This post is the third part of a three-part series on Maximizing Net Worth. If you are just catching up, be sure to check out Parts 1 and 2 below:
Maximizing Net Worth Part 1: Getting Under the Hood
Maximizing Net Worth Part 2: Diagnosing Changes in Net Worth
The Emotional Hurdle
Let’s face it - money matters are emotional. We hate losing our hard-earned dollars and we’re never completely satisfied with what we have. Consequently, we tend to act irrationally, sacrificing the potential for our future selves.
Consider the following scenario - you buy Tesla’s stock on January 2, 2020 at $430.
On February 19, 2020, Tesla’s stock soars to a high of $969 - 2.25x the price you bought for. Would you sell or push your luck just a little further and hold?
Let’s say you sold and the stock continued to climb. Would you be upset, even though you more than doubled your money?
Now let’s look at what really happened to Tesla. It’s February 28, 2020, and the reality of COVID-19 is setting in across the world. Tesla’s stock price tumbles from a peak of $969 to $668. You decide to sell before you potentially lose all of your gains and walk away with a 55% profit. Are you happy that you earned a 55% return on your investment or unhappy that you lost out on a potential 125% return had you sold at the peak?
Even though all of these situations leave you in the green, I am betting each one of them still makes you feel a little deflated. You enviously curse the winners who cashed out at the peak with brand new Tesla's in tow and wish you had made the same moves instead.
Of course, you can always take pride that your seemingly sub-par judgments were in fact, exactly in-line with the big man on top.
The stock market can certainly send one into a tizzy which is why many people avoid it. But the reality is that we experience the same decisions and outcomes on a daily basis. We take bets on our education, our careers, our purchases, and even our relationships in hopes of a better, more prosperous life. And even if the outcome of these actions is more favorable than before, our guides of comparison, whether that be the coworker who scored a better promotion than you or your buddy who pulls up in a shiny new car, can leave us wanting just a little more.
So how do we combat these emotional hurdles that keep us from building wealth in a healthy, sane way? The ones that trap us into taking unnecessary risks, tempt us into spending more than we should, or drive ourselves toward burnout to come out on top?
The answer is to reset your reference points.
Making Informed Decisions
When maximizing your net worth, you must stay focused on your own circumstances and no one else’s. Do not mix status symbols with eternal success and freedom. One wrong move or unfortunate event can send the unlikeliest of winners home packing. Your goal instead should be to build financial security that carries you through both the good and bad times.
As you move throughout different stages of your life, your strategy towards establishing and maintaining financial stability will evolve as well. An easy question you can use to check in with yourself is the following:
Are you trying to grow, protect, or enjoy your net worth?
Each of these goals comes with its own trade-offs, risks, and returns. Growing your money may mean taking larger bets on your investments, grinding harder at work, or making cutbacks on spending. But the potential to reap exponential gains increases in the long run.
Protecting your money may help you sleep better at night, but applied too early or for too long, can squander your dreams of living a better life. And while there is no reason to hoard all of your money in the long run, continual spending on thin margins can quickly push you off a cliff that can be hard to recover from.
Keep in mind as well that you may allocate different portions of your net worth towards different goals. For example, you may want to protect your savings for a down payment on a home while more aggressively growing a portion of your funds for a child's college tuition.
The following considerations can help you determine what your goals should be and how to maximize the outcome.
First and foremost, establish at the very least a baseline understanding of your current or prospective assets. Don’t let the masses lure you into a state of FOMO without applying some critical thinking first. There are many tempting investments out there that offer promising returns. But if you are not thoroughly aware of the risks and conditions, you may find yourself in a sticky situation.
You don't need to be a financial guru to evaluate an asset but it is in your best interest to do a little homework first. Research the entity and determine how it fits into your overall portfolio. Identify historical indicators that can help estimate future performance and anticipate external factors that could send expected performance sideways. And if you don’t feel equipped to make a solid judgement call, consult the pros or walk away.
Time horizon is oftentimes associated with age, but can also be considered as the time frame you are earning an active income. Unless you’ve landed a nice inheritance, are getting money from the bank of Mom and Dad, or win the lottery, you need to work for some period of time to be able to invest in income-generating assets. Once you have accumulated enough capital or cash flow to cover your cost of living indefinitely, you are free to do as you please.
Assessing your time horizon is critical in determining whether it is more appropriate to grow or protect your overall wealth. A 25-year-old college graduate on the traditional path to retirement has ample opportunity to build their assets and take larger risks. If you are on the fast track to FIRE though, your time to make the big bets are more limited.
As mentioned before, you may want to allocate different portions of your net worth to larger milestones, such as home ownership, college savings and retirement. Applying separate time horizons to these goals can help minimize risk for shorter term milestones and maximize returns for longer term targets.
If you have a longer time horizon towards your financial goals, take advantage of higher-risk, higher-reward opportunities once all of your other financial obligations can be comfortably met. Take that job at an early startup, stake a position in the market, or dabble with some alternative investments. The odds of raking in exponential gains increase and the blows from potential headwinds will be much softer.
Those with shorter time horizons should proceed more cautiously to protect themselves from significant losses. Look for opportunities to generate stable returns and minimize losses, such as bonds, risk-free assets, or even real estate.
A cyclical economy provides ample opportunities for one to capitalize on in any environment. The roaring bull market over this past decade handsomely rewarded investors with sizable gains to their portfolios. Real estate appreciation soared across many parts of the country. VC’s pumped billions of dollars into a booming industry of tech start-ups. It’s easy to take advantage of a thriving market when there is so much money to go around.
Downturns undeniably cause pain and suffering across many populations, but those who tread carefully can find ways to leverage devalued assets as well. Interest rates decrease, housing markets may soften, and stocks go on sale. Once you’ve hit rock bottom, there is nowhere to go but back up. And as history has shown, the economy always rebounds.
Staying in tune with the shifting economy can help you capitalize on different opportunities while also preparing for what is to come. Bull markets are great opportunities to grow your assets and maybe even indulge in some excess returns in the process.
Getting in a bull market early on increases your chances of generating higher earnings over time, but when you start to see the market hitting all-time highs, it’s time to think about protecting your gains. Don’t let greed cheat you in the process!
If you have enough time and capital to weather the storm, a market downturn is the event you have been waiting for. Heavy-up on your retirement contributions, invest in a diversified portfolio or consider purchasing or refinancing a home. Your good fortune will help carry you through future headwinds with the possibility of indulging in a few more goodies when the tide turns.
I am probably one of the most risk-averse people you will meet. I hate losing money. So much that a stranger handed me $20 in Vegas because I was too scared to put down my own on the craps table. Avoiding risks at all costs can hurt you in the long run though, so finding the right balance is key.
Below are three considerations for building an appropriate risk profile:
1. Time Frame
Your time frame is a key factor in determining risk. The more time you have, the more opportunity you have to invest or partake in high risk/high reward ventures.
While no one can predict the exact time and length of a recession for example, we know they last an average of 15 months. Bull markets, on the other hand, last on average 4.5 years. Even if you lose money in the short term, the blows will be much softer with multiple rebounds on your side.
2. Life Events
Consequently, life altering events can change your risk exposure. Career changes, large purchases such as a new home, and family additions are all examples of events that can reframe your propensity for taking risk. Anticipating these events ahead of time can help structure your time frames and plan accordingly.
Although many assets and investments on the market offer attractive returns, make sure your necessary expenses are covered by reliable sources of cash first. If your livelihood depends on the majority of your net worth, your risk tolerance should be much lower. If you can swallow a loss without impacting your day-to-day needs though, a higher stakes investment could yield you a better profit.
Taking calculated risks is an important component towards building long-term wealth. Whether you are a natural risk taker or someone that hides your cash under the bed, applying a logic-based approach can help shield you from potential land mines and increase your chances of yielding higher profits.
Over time, your overall asset allocation will inevitably shift due to career moves, life changes, external forces, and lifestyle habits. As such, you'll want to make sure your total portfolio financial assets are appropriately balanced.
For example, if you earn a hefty bonus at work or land a sizable inheritance, you may find yourself with some extra cash. If you are not applying it towards larger milestones, it's time to put that cash to work!
Alternatively, a fast market rally might increase your equity exposure if you are invested in stocks. Before celebrating a windfall, take a moment to re-assess your risk and determine if you should diversify your earnings or protect them from a potential correction.
Even if your net worth or progress towards your goals is plugging along fine, make sure you are keeping tabs on your underlying asset allocation. Your risk exposure can inadvertently change or opportunity might await to make your money work even harder for you.
Cost of Living
Your cost of living is arguably the easiest factor to control, however it is where temptation oftentimes lurks the most. Consumer culture, lifestyles, convenience, and material goods can lure us into all sorts of passive or destructive purchasing behaviors.
If you are trying to grow or protect your net worth but find yourself consistently running on thin margins due to your monthly expenses, it’s time to rethink your cost of living. Once you start digging a little deeper into your spending habits, you will always #findthemoney.
The spice of life however shouldn’t be compromised by a lifetime of extreme frugality. Find times to enjoy the fruits of your labor as well. Maybe it’s when you get better than expected returns on an investment or when you’ve successfully grown your nest egg to generate passive income indefinitely. Remember to enjoy your money too, you’ve earned it!
Maximizing your net worth is a muscle that continually needs to be flexed to stay strong. Asset allocation, life circumstances, and decisive action are all components that make up and drive financial security.
Plotting your unique financial blueprint against a long-term financial picture will bring into focus what steps you can be taking now to free yourself from financial worry. Now, more than ever, is a time we are reminded of the value of financial freedom. Take this opportunity to look inward, reset your intentions, and outline a new path forward.