Steve Tomisek, CFP®

We live in a world full of risks. We encounter risks in the daily course of our work and the past year has taught us that even nature can present us with extreme risks. Savvy investors know that risk is ever present. So, an important investment principle is the ability to assess risk and take prudent steps to reduce the effects of unwanted developments.

After you have taken inventory of your income, expenses, and assets, a great next step to safeguard your long-term plans is to establish an emergency fund. As you take this important step, it makes sense to answer a few questions such as how big the emergency fund should be, where you should maintain it, and when you should use it.

First, what is the purpose of maintaining an emergency fund? Simply stated, an emergency fund exists to handle those unforeseen developments that might disrupt your life and force you to dip into investments to cover expenses. The situation could be one of an unusual expense or a drop in income. The emergency fund is a safe source of short-term funds that protects your investments, keeps them focused on long-term goals, and allows you to have peace of mind.

But how big should the fund be and where should it be kept? A common measure says to keep 3 – 6 months of expenses in an emergency fund. For most of us, that is a sizable chunk of funds to keep in a relatively low-yielding account. Your long-term goals would be better spent keeping funds focused on longer-term, higher-yielding investments. So keep the emergency fund large enough but not too large.

Do you really need 3 – 6 months of expenses? It is surely a safe bet and peace of mind to have that amount in a safe place. Yet, one of the factors you might consider is the stability of your compensation and the security of your income. The past year has taught us that there can be a wide range of security. Some occupations such as those who deliver communications services found themselves with more work last year, while those who work in more face-to-face industries such as retail or recreation were out of work for extended periods. For instance, clients in government service face less risk on the income side. So, the guide of three months’ expenses might be a good first consideration. Our clients who are entrepreneurs with more volatile incomes should lean toward the six-month guide, or more, as a first consideration.

When you evaluate monthly expenses, focus on the essentials such as housing, food, health care, utilities, debt payments, and essential personal expenses. Don’t include nice-to-have costs such as entertainment, dining out, non-essential shopping, vacations, or savings. You’ll suspend those activities during the emergency and return them to your budget once the emergency passes.

Another guide that might be more helpful is “the three horribles.” This method calls on you to identify the three most likely unexpected events that could go wrong and hold aside some funds to cover all three. For example, a major expense on a car (such as a transmission replacement), a major expense in the house (such as an unexpected appliance replacement or storm damage) and an unexpected trip for a family emergency could happen at any time.

The technique takes the events you described and places a dollar value on each of them. The emergency fund is the amount you would have to hold aside to cover these three items. For this example, the “three horribles” look like this:

Major auto expense:  $3,000

Household appliance replacement:  $4,000

Travel expenses for a family emergency:  $5,000

Total Emergency Fund: $12,000

You might want to put a 20% buffer on top of these funds to make sure you always have enough. In this case, that figure would settle out at around $15,000. Regardless of the amount, pick a figure and commit to building the fund.

Your next consideration is where to stash this cash. You’ll want the funds to be safe from the market — there when you need it, especially in times of market or economic turbulence. Next, you want the funds to be easy to access. This will ensure you’ll be able to take care of your emergency quickly. Finally, you want to store the funds in an interest-bearing account. The point of an emergency fund isn’t to make money, but don’t turn down the opportunity to earn interest on these funds. An excellent vehicle that fits these criteria is a money market fund account, available through a bank or mutual fund.

To make sure you will stick to your long-term goals, you’ll want to set some conditions for the use of your emergency fund. First, ask yourself if the expense is truly unexpected, or if can you build this into a plan over time. Next, ask yourself if the expense is truly necessary, or if can it be handled some other way. Finally, ask yourself if the expense is truly urgent, or if is there time to research ways to reduce or eliminate the cost. If the answer to any one of these questions is “no,” then the expense is probably not an emergency and it should be factored into your larger financial plans.

Setting up an emergency fund takes work, so make it a first priority for your overall financial plan. Decide on a target amount, and then set aside a designated amount over time until you build your emergency fund in that safe and accessible place. For instance, a monthly deposit of $1,000 will build a fund to handle the “three horribles” in less than 18 months. You can build the emergency fund from there to fit your needs.

Life is full of risks, but they don’t have to derail your plans. Set up an emergency fund as a first priority. You’ll find it brings you great peace of mind and keeps you focused on your long-term goals. 

The marketplace for financial advice is changing if recent research is any guide. Simply stated, there are other (and better) measures past portfolio return to determine whether your financial advisor is performing well. In financial terms, does your advisor generate “alpha” or results that are better than those you could achieve on your own?[i] As the marketplace for financial advice evolves there are valuable services beyond portfolio investment returns that your financial advisor should provide to you as part of the relationship.

Financial research revealed some time ago that few “active” fund managers consistently beat broad market averages. Many active managers beat market performance by sheer luck or by taking risk they fail to disclose to clients. Moreover, many managers will trade frequently, seeking in vain to “time the market.” This raises costs, generates unwanted taxes and diminishes your returns.

But don’t sack your financial advisor just yet. Complex financial markets and the intricacies of life argue more than ever for good investment advice. One study identified that asset allocation — the alignment of stock and bond categories to your risk tolerance — explains two thirds of your portfolio returns. Asset selection – the choice of specific stocks, bonds or funds to include in your portfolio explains the remaining third.[ii] A good advisor will tailor your portfolio to meet your specific needs, which gives you control, flexibility, and transparency as you maximize returns and minimize costs.

But your advisor should deliver more value. First, good advisor will be a fiduciary — they will act in your best interest and they will submit to the oversight that keeps your interests front and center.

Next, your financial advisor will listen to you and understand your goals. They should show you where you are today and provide you a roadmap to take you where you want to be. They will bring research, experience, and consult specialized expertise where your circumstances require. The roadmap will be tailored to your unique goals, risk tolerance, and needs such as investment, cash, estate planning and timing. A very skilled advisor will understand your most important financial asset — your ability to generate income — and will incorporate education and career decisions into the picture. The advisor will review the plan with you as necessary and will watch for changes in conditions and your circumstances that call for adjustments.

Third, a good advisor will help you pay the taxes you must and no more. For many individuals, this is a high return area. They will remember that taxes are a feature, not the center of the plan. They will focus on goals, minimize your total tax bill and defer payments where possible so your assets can generate returns for as long as possible.

Fourth, your advisor will identify and help you mitigate risks in your plan. A good financial advisor will help you avoid costly mistakes along the path and help protect you against the ones you can’t avoid.

Fifth, your advisor will make sure you always have some spare cash — “dry powder” — to seize opportunities that arise. These will often come from rebalancing that keeps risk in line with your goals or from periods where other more fearful investors sell assets at “fire sale” prices. Spotting and taking opportunities consistent with your goals helps you to buy low and sell high.

Finally, perhaps the most important role the advisor can play is that of the “financial coach” who keeps you on the road to success. Much as a personal trainer who encourages good nutrition and exercise so you can have the health you want; a good financial advisor will keep you on the financial road that will help you achieve your goals.

How valuable is a good advisor? Research indicates that these five things done well can yield up to three percent of returns above what you could achieve by going it alone. Perhaps more significant, the most valuable elements require judgement, discretion and encouragement — things that a “robo advisor” will not do for you.

On your own, suppose you could secure a 3% return after taxes and fees. An advisor who could find that extra 3% for you would turn $10M into almost $18M in ten years compared with the $13.5M you would achieve on your own. Work with an advisor to find more returns, stick with it for a few decades and the additional returns compound. You and your advisor will multiply your initial investment many times over, your goals will arrive faster than you think, and you’ll have room for more. ■

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[i] Donald G. Bennyhoff and Francis M. Kinniry, Vanguard Advisor’s Alpha^®, Vanguard Research, 2018 also Capital Sigma: The Return on Advice, Envestnet, 2016

[ii] Renato Staub and Brian D. Singer, CFA, “Asset Allocation vs. Security Selection: Their Relative Importance,” Journal of Performance Measurement, vol. 16, no. 3, p. 10.

Investing is like charting a course through rough seas. There are risks you must navigate moment to moment and key decisions you must make over the short-term (daily, weekly, monthly etc.) if you wish to survive and reach your long-term destination. Unlike life on the real seas, most investment decisions are not life and death, and thankfully, most of the investment mistakes you will undoubtedly make along your journey can generally be overcome with the benefit of time and a strong dose of patience.

For all of us, an important aspect of wealth creation is an ability to maintain a financial course even in the face of short-term disruptions. That message has been reinforced this year as markets fell by 32% from peak to trough in the first half of 2020 only to rocket back and end the year 16% above where they started. It is only by having a long-term perspective that you can harness the power of compound interest, realize the tradeoff between risk and return and seize opportunities when they arise. This year reinforced the value of both patience and opportunity.

Franklin D. Roosevelt, our country’s 32^nd President, is quoted as saying “A Smooth Sea Never Made a Skilled Sailor.” He meant that your abilities and perseverance must be tested, and you must demonstrate the ability to take opportunities, learn from your inevitable mistakes and gain additional skills. We can extend his principle into the most important ingredient of creating financial wealth — thinking long term.

For the purpose of this article, we are focusing our comments on the traditional investment decisions you make with respect to your investment portfolio of stocks and bonds and your retirement account, such as your IRA. We are not speaking of investments you might consider such as starting or investing in a standalone business, a real estate venture, private equity investments, hedge funds or venture capital funds, as these investments have unique risk and return characteristics that live outside of traditional investments in stocks and bonds.

Celebrating 245 Years of Success

The nation will celebrate 245 years of independence on this coming 4^th of July. In reality, we will celebrate the amazing success that free markets and society have produced since our founding in 1776. Since our founding, we have overcome a civil war, presidential assassinations (e.g. Lincoln and Kennedy), World War I, a stock market crash in 1929, an economic depression during most of the 1930’s, World War II, the Korean War, the Vietnam war, civil unrest, protests and boycotts in the 60s, sky-high inflation and interest rates in the late 70s and early 80s, oil embargos, racism, sexism, discrimination, crooked politicians, the tech bubble of the late 90s, the terrorist attack on 9/11 and the Great Recession of 2008 and three 40%+ stock market corrections over the last 15 years.

We could go on and on, but through it all, Americans have not only persevered, but they have prospered which has historically made betting against the U.S. over the long term a bad bet!

The Risk of Missing the Best Days

But what about betting on the U.S. in the short-term? When the seas become rough, it’s very easy to change direction, plot a new course, or worse, jump ship altogether. It’s never easy to know in the heat of battle the best answer but when it comes to letting the latest negative headline of the day (especially in the era of a 24/7 non-stop news) influence your short-term investment decisions. This is a slippery slope as things are typically never as bad as they seem, or at least as bad as they are being reported in the news.

As we hinted at earlier, deviating from your long-term plan can be costly as we see in the chart below, courtesy of J.P. Morgan. The cost of missing just the 10 best days (over the last 20 years) is meaningful. If you invested $10,000 in the S&P 500 and “bought and held”, you earned 7.68% annually and your $10,000 investment grew to $43,933 in 20 years.

On the other hand, if you attempted to change course or jump ship, a.k.a. “get in and out” of your investment in the S&P 500, and in the process you missed the 10 best days, your return slips to 4.00% annually, for a gain of only $21,925.

If you missed the 60 best days, your return annual shrinks to a -5.76% loss! This is the potential cost of trying to time the market in the short-term and not thinking long-term. Another key point during this 20 year period is that 6 of the 10 best days occurred within two weeks of the 10 worst days. Think about that for a moment. The biggest upward surges in stock prices over the last 20 years occurred when the investing public was decidedly negative and selling pressure was strong. On Wall Street, this is known as the point in time when stocks change from weak hands (short-term thinkers) to strong hands (long-term thinkers).

There Are No Shortcuts

Creating wealth in investment and achieving financial independence is about focusing on the long-term objective and letting time be your greatest ally. As they saying goes “it’s time in the market that matters the most, not market timing”. Keeping this belief front and center is vital when financial markets turn volatile and the value of your investment portfolio has fallen. It’s even more vital when you are tempted to change course and focus your energy on the wrong things in the short run.

Achieving financial independence is a process, and a process by definition, takes time. There are no short cuts in life. It takes time to nurture children into mature and well-grounded adults; you can’t do it overnight. And it takes time for investors to grow wealth; they can’t do it overnight either.

Our best advice for creating wealth is to plot your course, be prepared for rough seas, and remember to think long term when you’re tempted to jump ship. ■