The last time we saw a real recession was 2008-2009. Over the past 10 years we’ve been in a perpetual bull market with nothing but upside (so it seems). 2011 was one of the rockier years during the bull run, but it persisted with double digit returns on a consistent basis. Looking back, the prior recessions occurred every ~5-7 years on average: 2008, 2001, 1990, 1980-1981, 1973 etc. There is no logical way to see forever growth in any economy so we should be aware of a potential down turn (relatively soon). Here we’re going to highlight portfolio management ideas along with age related opinions on how to manage a pull back. We covered building a recession proof life for older readers in a prior post.
Age Related Allocation
Young 22-26: In this younger bracket, you actually don’t care about recessions! That is right, your only goal is to keep your cash flows high. Unless you were lucky enough to already make it (skip to the net worth related allocation) you’re simply trying to stay employed. Financially responsible young adults will be able to put away anywhere from 20-40% of their annual income into savings. They don’t live glamorous lives a lot of the time (until they’ve made it) so they can easily weather a storm. Even if you’re at the high end of this range and you have 1.6x years of living expenses saved (40% * 4), you’re still able to sustain a 50% cut and end up at over 1 year of living expenses.
In general, the rule of thumb is to keep at least 1 significant cash flow item up and running. If you’re able to do this you’re going to survive and spend all of your additional time building that second form of income. Once the second form comes in and the economy improves, your income will sky rocket and you’ll triple the amount of money you’re putting away in a year (or more). So remember, if you’re young, recessions should be less meaningful to you. Just do everything in your power to create cash flow (career or businesses, either work since you’re young.
Young-ish 27-33: At this point, emotional stability should be quite difficult. This means a recession will certainly hurt your net worth. There is no way to continuously grow your net worth through a recession every single year for the rest of your life. At age 30-33 your net worth is high enough that it would be almost impossible to see an increase without selling assets (your business or another item that has appreciated materially). This is essentially the last “battle” you’ll face. Surviving one recession when your net worth is high leads you to an immense amount of wealth later on. It just isn’t fun.
Run the math on this. If you only had $100K, you would have seen your net worth roughly triple from the bottom of the recession to today based on boring S&P 500 returns. This means the survival of a recession will be enormous for you. If you have ~$1M and you’re able to weather the storm of the next recession… you can see a clear path to at least $2M and more likely $4-5M just on S&P returns and your regular income! Think of this as the final battle before seeing a blue sky scenario. After you’re through a downturn (seeing your net worth likely come down 20-30%), you’ll be in a great position to get rich over the following 5-7 years.
Age of Relaxation 34-40: At this point you’re set, you’re not really worried about making a billion dollars and you’re more worried about enjoying your life (maximizing utility). With this in mind, if you’ve already survived at least one recession during your high income earning phase you probably want to adjust your portfolio a little bit. This means you’re going to weight more into boring items like bonds and CDs because you only want to see a ~15% or so decline in your net worth. It’s not going to be easy to make up for a 50% or even 25% reduction in net worth so it’s better to limit the downside. Similar to age 27-33, there is just no way to see forever increasing net worth, but there is a way to mitigate the downside quite a bit.
The second way to think about this is risk tolerance. If you’ve already settled into a lifestyle that can sustain a 50% decrease, then you can be much more risk on. For example… If financial independence only represents 30% of your net worth, having a large exposure to higher risk assets isn’t a problem. Just remember that you’ll never dip into the money you need to continue with financial independence. You’ve already won the “money game” so no need to replay that one.
Age 40+: At this point no one is going to listen to advice/opinions anyway! That said for fun we’ll simply say that the person in this position shouldn’t risk anything that would hurt his own family. If you have kids (or don’t, none of our business), you shouldn’t put their futures at risk due to a high risk tolerance. Other people are relying on you and it is better to make sure that box is checked before looking at bigger, riskier assets.
As a side note, an interesting thing about people in their 40s is that they seem pretty “set” in their minds financially. There are really two groups: 1) people obsessed with making more – their identity and 2) people who are set and looking for lifestyle design. We are very heavily in favor of item 2 since the chances of being remembered on a historical basis are one out of one trillion or so (we don’t even know the inventor of the refrigerator or toothpaste for example). At this age it’s best to just agree with people since they won’t change their minds and they will fall into one of these camps.
Net Worth Related Allocation
$0-100K: The one benefit of being on the low-end? No worries! That’s right. You shouldn’t even bother with portfolio management because you should be focused on earning much more money. Earning money will increase this number even if the market goes down 60% over night. By finding a way to earn $50-100K extra per year, you’ve already made up for the entire decline and didn’t need to worry about the news, product cycles, earnings cycles and balancing a book.
$100-300K: At these levels you’re really focused on investing all of your money into another income stream. This means you shouldn’t be interested in investing yet again. Instead you’re interested in “building”. Instead of looking at opportunities to invest money, we would look for opportunities to buy an actual asset. This would mean an online business (of course!) or a fixer-upper home (if you’re going the real estate route). Essentially, when you’re in this range, you’re not earning enough to move ahead so you have to find an asset that can give you “forced returns”. Forced returns means you can put a lot of sweat equity into the project and force the returns higher (a business and real estate offer this).
$300-$800K: This is a very strange ball park range. Essentially you have enough money to do damage with investing (if you doubled $500K you’re a millionaire). But. You also unlikely have a high income. You need to increase your income a bit more and make sure you can cross the low seven figure range before really making it to financial independence. We’d argue that $500K isn’t enough to be independent because a $500K portfolio that goes down 50% is not going to support anyone for very long.
In this ball-park range we would say you’re forced into online business. Unless you already have a real estate portfolio, you’re not going to find an easier way to increase your income. Why? Time constraints. Working online means you can work while in a cab, on a flight, at home or in an office (hint hint!). We’d be doubling down online until you can get cash flow numbers up another $60-90K. It sounds small but it would be enough. At these levels you’ll likely have a lot of deductions, ability to reduce taxes and the incremental $5.0-7.5K a month will cover the vast majority of your living expenses. Your regular income outside of the online business would flow 100% to the bottom line.
Financially Independent: Once we start talking about numbers in the million dollar plus range, the majority would call this “financially independent”. Sure you still have to do something for money (just because you will be bored otherwise) but you’re not taking it seriously. Our rule of thumb here is to “protect the principal”. As soon as you have 25x the amount of money you need to live in a year (25 annual living expenses) this should be thrown into very low risk items. Majority bonds, CDs and a small amount of boring dividend stocks. You’ll probably clip around 4% and this is just enough to live if things really hit the fan. The rest of your money isn’t material and we’re sticking with this strategy. Under no circumstances do you ever dip into principal associated with your financial independence hurdle.
Net Worth In a Recession
No 401K: We got a lot of negative feedback when we stated that your 401K should not count towards your net worth. We continue to believe this since it will help offset any declines in a recession. As a basic example if you have $1 million and then $300K in a retirement account, the real number is around $1.15 million since it would cost you 50% to take out the retirement account money. The good news? If you’re conservative you never counted the 401K money in the calculation in the first place.
By never including the number, you’re able to have an extra emergency buffer in a downside scenario. We have always used this as a tactic to avoid inflating a net worth number. The tax rate is unknown so strip it out and get the real number before calling yourself “set”.
Adjust Down Based on Upticks: If you’ve never seen a recession we would say net worth should be deducted by 25%. Another way to do this is to discount your total net worth as you move along. As an example, since we know each recession occurs every 5-7 years or so, we can just use a 5% haircut at all times. If you have a $1M net worth, that would be $750K if you’re 5+ years into a bull market. If you are in a recession the net worth number really is $1M. This causes you to become a lot more realistic about the real net worth.
Every single year the market is up, at the end of the year, take 5% off the total number and that is the real net worth. If you go into a recession with a $1M net worth but mentally believe you have $750K… when it drops to $750K you won’t be rattled. Once you make it out you can then adjust back to normal (no discount) which reflects your true net worth. This is a very solid strategy for people in the later years since retiring and seeing a recession would be the worst possible set up imaginable. (this happened to a lot of people in 2008!).
10% Rule: The last item to keep in mind is the 10% rule. This is applicable to people who are above the age of 30 or so. You want to have 10% of your net worth in boring cash. Simplistically you move up from 2% and each year the market is up you increase this by a point or two. This helps offset the downside of a recession. Running the numbers, if you have 25x annual living expenses this means you have 2.5 years sitting in cash. This will allow you to weather a material recession and if it lasts longer than 2.5 years… well the world has a lot bigger problems and other people are suffering much more than you are.
Paper Napkin Calculations: For fun we’ll highlight a few numbers we use to give an idea of what type of portfolio you’ll want. 1) If you’re under $250K or so, it just doesn’t matter and you should be focused on building more streams – real estate or online, 2) If you’re above $500K you’re switching to online business and you’re just barely low enough that you can own stocks + real estate and weather the downturns, 3) at $1M you should begin diversifying quite a bit because a 50% decline at $1M would be difficult to make up (it would require ~$750K in gross income just to get back to $1M), 4) to be more conservative, adjust your net-worth down by 5% every single year the stock market is up, 5) take 25x your annual living expenses and this is essentially the amount that you don’t want to gamble with once you make it (the rest will be risk on – our style, or risk averse depending on your personality).
