Hello again from the end of the world!
Ha, just kidding. It is not the end of the world. Don’t get me wrong, this is a very, very serious health crisis the world is dealing with right now, and everyone should be practicing good hygiene, washing their hands, and practicing proper social distancing, unlike these idiots who are deliberately going around coughing on old people because they think it’s funny. Morons.
I am continually amazed by how quickly the world can turn on a dime. Just a few months ago we were sitting on record stock market gains and debating on how much we should increase our equity allocation. Now, the streets of every major city is sitting virtually empty as the global economy screeches to a standstill. What a ride this has been.
But this isn’t a news blog, it’s a finance blog. And if I could use two words to describe the mood in the finance/business world right now, it would be “abject terror.”
I get it. The world’s stock markets are in free-fall, trillions of dollars of valuations have been wiped out in a matter of weeks, and nobody knows where the bottom is. Dow futures are regularly hitting stop limits, and we have seen multiple days of breathtaking, record-setting movements in both directions. In short, it’s starting to feel a lot like 2008/2009.
So are we panicked? Not at all.
I mean, don’t get me wrong. We’re not taking a blasé approach to the dangers of the coronavirus, and we are taking all the steps recommended by the WHO and the Canadian government to make sure we don’t get sick (and more importantly, we don’t pass the disease on to anyone else), but from a personal finance perspective we are going to be just fine.
Remember, the reason that we invest in the stock market is not just to grow our portfolio. The real reason we invest is to secure our cash flow.
Cash, after all, is what we use to buy groceries, to pay for rent, and to go out and enjoy life. ETF prices are just numbers on a screen, but if you don’t have a good way of converting that into cash, then you aren’t actually ready to retire yet.
That’s why while we talk a lot on this blog about financial topics and how to build a balanced, diversified ETF portfolio that will help you retire, equally important is how you turn that portfolio into cash, and how to do it safely even in times of crisis.
The Three-Bucket Strategy
Central to this is our Three-Bucket Strategy. We explained all the inner workings of this system in our book Quit Like a Millionaire, but just to briefly sum it up, you basically organize your money in retirement into three groupings, or buckets, like so.
On the left you have your retirement portfolio full of low-cost index-hugging ETFs. On the bottom right, you have your Current Year Spending. This the amount of money that you reserve for your rent, food, entertainment, etc. for the upcoming year. And finally, you have a seperate savings account for your Cash Cushion. This is a certain amount of cash you keep that will help tide you over during market downswings, like the current one we’re facing.
Remember that your portfolio returns money in two ways: the portfolio yield (or the Yield Shield, as we like to call it), and capital gains. In good times (like last year), at the beginning of the year you fill up your Current Year Expenses bucket by harvesting your portfolio’s Yield Shield, and selling off a few ETF units that have gone up in value.
In bad times, you fill up your Current Year Expenses bucket by again harvesting your portfolio’s Yield Shield, and also taking a year’s worth of Cash Cushion to make up the difference.
And when the good times later return, you use the extra capital gains of your portfolio to refill up your Cash Cushion so you’re ready for the next economic downturn.
Some have criticized this strategy of ours as being overly cautious, as it does keep some amount of cash out of the markets (though not nearly as much as you might think), but BOY are we glad we have this system in place right now. Last year when markets were red-hot, I refilled our Cash Cushion account back up to our target of 3 years. So right now, even as our investment portfolio is getting whipsawed like crazy, our 2020 expenses are already taken care of because we harvested our Yield Shield in January, and our refilled Cash Cushion will provide us another 3 years of cash flow, for a total of 4 years of living expenses already accounted for.
Oh and that’s not including any blog/book income, which while is nice to have, we don’t actually live off in order to keep our early retirement experiment as pure and relevant to all of you as possible.
So that’s what we did on our investment side to make sure temporary market dips don’t affect us. However, just as important is how we spend our cash year-to-year. I’m talking, of course, about lifestyle inflation.
Don’t Inflate Spending during Good Times
I get it. It’s super easy to look at a hot year in which your portfolio has gone up six figures and think “You know, I could really use a new Tesla right now…”
That would be a mistake. Remember, the 4% rule that FIRE is based on assumes that when you retire, you only increase your living expenses year-to-year by a rate not exceeding inflation. If you jump your living expenses up more than that, you may be increasing your chance of portfolio failure, or sequence of return risk as the finance nerds call it.
On this one, FIRECracker gets all the credit for the success we’ve had on this. If you look back at our annual spending summaries, you might notice that it somehow never goes about $40k. That’s all because of her.
She’s the one who takes all of our receipts every night and puts it into her magical spreadsheets. She’s the one that finds all the deals on lodgings as we travel the world with our two backpacks. And she’s the one that notices immediately when our spending starts to creep up and figures out how to get it back down.
As a result of her (and our geographically arbitraged lifestyle), we’ve not only managed to NOT inflate our lifestyle over the last 5 years of retirement, we’ve somehow sidestepped inflation completely. This has caused our portfolio to increase at a faster rate during the stock market run-up than we initially modelled, which is great because when the inevitable crash comes, you need every extra penny to weather the downturn.
Be Militant With Your Cash in Bad Times
And finally, when the inevitable crash does happen, it’s even more important to manage your spending even more.
This is actually turning out to be easier than I thought. One of the very, very, VERY few upsides of this coronavirus crisis is that it’s become surprisingly difficult to spend money. We enjoy our eating out, but that becomes kind of difficult when every single restaurant is closed. And as FIRECracker noted in the last article, the cost of AirBnbs in city centres have plummeted in value. We are able to pick up AirBnb’s now in downtown Toronto for less than a long term rental!
As a result, our spending has plummeted. In fact, if the worst case scenarios that the media are predicting come true and we remain locked down for most of the year, we are projecting that we will under-spend our budget by $5k – $10k. That has a profound impact on our cash position, because at that level of spending, it would actually allow us to INCREASE our Cash Cushion rather than spend it down. So somehow, the longer this crisis lasts, the safer our cash flow becomes.
Cash is King
There’s a saying in the financial world that in a crisis, Cash is King. Well, we are in a crisis and we’ve definitely found that statement to be accurate. All the financial wizardry in the world doesn’t matter when your fridge is empty. That’s why it’s so important to have a cash flow strategy as well as an investment strategy, because at times like this Cash really is King.
Stay safe, everybody. And no coughing on old people!
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