Recently, I've encouraged more people to contact me to learn about their safety ratio.
"Safety ratio" sounds like it might be complicated, but it's not.
My definition is: how many years' worth of safe money you have on hand if the stock market drops again.
We know by studying history that the stock market can crash at any time. I also don't believe that we can accurately predict it over time.
So, the strategy that I prefer is to hold a certain amount of money in relatively safe assets. By relatively safe, I mean assets that are less risky than stocks. This can mean a mix of cash, bonds, and alternative investments—which are like stocks but have some downside protection—or real estate, which we also know can have some downside protection.
The point is to have some assets in things that are either less risky or less correlated with whatever the stock market is doing from day-to-day. I recently did another analysis with a client who was wondering,
“If it gets ugly again, how many years would (they) be able to live on the safe savings before having to sell the stocks when they are beaten down?”
We took a look at their cash, bonds, and for this case, I included alternative investments, too, and tallied them all up.
For simplicity, assume they have a $1 million portfolio, and half of that is in bonds, cash, and alternatives.
So, they have about $500,000 that is invested in what will almost certainly be lower returning investments, but safer than stocks.
At the outset of the plan, we are allocating money to where, by definition, we think it will underperform the market.
- This is by design.
- This is intentional.
- We are not doing this to be cute.
- There's a reason for it.
The $500,000 in relatively safe money, as compared to the stock market, is for when the stock market has severe drops. We know that the recent correction, or crash, and subsequent recovery, thus far, has been the quickest in history.
The crash of 2008 was back to even in about five years, and the crash of 2000 was back to even in about seven years.
Out of the last three, one of which was the worst crash since the Great Depression, we're back to even in all of them in under seven years. If we took an average, that number is probably two or three years!
How quickly the markets can recover, even in the face of incredibly scary news, is an important thing to remember.
Now, it would be foolish to assume that the next crash is going to get back to even as quickly as any of the last three.
I feel more comfortable preparing my clients for 10 to 20 years of poor stock market performance and thus perhaps waiting until the stock market recovers to a more reasonable level before selling stocks that are beaten down. We prefer that when selling it isn't done in a panic-type environment.
Back to the safety ratio:
If we want to figure it out, we take the $500,000 of relatively safe money and divide it by one's annual spending.
This includes all the costs of maintaining your homes, living expenses, income taxes, help for children, and gifts to grandchildren, etc.
Tally your expenses, say perhaps $1,000 a month to maintain your home, $5,000 a month for living expenses, and $200 a month for family items, gifts, etc. for a total of about $80,000 a year.
Then subtract from it the income that you have coming in from social security, pensions, rental property income, farm income, part-time work, etc. Say, for our example, $40,000.
Spending need from your investments: $80,000 minus the $40,000 coming in guaranteed = $40,000.
Then, divide by this what you have to spend.
$500,000/$40,000 = 12 ½ years is your safety ratio
Financial planning is more complicated than this, but I find that knowing how many years' worth of money you have, in relatively safe investments, is a big hurdle to finding what might be a comfortable level of risk for you and your family to take.
Furthermore, examining this and taking a look at how many years you do have before you'd have to sell stocks when they were down, can help give you the resolve that you need to maintain your positioning when times get scary. Trust us, they will get scary again. We know that.
We don't know why or when, so be prepared.
If you'd like help going through this with more in-depth calculations, give us a call. We do this every day, and we love to help.
Thank you for taking a look!
-Your Team at ISC Financial Advisors