Money Obedience

Let me start this post with a saying we have used before in other posts, “We live in interesting times.” So far we pretty much ignored this fact when we have discussed saving for long-term goals such as retirement. Let’s change that.

A very important feature of saving for retirement is the way you allocate your money among the different choices such as stocks and bonds. There is a certain “conventional wisdom” among financial professionals who would advise you to put a set percentage of your savings into stocks and then tell you to adjust that allocation over time as you get closer and closer to your retirement. This percentage largely depends on your risk attitude and the time remaining to retirement day. Financial professional treat this percentage as something that you should not tinker with. We ourselves have fallen into that thinking when we have discussed asset allocation in previous posts.

But now, we are wondering whether these “interesting times” should make us rethink such a time-honored wisdom as the proper amount of money we should put into the stock market. Maybe we are indeed on the cusp of a prolonged economic slowing which will keep the stock market in limbo for a long time. What if we face a period that repeats times like the 1930s and 1940s when it took the stock market 25 years (or until 1954) to regain the level from which it plummeted in the fall of 1929? If flat returns in the stock market are the medium term prospects, why should we put the conventional amount of money into the stock market? What benefit could we have if we instead started thinking outside the box a little bit? What answers could we get if we challenged a time-honored wisdom and opened new doors?

We are not answering any of these questions right now, since we have to ponder them for a little while ourselves to come up with a sensible response we feel responsible enough to share. But our hunch tells us that we may want to rethink the savings strategies that we previously thought were the right way to go. Things have changed dramatically. It probably makes sense to change our savings strategies (dramatically?), too. We may not come right now to the conclusion that we should stay out of the stock market completely, but we may, for example, want to reduce our exposure significantly. If the traditional rule for us would call for half of our savings to go into stocks, maybe we should think about putting only a third or a quarter of our savings into stocks right now.

As the US and the world economy face new challenges that neither we nor the movers and shakers have foreseen (or know what to do about them), we also face new challenges with our own personal finances. At this point we can only say that is probably not a bad idea to examine our basic strategies for our own personal finances. Please, let us know what you think!

Let me give you a little background about my thinking before I get to the meat of this post. I used to be a trader on Wall Street where I traded the firm’s money. My buy and sell decisions determined my success or failure. In the more than two decades of doing this, I was always guided by one question. What is the worst thing that can happen? Or rather, what is the worst thing that I will allow to happen? In trader terminology we used to ask, “when do you cut your losses?” Every trader knows that life as a trader is much easier when you can keep your losses small. But believe me, for most traders this is easy to say but difficult to execute all the time.

So, naturally I think like that in my personal life. There are some differences between my trading decisions and my personal finance decisions but the concept is very similar. One difference that stands out is the emotional impact of my personal decisions. My my wife and I have got to make sure that our financial decisions allow us to have a happy life. Heck, the purpose of this blog is to share our thinking about the connection between our happiness and our financial decisions. (Just in case you were wondering, in trading nobody cares about happiness – the bottom line is everything.)

Our life-style is based on our two incomes. We live below our means, which allows us to sock away a little savings here and there. We own a home that both of us really like. We have never looked at this home as a real estate investment. It has always been the place where we want to raise our children and where we want to live until the steep and creaky staircases are too much for us to climb. (That rule is suspended for the two days after I run a marathon when I don’t like walking up and down any stairs, not just the ones in my house.) In short, we conscientiously have developed an emotional connection to our home. We like it that way. It makes us feel good.

As most of you know, I no longer draw an income. Since our lifestyle is based on two incomes and since we know neither when I will get another income nor how big that income will be, we have to be prepared for the worst case, i.e. no income for a while. (But I’m still trying to convince my my wife that we turn my unemployment into retirement. What do you say, honey?) No matter what we decide, my wife’s income alone cannot support our current running expenses.

We have two choices now. One, we can rearrange our assets quite a bit. We could liquidate most of our savings - including our retirement savings - and pay off almost the entire mortgage so that we can afford the payments on just my wife’s income. Since our investments and savings have declined in value over the last year we cannot pay off the mortgage completely, but we can get it low enough to make the monthly payments affordable enough to be able to stay in our home indefinitely.

The other option is that we just stay put with things as they are. What would be the worst case then? It will be a while before I can create an income stream that will provide us with a sufficiently large income that our current belt tightening will be enough. What would we have to do to make a “stay put” scenario work out? Well, at some point we would have to liquidate our savings - again, including our retirement savings - but using this method of crossing financial crisis bridges when we come to them means it would take a good many years before we completely run out of money. This is mainly because in previous years, we worked very hard to put most of our savings into a retirement fund. Even though our 401Ks suffered a lot in recent months, as a rough estimate I even think that we could live like that until I can draw social security benefits under the current law.

So, what do we decide to do after all? The choice between these two options is pretty clear once you think about the tax implications of liquidating a retirement account. If you liquidate a retirement account all at once, you right away put yourself into a much higher tax bracket, and this costs you an awful lot in extra taxes. On the other hand, if you dip into your retirement savings over time, you will not have to pay the high taxes but you will probably stay pretty close to your current tax bracket. In either case, you can’t avoid paying the penalty for early withdrawal under the current law, unless you are withdrawing the money for a legitimate “hardship”. But the fact is that early withdrawal does not cost you as much in taxes if you withdraw money over time rather than all at once. (Plus, I hear that Congress is thinking about ways to lower the penalties for people like me who try to stay afloat by dipping into these savings, so now, it might make even more sense to go slowly with that kind of scheme.)

No matter what we decide in the worst case scenario, our retirement may not be as rosy as we thought only a few months ago, but a retirement plan needs to be adapted all the time anyway. We will figure something out. But right now we achieve our most important objectives. We know that we can continue living in our home for a very long time no matter what. This knowledge about our financial situation should give us comfort and allow us to relax a little about our future.

The other day I overheard an older gentleman – and he truly is an “older gentleman” – say that he would have to continue working for another 18 years since the stock market was performing so poorly. For a number of reasons, I was very surprised to hear him say that.

First, this guy looked like he was around 70 and should be retired already. But, hey, maybe he enjoys gainful employment or else, he has not yet put enough money aside so that he can indeed retire comfortably. Even if he was not retired yet, he must be pretty darn close.

Second, since he has got to be close to retiring, he should have already switched many of his assets out of the stock market and into more conservative investment options, like bonds and money market accounts. (It’s not that these are all that safe right now, either, but they are definitely not as scary as having your nest egg in the stock market when you are needing that egg to hatch just about now.) Having already done this switch would mean that the recent nasty moves of the stock market would not really affect him that much.

Me, personally? I am not so happy about the stock market’s declines, but neither I am too worried. I think my wife and I have the right amount of money exposed to the stock market - not too much and not too little. Our allocation of stocks and any other financial instruments (like bonds, international investments, and money market funds) don’t keep either one of us awake at night. To me, our good night’s sleep is the best indicator that my wife and I have put the right amount of money into the right investments. We may not have done this by the book, but we probably got it right anyway, since there is more than one way to skin a cat, as they say. As long as we are comfortable and as long as our investments do not cause us much stress, we are doing something right. Our goal is not to make a killing with our investments, but instead to lead a happy life, aided by as secure a financial situation as we can get while we do our best to accumulate wealth. So far we are doing fairly well achieving this life goal of ours. I wish you the same.

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