"Imagine thinking you could predict when you would sprain your ankle or get in a car crash. Instead, develop the ability to absorb damage. Train consistently, remain athletic, buy a safer car, etc. A margin of safety beats playing an oracle." - James Clear, author of Atomic Habits
Last week, we covered the odds of a U.S. recession. It's reasonable to assume two things...
A U.S. recession looks increasingly likely in the next 2-3 years (although nothing is certain).
Most people will feel some level of financial strain if we do enter a recession.
Our focus turns to mitigating damage, without an opinion on what the economy and market does next.
What does mitigating damage look like?
Meet our friend Bert. Bert is a nervous nelly and increasingly worries about a deep U.S. recession and market decline.
Meanwhile, here's what Bert is actually doing...
Lease a luxury car for $1,000 per month.
Max leverage across five rental properties.
Tap a home equity line of credit to buy a vacation home.
Borrow against investment portfolio at a variable rate.
The same portfolio has 25% allocated to risky EV car manufacturers.
Write a $200,000 check to help Bert's son buy his first home.
The worst outcome for Bert is being correct. Our recession predicting friend is positioned to get wrecked.
The above scenario might seem extreme, but it's a reality for many people. They worry about external factors outside of their control, while the things they can control are a disorganized mess.
Stacking up what Bert is doing vs. what he's saying produces a gap wider than the Grand Canyon.
Bert would do well to concede that we will all experience some level of pain in the next recession. His focus should pivot away from playing the market oracle to mitigating potential damage.
We call it creating a margin of safety.
What is a margin of safety? Living to fight another day when your plan doesn't go according to plan.
Do you fully understand the range of potential investment outcomes for your portfolio? We found that investors who anchored to arbitrary identities behaved poorly during the COVID selloff.
For example, the "60/40 investor" was caught off guard by the -25% drawdown during the spring of 2020. If you're surprised by a steep loss, you're more likely to make an impulsive, emotional decision.
Tighten up Expenses
In a recent podcast, we estimated that over 70% of new clients we onboard don't have a handle on expenses.
How much a retiree spends is one of the biggest controllable inputs to a successful retirement plan.
If possible, reduce expenses or portfolio distributions during periods of market stress.
Debt amplifies outcomes for better or worse. Our friend Bert is one bad break from financial Armageddon.
We'll say it again, avoid risks where the best outcome won't change your life, but the worst outcome could ruin you.
Risk Management Plan for Investments
Jumping in and out of stocks isn't a risk management plan. It's an emotionally charged decision that ends poorly almost every time.
If you're a do-it-yourself (DIY) investor, develop a framework for making portfolio changes.
If you work with an advisor, understand their risk management process. You would be surprised how many advisors are making it up as they go.
*The following action items are from our May 21, 2020 post, "Mitigating Damage without Placing a Trade."
It takes some moxie, but market sell-off's are an opportunity for Roth conversions.
We encourage investors to do your homework first. Where are taxes owed going to come from? Does the conversion push you into a higher tax bracket? Does it positively impact the financial plan?
Model the Ugly
Update your financial plan for any loss of income, change in retirement dates, lower portfolio values, etc. Run 'what-if scenarios' side by side to show lower future returns, higher expenses, lower income, to see if the plan is favorable or if adjustments are needed to keep you on track.
The planning process is fluid; life changes and markets evolve. Make sure you're capturing an accurate snapshot of your current reality.
Unwind Concentrated Stock or Legacy Mutual Fund Positions
Stuck with an expensive, tax-inefficient mutual fund? Do you have an overallocation to company stock? It might be a good time to reduce unwanted positions, realize embedded capital gains and wash away with unrealized losses.
There is always a place for cash on your personal balance sheet; to cushion against losing a job, portfolio losses, or reduction in income.
Cash can serve as as a weapon to pounce on investment opportunities.
Fee & Tax Efficiency Check
Have a conversation with your advisor about fees, expenses, and tax-drag (reference your 2021 1099 tax document).
According to a Cerulli study, 42% of folks have no clue what they're paying for financial advice or they think it's free. If you can't tell what you're paying, that's a red flag.
Don't be like Bert. Throw your crystal ball in the dumpster and quit playing oracle.
Turn the lens inward and focus on cleaning up the things you can control.
Mitigating damage beats trying to predict what happens next.
For more on mitigating damage...