Will you have the money when you need it? Maybe you have some money now, but don’t need it. Later you may need money, but will you have money then? Having the money is important, but so is the timing.
Let’s assume you bucked the trend of many physicians. You paid off debt and live below your means. That extra cash can now fuel your future goals and dreams. You are getting your financial house in order. Congratulations!
Money Now & Money Later
If your dream is now, go for it. But what if your dream or need for cash is in the future? Doctors tend to be conservative. We fear a market crash that could destroy our savings.
But the money won’t go as far in the future. The concept of “Time Value of Money” tells us that a dollar now is worth more than a dollar later. This is due to both lost investment growth opportunities and inflation.
Are Stocks Worth It?
In the past, stocks have outperformed cash, bonds, and inflation. The stock market rewards us for taking a risk. That amount of extra return is the “equity risk premium.”
But anyone who remembers the crashes of 1987, 2000, or 2008 will be aware of the stock market’s risk. Prior crashes were even worse.
So what are we to do? How can we be sure to have the money we need at the time we need it?
ROI Isn’t Everything
Most of us spend too much time focusing on market performance rather than our own cash flow planning. A focus on the market leads to futile attempts to outperform the market. This misguided focus causes misbehaviors.
Those misbehaviors can devastate your portfolio. It is better to work within a framework, such as these seven steps. Ashvin B. Chhabra inspired me to write this post. His book, “The Aspirational Investor” is excellent.
Step 1: Why Do You Need Money?
Outline your goals. Do you know what your financial goals are? What is the likelihood you will reach targets that aren’t clear to you? The best financial goals relate to one of the three areas of importance.
- One, you need protection and adequate safety.
- Two, you will need to maintain your purchasing power.
- Three, you need to create opportunity through aspirational goals for wealth. You can cluster these in three categories: Essential, Important, and Aspirational.
Step 2: When Will You Need Money?
Convert your goals into cash. Now that you know what sums you will need for each category, you can convert that to a cash flow value. How do you do that?
Chhabra recommends the “zero-discount method.” It sounds complicated, but it is the easiest way imaginable.
Savings Required This Year = Cost of Goal / Years in the Future
For example, let’s say you will need $120,000 to pay for your daughter’s college. She is now 7. The annual “cash flow” to save this would be $12K ($120K / 10 years).
The beauty of this is it assumes the investment growth rate and the inflation rate cancel each other out. They are often similar. They are also both unpredictable. Because of these factors, the calculation becomes simple.
Future Dollars = Today’s Dollars
This seems wrong. Especially since I just explained the “time value of money.” But it is a deceptively simple estimate. This result may not be 100% perfect, but it isn’t bad. This financial prediction will put you in the right ballpark.
You can reassess the goal each year. Rising expenses, low investment returns, or better information may change the picture. Make a course correction if needed.
Three Types of Goals
- Essential goals will be goals that are a must-do for you. Things like building a cash cushion and saving for retirement. Maintaining your lifestyle while paying off college loans may be here.
- Important goals may be college funding for a newborn child, or a vacation.
- Aspirational goals may be saving for a condo or creating a charitable foundation.
Use the zero-discount method to determine “your number.” Your number is the amount needed for your retirement nest egg.
Take how much you spend in a year (e.g. $100K). Multiply by the years of retirement (e.g. 25). The nest egg needed to retire is $2.5M ($100K x 25). Easy peasy.
Step 3: What To Invest In
Divide up your assets. We need a framework for financial risk. Dividing your money into the different risk buckets is also called “asset allocation.”
Organize your assets and liabilities across the buckets. The three buckets are your personal risk, market risk, and aspirational risks.
Three Investment Buckets
Don’t put assets needed for safety at risk in the market. They should be in the safety portfolio.
Assets that need to grow in a risk-adjusted way belong in the market portfolio.
Assets that perform better than the market carry extra risk. Those should be in the aspirational portfolio.
As proxies for the categories, consider three buckets based on risk: low, medium, and high.
Options include: cash/short-term bonds, S&P 500, and private investments. If you aren’t clear where to start, consider how I invest as a starting point: 40:40:20.
40% safe. 40% market. 20% high-risk. 40% short-term bonds. 40% total stock index fund. 20% other investments. My “other” is mostly small private companies and individual real estate investments.
Step 4: Should You Risk Losing Money?
Assess your risk level. Is 40:40:20 the right mix for you? What is the “right” asset allocation? Unfortunately, there are no exact answers.
Subjective factors matter. How well would you sleep at night if your stocks crash? That indicates your psychological ability to withstand a loss.
It isn’t all about emotions though. Other factors matter too. What is your financial ability to withstand a loss?
Can You Recover From a Loss?
Do you have enough time and human capital to earn it back? Could you financially wait it out until returns turn in your favor?
Some should be aggressive with investments. They have a high ability to take on risk and a low desire to avoid risk.
Others are more conservative. They have a low ability to take on risk and a high desire to avoid risk.
The rest of us are moderate.
Do You Have Enough?
If you stopped working today, how many years could you live on the money you have?
Let’s say you have $2.5M. Your burn rate is $100K/year. That is 25 years of income that you have stored up.
How does your actuarial life span compare? Do you fear running out of money in retirement? If you likely have only 10 years of life left, you could take more risk with your money if you want to. You are building a legacy fund at that point.
Human Capital is Your Best Asset
Your level of human capital is important. Think of human capital as a store of future earnings. It is an asset. Its value depends on your future earnings.
Compare, for example, that amount for a surgeon versus a carpenter. A 30-year-old orthopedic surgeon may have $8M more human capital.
Keep Getting Paid
Also, consider a semi-retirement phase before complete retirement.
You may not want to fully retire. Even in retirement, we need purpose and structure in our lives. It is worth thinking about making some money then too.
A profitable hobby or part-time job can help a lot. It can provide social support, meaning, and some income. Even a small stream of income would lower your savings need and delay your asset spend-down.
Step 5: Where Will You Invest?
Here is where you explore the practical options of implementation. Where will you put your “safe-money?” Common choices include a savings account, money market fund, or short-term bond fund.
What about your “market bucket?” Options include an S&P 500 or total stock market ETF.
And your “aspirational bucket?” Think leveraged real estate, venture capital, or a physician-owned hospital. Make a plan now. Who do you know who has such investments? Could you reach out to them?
Opportunities are out there, but they won’t just fall into your lap. How will you find these investments?
Step 6: Will You Have Money After a Crash?
Analyze and test. Crash test your portfolio. Run some worst-case scenarios. If you have an advisor, get them to help with this.
If you are a do-it-yourselfer, use an online Monte Carlo simulator. Work through possibilities like these.
- You can’t work for five years.
- The “market bucket” crashes 50%
- Your “aspirational bucket” crashes 70%
How would you feel about all that? If you would be comfortable and not overreact, then that asset allocation is fine. If not, adjust now.
Step 7: Review and Rebalance
Unfortunately, this isn’t a “one and done” process. You will need to reassess. This could be between one and four times a year. See if your assets have gotten off track.
If your job is less secure, beef up your safety bucket. Add to your bond fund after rising interest rates decreased your balance.
Stop Speculating. Start Investing.
Is it time to cash in on your Bitcoin success? It might be too late for that one! It could be time to cut your losses on that Chinese stock you bought on margin. Switch to a low-cost market-based index fund.
Beat most active managers by following this path. Pay for asset protection. Invest in market returns. Put some assets in high-return investments.
You now have a road map for achieving your life goals. Follow these seven steps. You will have the money when you need it. What do you think?