It’s now a tradition for bloggers to do year end write-ups and forward looks. This post certainly aims to pull together threads of a 2020 review and a 2021 look ahead. I’m also introducing a demonstration of exponential growth and a trade-off between two different modelling approaches. Let’s begin. while my general sentiment is to say, “Good riddance” to 2020, we’re super privileged to have escaped mostly intact (knocks on wood)…
Let’s start with what matters most:
Health
We’re healthy, all of us. We took as many precautions as we could to minimize our Covid19 risk throughout last year. We’re patiently waiting for our turn to get vaccinations and look forward to some semblance of normalcy. Our hearts go out to the millions of families who have lost loved ones and to the millions more whose lives have been upended.
We survived the in-hospital birth of our second child. We now have two healthy girls! After a significant scare with my wife’s health post-delivery, I have a healthy partner again. I am so grateful to have healthy girls in the house.
Next, as this is a website about the journey to financial independence, let’s talk money.
Wealth
I actually wasn’t planning to write a 2020 review/2021 forward look. But, then I stumbled onto a thread at boggleheads about the shape of folk’s net worth curves. I think this is a fascinating topic and worthy of exploration. As we’re still starting out the 2021 calendar year, I was inspired to reflect on several lessons from 2020 and look forward to 2021 and beyond.
Exponential Growth Is Real
The path for financial independence feels like a marathon. But, unlike a marathon, the first miles on your journey to financial independence are the hardest. We scrimped and saved to pack pennies into our accounts only to see minor or maybe modest gains year over year. It felt like financial independence was totally out of reach. But, through the steady inspiration and encouragement of the online personal finance community, we kept at it. We’re not there yet, but that exponential growth curve makes me do a double take every time I see it.
Here’s a plot of our net worth since I started tracking it in 2009.
While it doesn’t feel life altering yet (in part because we cannot touch most of our net worth), it sure looks like we’re on an exponential growth curve, even with our conservative asset allocation. Why do I think this: a little statistical concept called standard error.
Standard Error
I’m not going to delve deeply into stats here, but this concept is useful here and will be again in many of the other topics discussed. Standard Error is a measure of spread. It tells is how much distance is between a group of data and some statistic. In this case, we’re looking at how far the points are from the fitted line. When comparing different models, smaller standard error (less distance) means the fitted line is likely a better fit for this data.
Let’s try it. We see the fit and standard error for the exponential growth model. Here’s the same data with a linear fit. Just eyeballing it, you can see this line doesn’t match the data as well. Standard error calculates the distance from the fit line to each point. Models (lines) with better fit have smaller standard error.
Take a look at the exponential model again, especially at the most recent months. The most recent points are consistently above the fitted line. You could attribute this to our investing genius. Or, maybe irrational exuberance round 2. This model is not perfect either. We need to be very careful not to extrapolate too far into the future lest the difference between the model and reality becomes too big. I don’t think we’ll be 401(k) billionaires in 20 years!
Between the two models, it’s obvious that exponential growth is a better fit, both visually and using math. Now that we can measure our net worth growth and fit a decent model to it, let’s dig into why the shape of the curve looks the way it does. We’ll also discuss what we could be doing differently to change the shape.
Analysis: Why Our Net Worth Is At An All Time High Despite The Pandemic
Despite the worst health crisis in a century, our net worth is at a record high. Why?
- We kept our jobs
- We benefit from the booming equity market
- We benefit from the booming real estate market
- Our rental business has lower but still positive cash flow
We Kept Our Jobs
Let’s take each in turn, starting with our jobs. Like it or not, our jobs provide 90+% of the income into our lives. Therefore, as much as I grump about being a W-2 employee, these revenue streams are important! We both work hard to contribute as much value as possible to our employers in the hope that they will continue to provide gross income in exchange.
Call it fate or luck, both of us have continued to be gainfully employed throughout the pandemic (knock on wood!). This means our ability to save/invest/grow net worth continued throughout the pandemic. One of my favorite pod-casters has a whole series on why the number one task of any employee is: “Don’t lose your job.” Obviously, that can be easier said than done depending on the industry and ones’ specific circumstances. Regardless, the number one priority for each of us is to maintain our respective revenue streams.
We Benefit From The Booming Equity Market
While we’re not 401(k) millionaires (nor “Teslanaires”), we have consistently invested in a broad mix of index funds for the past ~20 years. (OK, OK, we do have some “dumpster fire money” in individual stocks). That said, we’ve largely maintained an asset ratio of 60% stocks and 40% bonds over this period. We re-balance when things get too far from that mix. I know: it’s boring. No options trading. No short selling. I couldn’t even tell you what a put or a take is. And, I don’t really care. What I do care about is the overall growth of the equities market, namely the S and P 500 and the total market indices. Their values have exploded relative to the values of our other asset classes (e.g., bonds, cash, and real estate).
If I am honest, over the past several years, stocks have been the main engine of our net worth’s exponential growth. We keep these other asset classes around for when the market inevitably turns. But, just like JL Collins says, “Toughen Up Cupcake.” Embrace the volatility that comes with exponential growth via the stock market.
We Benefit From The Booming Real Estate Market
Speaking of other asset types, real estate remains my favorite. I love the tangibility of it. I love the chance to provide meaningful value directly to other people. I love the way the government treats it when tax time rolls around. Thus far, we only have one rental unit, a nice 2 bed, 2 bath condo. We took this plunge back in 2015. While we’ve had one challenging tenant, for the most part, it’s been an awesome investment. We negotiated with our current tenant at the start of the pandemic: lower rent in exchange for an 18 month lease. It was a relief not worrying about filling an empty unit during the lockdown. Most importantly: we’ve been able to maintain positive cash flow throughout these crazy times.
And, guess what, due to the booming real estate market, the theoretical value of the property rose too. Of course, we’re not interested in selling any time soon. But, we do track the market value of the property as part of our net worth (discounted to an investor friendly price). Lately, our real estate has grown, maybe not with the same exponential growth that equities have, but I believe real estate will be a lot less volatile whenever the next downturn comes.
Our other real estate, our primary residence, also shows a decent lift in the market value. Again, we’re not planning to sell any time soon, but these increases do contribute to net worth growth. They also buffer our net worth during down turns. While real estate may not be negatively correlated with stocks, it tends to be less volatile. Unfortunately, our house (like everyone’s) is not really an asset. It consumes cash rather than contributes it.
Our Rental Business Has Lower But Still Positive Cash Flow
You cannot eat net worth.
This is an interesting realization. So many of us are taught to invest in stocks and bonds so that we can take advantage of their long term appreciation. The plan is to sell some of these appreciated assets during our retirement years. The hope is that we draw down our pile slowly enough to die before we run out of money. As long as you stick to certain assumptions, this works pretty well.
Let’s talk about tax deferred retirement accounts for a minute. If you want to draw from your retirement pile before retirement age, the government charges a fee of 10% Further, because you put tax advantaged dollars in, you will pay income taxes on the dollars you take out. No opportunity to pay the potentially lower taxes on dividends or capital gains.
The cash that a rental property generates (assuming it is not held in a tax advantaged account) is available for use immediately. And you don’t have to sell a bathroom from your rental property to get the income. (This is unlike stocks where, unless you are only spending the dividends, you have to sell part of your base.) That’s what rent is for. I can feed my family today using the positive cash flow from our rental. Or, I can reinvest it for the future. This flexibility is awesome.
When the pandemic hit, our tenant reached out to us looking to renew his lease with us. In exchange for an 18 month agreement, he asked for a 20% discount. He’s a great tenant, and there was a pandemic just starting! We wanted to keep him We did a little math and offered a 15% discount. We agreed and signed the new lease. I’ve never been happier to give a discount! So, while our business income is down, we avoided (for at least a while longer) a dreaded vacancy.
Resiliency
To me, all these things add up to the beginning of a resilient lifestyle. If one part of the system fails, the rest of the system can absorb the shock and we can continue onward. It helps that we have a pretty big gap between our total income and our total expenses, again part of a resilient system is avoiding overloads. For example, if I lose my job, between my wife’s job and our other income sources, we could continue to maintain a substantial portion of our current lifestyle. If we have a vacancy in our rental property, we can afford to cover the expenses using cash reserves and surplus income until we can get a new tenant. We have tried to set up our affairs such that some part (or parts) are always able to perform.
To see a master of multiple income streams and truly resilient financial setup, check out John C over at actionecon.
There will be ups and downs; there will be bumps in the road. The hope is that through good times and bad, we continue to stay the course: keep earning, saving, investing, and growing. When the pandemic hit and now, as things recover, our assets continue to grow… hopefully for decades to come.
Actions to Take in 2021
No one has a functional crystal ball, so I’m always leery of forecasting economic or market movements. Regardless of your circumstances, I think there are some fundamental ways to approach finances in 2021.
- Grow your gap either by increasing your income or decreasing your expenses. This is a good action to take in almost any set of economic circumstances, market conditions or time of your life. Today is no different. The job market may be terrible or amazing; reducing expenses gives you more financial runway in case of a change in your employment. The market may be high or low. Having a bigger gap gives you the ability to invest that cash directly or save it for another opportunity.
- Adjust your asset allocation. Whether 2020 was financially kind or terrible for you, it’s a good time to review your specific situation and adjust your mix for the coming year(s).
- By some measures, the US stock markets are significantly over-valued. If your asset allocation percentage is out of balance, this might be a good time to rebalance. You can lock in your gains from the past 10 months of ear-popping highs. Be sure to balance prudence with the fear of missing out. No one knows how high (or how low) an asset class will go tomorrow.
- Age adjustments. We turn 40 this year. We have 2 kids. Our risk profile looks way different now than it did 15 years ago. Back them, we could say go all-in on the stock market. Now, our asset base has grown, and our appetite for full risk has perhaps decreased a bit…or not. I’ll save a discussion of how we approach risk/allocation for another time. Regardless of what our asset allocation was for the past 10 years, we may need to have a different ratio for the next 10 years simply because our runway to needing to use our assets is a lot shorter. And, the same may be true for you. Think carefully about how much risk you are really willing to accept. My heart goes out to the family of this young investor who took his own life after (mistakenly) thinking he lost almost $750,000. I know our allocation is pretty conservative, but I sleep well at night. I hope you do too.
- Pay down debt. For us, this would most likely be early payments on the note at our rental/primary residences. We’re not rolling the dice with Bitcoin. Instead, every extra dollar we pay towards our mortgages, comes with a guaranteed interest cost that we avoid paying. It’s like our own bond fund.
Keep plugging away; exponential growth is alive and well. With that, we wish you and your loved ones a prosperous 2021 and beyond.