Financial-SEER
00:00:00.000 | Hello, everybody.
00:00:00.880 | It's Sam from Financial Samurai.
00:00:02.800 | And in this episode, I'm going to introduce a new concept
00:00:05.400 | called Financial SEER, S-E-E-R. It
00:00:10.000 | stands for Financial Samurai Equity Exposure Rule.
00:00:15.280 | And it's a way to quantify risk tolerance
00:00:17.760 | and determine appropriate equity exposure.
00:00:21.240 | So after the fourth quarter of 2018,
00:00:23.240 | where we saw basically a hammering of the stock market,
00:00:27.840 | I thought it was a good idea to figure out
00:00:29.840 | and to help listeners figure out what
00:00:32.320 | is the appropriate amount of exposure
00:00:34.280 | one should have to equities.
00:00:36.200 | I've been trying to build meaningful wealth
00:00:38.720 | in a risk-appropriate manner ever
00:00:40.400 | since I graduated from college.
00:00:42.480 | And that's what I want all you guys to experience as well.
00:00:45.720 | I started my career soon after the 1997 Asian financial
00:00:48.920 | crisis.
00:00:49.840 | And that was an interesting one because currencies,
00:00:53.120 | from Thailand to Indonesia, they devalued tremendously
00:00:57.360 | overnight, causing many international college students
00:01:00.480 | to just drop out.
00:01:01.720 | And I had a couple of those.
00:01:02.840 | I was like, whoa, what's going on?
00:01:04.760 | So I fully appreciate how hazardous the road
00:01:07.600 | to building great wealth can be.
00:01:09.640 | And I think most investors overestimate the risk
00:01:12.200 | tolerance, especially investors who've only
00:01:15.160 | been investing with a significant amount of capital
00:01:18.320 | since 2009.
00:01:19.640 | We've just seen a phenomenal nine-year-plus run bull market.
00:01:24.240 | And sequence of risk is pretty real.
00:01:27.960 | Once the losses started piling up,
00:01:30.440 | it's not only the melancholy of losing money
00:01:33.240 | that starts getting to you.
00:01:34.520 | It's the growing fear that your job might also be at risk.
00:01:39.320 | Some of you might erroneously think the richer you get,
00:01:42.800 | the higher your risk tolerance.
00:01:44.320 | After all, the more money you have, the bigger your buffer.
00:01:47.760 | This is a fallacy because the more money you have,
00:01:50.520 | the larger your potential absolute loss.
00:01:53.360 | For most rational people, their lifestyles
00:01:56.000 | don't inflate commensurately with their wealth.
00:01:58.720 | They still remember what it's like to be frugal
00:02:01.400 | and to save money.
00:02:02.680 | This is why even rich people can't resist a free rubber
00:02:05.540 | chicken lunch.
00:02:06.960 | Further, there will come a time, hopefully, for all of you
00:02:10.200 | guys, when your investment returns have a larger
00:02:12.360 | impact on your net worth than your earnings and savings.
00:02:15.940 | As a result, the richer you are, the more dismayed
00:02:19.080 | you will be to lose money.
00:02:21.200 | Because no matter what you do, you
00:02:23.600 | can't really make a difference through working harder or longer
00:02:27.200 | and saving more.
00:02:29.060 | And the reason we all continue to fight
00:02:31.280 | in this really difficult world is because we have hope.
00:02:34.720 | But eventually, our hope fades because our brains
00:02:37.480 | and our bodies slow down.
00:02:39.040 | When we're younger, we often think to ourselves,
00:02:42.000 | we're invisible.
00:02:43.200 | We can do anything.
00:02:44.600 | Nothing's going to hurt us.
00:02:46.160 | Then eventually, we start experiencing
00:02:47.800 | the realities of aging.
00:02:49.880 | And due to these fading abilities,
00:02:52.440 | we must bring down our risk exposure as we age.
00:02:56.680 | The only way most of us can rescue our investments
00:02:59.640 | after a market swoon is through contributions
00:03:01.480 | from earned income, i.e.
00:03:03.320 | our salaries.
00:03:05.520 | And to understand reward, we must first understand risk.
00:03:09.720 | Since 1929, the median bear market price decline
00:03:13.040 | is about 33.5%, while the average bear market price
00:03:17.400 | decline is about 35.4%.
00:03:21.040 | Therefore, it's reasonable to assume
00:03:22.760 | that the bear market could bring equity valuations down by 35%
00:03:27.760 | over an 8 to 12-month period.
00:03:30.320 | And if you look at the post, you can see this chart
00:03:32.400 | that chronicles the bear market.
00:03:35.320 | So most people just regularly invest in stocks over time
00:03:40.060 | through dollar cost averaging.
00:03:41.960 | They have little concept of whether the amount of stocks
00:03:44.360 | they have as part of their portfolio or their net worth
00:03:47.240 | is risk appropriate.
00:03:48.680 | Hence, to quantify your risk tolerance based
00:03:51.360 | on your existing portfolio, use the following formula.
00:03:55.800 | And this is part of financial seer.
00:03:58.560 | Public equity exposure times 35% divided by monthly gross
00:04:04.120 | income.
00:04:04.960 | So let's say you have $500,000 in equities
00:04:07.560 | and you make $10,000 a month.
00:04:09.480 | To quantify your risk tolerance, the formula
00:04:11.560 | is simply 500,000 times 35%, where 35% is the average
00:04:16.160 | decline in a bear market, and you get $175,000.
00:04:21.760 | And then you divide that by $10,000,
00:04:23.800 | which is your monthly gross income, to get 17.5 months.
00:04:28.240 | In other words, the formula tells you
00:04:30.520 | that to make up for your potential losses,
00:04:34.200 | you have to work an additional 17.5 months of your life,
00:04:40.320 | and that is gross income only.
00:04:42.120 | So because you have to pay for taxes,
00:04:45.000 | you're probably going to have to work closer to 22-plus months.
00:04:48.960 | And then because you have to pay for basic living expenses,
00:04:51.760 | you probably need to work more than 22 months
00:04:54.600 | to make up for that loss.
00:04:56.400 | So in other words, that risk tolerance multiple of 17.5
00:05:01.280 | is really--
00:05:02.760 | well, you probably need to multiply by 1.2 to 3 times
00:05:05.680 | to get the real amount of months that you need to work
00:05:10.040 | to make up for your losses.
00:05:12.000 | And just think about this classic scenario--
00:05:13.760 | 68-year-old guy, retired with a million-dollar portfolio,
00:05:17.160 | living off $20,000 a year in Social Security,
00:05:20.080 | and $20,000 in dividend income from his portfolio.
00:05:23.680 | If his portfolio loses 30%, that's
00:05:25.960 | going to be really, really, really tough.
00:05:29.320 | We're talking losing $300,000.
00:05:32.120 | And if you have a fixed income of $20,000 a year
00:05:36.200 | from Social Security, it's practically
00:05:37.840 | impossible to make that up.
00:05:40.800 | The only thing the retiree can do is pray the market
00:05:43.040 | eventually goes up while also cutting costs.
00:05:46.720 | Now, the second part of financial seer
00:05:49.620 | is to figure out what the appropriate equity exposure
00:05:53.280 | should be based on the risk tolerance multiple.
00:05:57.560 | So here's another formula.
00:05:59.080 | Your max equity exposure equals your monthly salary
00:06:04.800 | times 18 divided by 35%.
00:06:08.040 | So what is 18?
00:06:09.720 | 18 is my recommended risk tolerance multiple,
00:06:13.800 | where on a gross monthly salary basis,
00:06:16.160 | you don't want to risk more than 18 months worth of gross salary
00:06:18.960 | on your equity investments.
00:06:20.760 | And 35%, again, is using the average bear market
00:06:23.520 | declined in your public investment portfolio.
00:06:26.800 | In other words, if you make $10,000 a month,
00:06:29.600 | the most you should risk is a $180,000 loss
00:06:33.560 | on a $514,000 pure equity portfolio.
00:06:38.160 | Now, your portfolio can obviously
00:06:39.720 | be more than $514,000 in this equation.
00:06:43.620 | You can have 250,000 in AAA-rated municipal bonds,
00:06:46.960 | if you wish, for a reasonable 67%, 33% equity fixed income
00:06:51.000 | split with a total portfolio size of 764,000.
00:06:55.960 | You basically have to adjust assumptions as you see fit.
00:06:59.240 | Maybe you only think the bear market will only decline by 25%.
00:07:03.400 | Well, then you can just replace 35% with 25%.
00:07:07.800 | And the result would be $10,000 salary times 18 divided by 25%.
00:07:13.120 | So you can actually have 720,000 of maximum equity exposure.
00:07:17.360 | Maybe you see yourself getting promoted
00:07:19.600 | and earning 20% yearly earnings increases for the next five
00:07:24.480 | years.
00:07:25.800 | Maybe you can increase, therefore,
00:07:27.520 | your equity risk tolerance multiple to 36, maybe,
00:07:34.080 | from 18, and maybe, as a result, you
00:07:38.300 | could have 1.44 million in equity exposure using
00:07:41.960 | a 25% denominator as the bear market scenario.
00:07:45.760 | Just remember, whatever your gross risk tolerance multiple
00:07:48.080 | is, you're going to have to increase it by 1.2 to 3 times
00:07:51.200 | to truly calculate how many years you
00:07:53.560 | will need to work to recover from your bear market
00:07:56.180 | losses due to taxes and general living expenses.
00:07:59.500 | At the end of the day, it's a judgment call
00:08:01.280 | regarding how much equity risk you should take.
00:08:04.140 | If you've quadrupled your net worth after a nine-year bull
00:08:06.960 | run, it's probably wise to lower your risk exposure multiple.
00:08:11.360 | Conversely, after 30% correction in equities,
00:08:14.840 | it's probably wise to increase your risk exposure multiple.
00:08:18.400 | Only you can decide how much more
00:08:21.280 | you're willing to work to make up for those losses.
00:08:25.080 | The closer you get to retirement,
00:08:26.600 | the lower your multiple should be.
00:08:29.000 | Nobody wants to get close to being financially free
00:08:31.800 | only to break a leg and get carted off in an ambulance.
00:08:36.000 | I hope the financial samurai equity exposure rule
00:08:39.200 | helps you take the subjective term of risk tolerance,
00:08:42.360 | because everybody just throws that around,
00:08:44.160 | and shapes it into something more quantifiable.
00:08:47.120 | You now have a concrete way of determining your equity
00:08:49.880 | exposure and risk tolerance.
00:08:51.920 | As for 2019, well, earnings are set
00:08:54.880 | to grow by only about 6% to 7% from about 20-plus percent
00:08:58.800 | in 2018.
00:09:00.400 | But the good thing is the market corrected.
00:09:02.200 | We're back to historical averages on a P level.
00:09:06.160 | And I could easily see the market go up 10%.
00:09:08.640 | And at the same time, I could easily see the market go down
00:09:11.160 | 10%.
00:09:11.920 | So for me, in particular, I'm looking to lock in wins.
00:09:15.700 | And I'm doing that by paying down some mortgage debt
00:09:19.040 | and also taking advantage of shorter-term interest rates.
00:09:22.520 | For example, SITBank has a 2.45% money market account now.
00:09:27.600 | I mean, that's huge.
00:09:29.200 | And you can sign up at financialsamurai.com/citbank
00:09:34.080 | savings to get that 2.45%.
00:09:37.600 | That's pretty much the same as my 5-1 arm mortgage rate.
00:09:40.520 | So basically, I'm living for free.
00:09:43.320 | You really want to lock in some games.
00:09:44.900 | Yes, continue to invest, but make sure it's
00:09:47.520 | in a risk-appropriate manner.
00:09:50.400 | My current allocation is about 40%, 45% stocks, 50% to 60%,
00:09:57.920 | fixed income.
00:09:58.840 | And it's just going to depend.
00:10:00.080 | If I see opportunity, I'm going to take it.
00:10:02.560 | And if S&P 500 gets back to 2,800,
00:10:05.000 | I'm probably going to sell a lot more equities.
00:10:07.520 | And hopefully, ironically, hopefully,
00:10:09.760 | rates continue to go higher so I can get
00:10:12.200 | that risk-free rate of return.
00:10:14.440 | Thanks so much, everybody.