes — such as Roth conversions — for reducing taxes. You’re entitled to spend as much time as you please optimizing the labyrinthine U.S. tax code for your situation. Personally, I don’t invest much effort there, and it hasn’t hurt my quality of life so far. I value my time and peace of mind over modest tax savings. If you want a more sophisticated approach, learn tax law or hire a CPA if you must, but understand that the cost and complexity can be high.
In a depression/deflation there is a shortage of cash. It follows that the best preparation is to have plenty of cash on hand, and relatively few reasons to spend it. Liquidity is king. This is why you keep an emergency fund. It gives you flexibility and protection during economic hardship — personal or global. Beyond that emergency fund, fixed income such as bonds or annuities provides peace of mind and cash flow that increases in value during a depression. Other insurance against a downturn includes playing a valuable role at work, possessing multiple professional skills, living frugally, and having low fixed expenses. Avoiding debt is always advisable, but can be critical to your financial survival during a depression. Without adequate cash flow, people fail to service their debt, and thus lose their underlying assets. If you have cash, a depression or recession is a great time to pick up assets for cheap. That is one of Warren Buffett’s favorite strategies. In general, the cost of preparing for a downturn is low: traditional conservative financial vehicles, and a bit of your planning time, are all that’s required.
For all the fear and loathing it inspires, most forms of inflation are relatively easy to defend against. Inflation isn’t generally a surprise. And, by definition, almost any asset other than cash or fixed income will increase in value with inflation: stocks, real estate, commodities, Treasury Inflation-Protected Securities (TIPS). Social Security is possibly the best inflation hedge available to most of us. Delaying it is a simple step that potentially gives you an inflation-adjusted annuity paying near 8% annually. Some traditional inflation hedges offer mediocre performance: Yale economist Robert Shiller has argued that housing prices cannot outpace inflation in the long term. Recent research has questioned how well the price of gold correlates with inflation. Supposedly, debt is great to have during inflation, because you can pay back your obligation with lower-valued dollars in the future. But I avoid debt, regardless of what the economy is doing. Defending against inflation needn’t be expensive: The best tools for most of us are simply our Social Security accounts, and low-cost stock-based index funds.
Devastation is ugly to contemplate. Many ignore the possibility, while a few prepare. Wide-scale destruction from war or natural disaster is usually a function of your location in the world. So flexibility and mobility are key. In retirement, we’ve chosen to live away from coasts and major population centers. We rent a home and maintain a small RV that would let us live on the road comfortably at short notice. If you’d rather stay put, preparedness can take the form of creating strong relationships with your neighbors, and cultivating local food sources. Stockpiling is difficult and expensive: most foods and household goods have limited shelf life. Gold, whatever its long-term investment or inflation-beating prospects, has proven useful in panics throughout recorded human history. Foreign-based assets — bank accounts and real estate — have long been a hedge against devastation for the wealthy. But the costs, in money, legalities, and time, are high for this and most efforts to prepare for the unthinkable.
Unfortunately, the new devastation on the horizon — environmental degradation due to overpopulation — won’t be so easy to escape. The best solution is to reduce our footprint on the planet. The ability to live simply and self-sufficiently is critical to all our futures.
As you contemplate the risks I’ve described, and ways to reduce them, don’t fixate on a single version of the future. I sometimes hear from readers who have moved all their investments into gold, cash, bonds, or some other “conservative” investment. Yet each of these asset classes has its own vulnerabilities and can be highly risky under certain conditions. Hoarding in one asset class generally increases your vulnerability.
Cultivate the ability to survive and prosper under any scenario. Some proven behaviors will help: keep expenses low, remain flexible, live frugally, stay mobile, and maintain liquidity. But one principle trumps them all: Diversification is your single most powerful tool against risk. Diversifying among assets and balancing your behavior are your best hope for financial security in an uncertain world.
Just know that, while you can enhance your security, you can’t always guarantee it. That’s how the world works. As my fellow blogger, The Investor, recently wrote at Monevator:
“…sing the praises of instability for giving us all the wonderful change we see in the world – at the price of the occasional wobble. Remember every investment can fail you. Don’t put all your eggs in one basket – and ideally have a few chickens about the place, too! Beyond that, I say embrace the world like a buccaneer, not as a sailor who thinks the world is flat. There be dragons!”
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