Preparation for old age should not begin later than one’s teens. A life which is empty of purpose until 65 will not suddenly become filled on retirement.
—Dwight L. Moody
Chapter 7
The World Is Full of Risk—Especially Now
Trying to predict the future is like trying to drive down a country road at night with no lights while looking out the back window.
—Peter Drucker
In Appendix C of The Value of Debt, I wrote:
We live in a radically indeterminate world. Not only do we not know what will happen next, in principle—according to modern physics—we cannot know what will happen next. This is true whether we are walking down the street or investing our hard- earned money for retirement.1
Many of us feel uncertain about the future of our investments and our economic
situation, and that makes perfect sense. We live in a world of both “endogenous risks”
that come from the inside, that we already know about and have factored in and
“exogenous risks” that occur outside of our assumptions and that we couldn’t have possibly factored in.
Anyone who tells you that they know what is coming down the road, whether it involves the direction of a particular stock or sector of the stock market,2 a national economy
(whether our own or another country’s), or a breakthrough technology company that will be the next Google/Apple/Facebook, is pretty much lying to you. They don’t know and can’t know, and you don’t know and can’t know. That’s just the way it is. With that basic understanding, you can begin to make rational decisions with the understanding that ultimately, economic matters (as well as everything else, including matters of personal and family health) are indeed unknowable and any and every action you take can end up proving to be anywhere from slightly risky to incredibly risky.
This chapter is divided into two sections: the risk of not having debt and the risks of asset allocation and particular assets.
Not Your Usual Serious Caution
Danger, Will Robinson! Danger!
—From the TV show Lost in Space
Here’s an unusual warning that you’re unlikely to read elsewhere:
Given the unusual times that we’re in, failing to consider your strategic debt options and failure to take on better debt when it’s accessible and feasible to do so may be among the worst mistakes you can make as you head into retirement.
Learning from What Companies Do—Value Liquidity!
Learning from What Companies Do—Value Liquidity!
I recently spoke on a panel with representation from the Federal Reserve, academia, and me there as an expert on individual debt strategies. The conversation took an interesting turn to a discussion of how individuals and companies responded to the 2008 financial crisis in nearly opposite ways.
Companies: Generally chose to reduce their reliance on the banking system. They have done this by increasing the amount of cash they had on hand and increasing the amount of debt they had. They issued longer-term debt and increased their access to credit. In short, their perspective changed and they placed a greater value on liquidity, flexibility, leverage, and most important, survivability.
People: Generally decided that debt was the evil that created the crisis and therefore they rushed in to pay off all of their debt. Ironically, it may turn out that by paying down their debt they actually reduced their liquidity and flexibility should another crisis occur.
I believe that 2008 was as much (if not more) a liquidity crisis than a “debt-driven” crisis.
Let’s imagine that, like many Americans, you have a mortgage, your money is mostly in retirement accounts, you have some (but not much) credit card debt and some (but not much) money in your checking and savings accounts. You miraculously win a $100,000 lottery ticket in late 2007. You follow conventional wisdom, pay off the credit card debt, and pay down your mortgage.
When 2008 rolls around, you lose your job. Your monthly expenses keep coming in. But wait, you can’t access that $100,000! Even though your home equity is higher, you can’t refinance because you don’t have a job. Your reserves are eaten up in a few months. If you access your retirement accounts you may have to pay taxes and penalties, and you are likely selling assets at the exact time that you should have been buying (at the low!). Your credit card debt starts to skyrocket, you stop making mortgage payments, destroy your credit, and almost (and possibly do) go bankrupt. Mortgage rates go down in 2013 and your equity recovers, but you can’t refinance because your credit was crushed.
Here is what I would have done in the same situation: Keep the $100,000 in a very
conservative, liquid account so that if a shock came I would have many, many months of reserves. I would have liquidity, flexibility, and survivability—and better perspective. I could take advantage of increased leverage, ride out the storm, and refinance my house when rates fall.
Never, ever underestimate the power of having $100,000 (and more) in a very
conservative account versus paying down on an asset. Forget rates of return. Yes, if your money is earning $0 in the bank and your debt costs 4 percent, this strategy costs you
$4,000 a year. But it affords you incredible opportunity and survivability in times of distress. Think of it as a type of self-insurance policy. Who else does this? Companies do this, and after 2008 they are now doing it at extreme levels.
In fact, I would suggest that until you have enough built up to completely pay off your
house, you should consider if you should pay off any of your house. The only benefit in paying down principal is that you will effectively be receiving a guaranteed rate of return equal to the after-tax cost of your mortgage. The cost that it comes with is a significant reduction in your liquidity and flexibility. For most mortgages your payment doesn’t
change and in most cases it is hard (and perhaps impossible) for you to access that money again if you need it for any reason along the way. Never underestimate the value of
liquidity in increasing your flexibility and survivability!
Conventional wisdom has people so excited to get out of debt that they can threaten their own survivability! Liquidity is what you should value most. It makes you a flexible force.
If you are liquid, you always can pay off your debt. If you do not have liquidity you can get into a liquidity trap.