Thinking about long term independence

BY BRUCE SHEPPARD

Now before I start on a series that is, in essence, long term financial planning and targeted investing advice, it is worth pointing out to you the following:

•  I have absolutely no qualifications whatsoever as a financial planner. I have never studied its principles nor have I ever felt inclined to study the inner working of modern finance theory, portfolio theory, efficient market hypothesis or any of the other wonderful stuff doctorates are awarded for.  A simple paper on investment theory and net present value and related topics was enough, in fact I got halfway through the paper and didn't bother to finish it. I figured despite my education the world is quite simple.

 

• I have a very rudimentary education in economics and history, and thus I can't claim any particular expertise in this either.

 

•  I have no formal training in governance, board processes, capital markets processes, in fact I have absolutely no qualifications in anything that I habitually express opinions on.

 

• Like many "business" people, although being an accountant sort of rules you out as being a creator, in a business sense, I have no qualifications in that either, and nor do I have any qualification in human psychology politics, or business administration. In short I am completely unqualified to do anything, think anything or say anything, so you read me at your own peril.

 

Thus ends my disclosure statement, and I guess I am unqualified to be licensed as an advisor either, and I certainly have no intention of completing "continuing education' as it will undoubtedly be structured to be less than useful.

So, unqualified and unlicensed and soon maybe to be actionable without such a licence, here goes.

To be independent long term what you need are two things and they are surprisingly different but interlinked.

The first is you must always have access to "cash" whatever that might be in the brave new world over the next 50 years, so that you have the ability to pay for the things you want and need. Cash or its equivalent is the tool in this world to the power of personal freedom and choice.

Your first big choice, is whether you choose to live on capital or off capital. Living on capital is the one that requires the least amount of thinking, but the most gruntingly hard work and initial self sacrifice.

Living on capital involves saving say $1 million over 40 years, and spending it over the next 20. ie: put money in the bank earn 5 percent compounding, then run it down and hope its lasts longer than you do. This is living on capital.

The better outcome is to live off capital. This is a process of building "assets" that produce income, and importantly and don't forget this IN CASH. Then you have cash without consuming your capital.

Long term investing is about building passive income flows that are defendable. But to make this work over time takes a different commitment, a commitment to think learn and analyse, and the capacity to cope emotionally with risk, which means loss. The emotional ability to cope with loss is just as important as the actuality of loss.

You have made it to adulthood, you have a home you can afford, you have spare borrowing capacity, you have insurances and you have spare income. You are now ready to start investing, and this means at least at the start of the process investing with either debt or with drip feed plans using your spare income.

 So this series of articles is going to try and cover the following.

• Investment planning. 
• Compounding and drip feed plans  
• Debt funded investing  
• A quick guide through the pathways and alternatives to passive investing. 

Before you begin a long term action like deploying your savings or your saving capacity to anything it is important that you have the structure of a long term plan that you understand and a short term action plan that you can execute with confidence and comfort. This article is about the long term plan.

MORTALITY

We are all going to die, we just do not know when or how. Read the death notices one day. You will not find a death notice that says "died after a long period of planning".

You will also note that most of the death notices are old people, so here is another truism, if you have got through your life this far, home kids etc and worked out how to be useful, you are going to live long enough not to be useful. Surviving independently is your task, surviving with dignity is your objective, and while money is not the sole answer to this it sure as hell is easier if you have got some than none.

Now as you move along the continuum you have less time in front of you. When you hit middle age you are likely to have more time behind you than in front of you. Think of yourself as the energiser man, eventually your battery will run flat. It is really important that you have passed on your experience before this happens and that you have built passive income flows to cover the loss of the income volumes generated by high energy outputs.

So to put things in perspective sub age 30 (these days anyway) you are learning and more or less useless,  but you will have rising income and rising expenses. Thirty to 50 you will be really useful. You will have high energy levels and high incomes and near the end of this segment of life, declining costs. From 50 to 60 you plateau but are still a high performer. Sixty to 75 you start to run down, and by 75 you need to be well prepared for the cruise to what might be 100.

Technology is extending these bands including the useless young one, because the bright ones stay at school bloody near to retirement.

This is just a guide. So don't beat yourself up if you are 45 with no financial assets, if you get to that age and have educated a family and paid off a house you are doing ok. The next 15 years of income will build the retirement capital to a point, and if you make the capital work rather than adopt an accumulation strategy alone you will be even better off.

ATTITUDE TO RISK

When you are young you are indestructible, you will thus take more risk willingly than when you are older.

Again life and propensity to take risk is like a battery. But here is the problem, when you are young you are also stupid. So risk taking is best conducted in the cross-over zone of mid 30s to around 60. In that time you have accumulated life and other experiences, while still having enough time in front of you to recover from losses.

When you are 30 to 40 - the prime risk taking zone - you will have no or limited capital, thus at the time when you should be taking risk and learning, you are out of the game. Thus my recommendations to use your home equity for risk taking or otherwise deploy debt.

WHAT TO INVEST IN?

Financial planners will confuse you with a long list of asset classes. Cash, fixed interest bonds, corporate bonds, shares, derivatives, property, in all it flavours, local, global, currencies... the list goes on.

They will say to you the most important part of long term planning is asset allocation, if you get this right over the long term the returns will be stable and sound. The aim of asset allocation theory is to spread your investment across differing asset types in the belief that some assets perform well when others perform badly. This approach is buying the market, always a long tem pedestrian bet as against buying an asset (but wait for it - research says I am wrong)

Now it is not hard, there are only two asset classes, cash or businesses. And here is the next trick when thinking about asset allocation - cash can be negative, (ie: your portfolio can have debt) assets can rarely be negative and if they are you are in serious trouble.

There is usually some value in assets, I guess that is why we think of them as assets. Well not quite, all assets have holding costs attached to them, and when these costs exceed the income from the asset over the long term the asset has negative value. It is always worthwhile quarantining assets that might have this characteristic so you can walk away and say, zero is my worst case scenario.

SO, ASSET ALLOCATION?

It is simple really, based on your risk appetite determine an allocation of investment between cash and assets.

The start point of this is to determine these things: If I take a loss how will I feel? Will I have the attitude to lose and move on, or will I more likely look to blame someone else and stew on it forever trying to get even. If it's the latter, do not take risk stick with cash.

Am I prepared to work at investing? Am I prepared to learn? Do I actually think this space is interesting and challenging? Am I prepared to make investing part of my life, or is the beach more fun is camping fishing travelling more fun, is life more than investing? If it's the latter stick to cash.

Assuming you have answered these simple questions and you are now guided to investing in businesses, as all assets are businesses, including property, what is the split?

You magnify risk by deploying debt and mitigate it by holding cash. More debt = more risk to your "portfolio" more cash = less risk.

For most it is a simple equation, once you get to 75 at the latest you should be entirely in cash, and have no assets at all, (but this does depend on the scale of your portfolio) and at age 30 you should be 100 percent in assets financed with 100 percent debt, ie: your assets should equal your debt.

Between 30 and 60, preferably at around 40 to 45, you should be 100 percent in assets no cash, no debt. If you do have debt, and you may, you should also have cash to mitigate the risk of debt, bloody inefficient but sometimes useful if you want to run 100 percent net assets with no cash, but want to have access to cash to increase your asset position opportunistically. I have credit lines and cash to magnify my ability to act or react to quick changes and the last five years have been very "interesting".

So the first part is draw a graph plot your age at the left side, a stop age at the other side, and determine the start ratio of cash or debt to assets and draw a line over time to your end goal.

Then pull out asset allocation splits at five year intervals, which will be your review points as you go through life. At these points you may choose to change your asset split plan fundamentally. For example say you have invested well and made $20m and you then re-ask yourself the two questions above and you determine fishing is more important, then you should change your plan.

If you then say to yourself I really love this, $2m cash is enough, the rest is going into assets no matter what, that is fine too.  The five year stop and reassess is simply a life stock-take pause event. So once every five years you prepare an investment balance sheet, and guys THIS DOES NOT INCLUDE YOUR HOME.

Also don't forget that while you are investing you will still be saving, so the cash build up will change each month, so you should also have a real time balance sheet that you monitor more closely so that the trigger points for when to go asset shopping are acted on.

Don't be too concerned if the ratio is out by plus or minus 10 percent in the short term, but more than that needs your attention.

If you have a real winner of an investment that multiplies 10 fold, your asset to cash ratio will also change. Guess what - this is a trigger to consider selling down, equally if an asset turns to complete custard your cash will be too high, this is a trigger to reinvest or find a new investment, rebalancing is a dynamic process, or responding to change.

Now the final thing to decide is what type of businesses are you most comfortable with, that is the next blog.