Our paycheck protects us against all sorts of risks. You are in a much better position to absorb unexpected bills, divorce, a lawsuit, or a 20 year bear market when you are employed and have a steady and dependable source of income. A paycheck also hedges you against inflation. Typically, your W-2 income will rise over time to account for increases in the cost of living.
Our biggest financial risk is not losing assets or market value. It is losing our source of income.
According to a paper published by the Center for Retirement Research, more than three-quarters of adults age 51 to 61 experience financial shocks over a 10-year period. They include widowhood, divorce, job layoffs, health problems, or the onset of frailty among parents or in- laws. Health problems and layoffs dominate at this age. They also find the incidence of financially disruptive events increases with age.
If our biggest risk is losing our paycheck and the safety net it provides, how do we hedge or insure against that risk? We build an investment portfolio that generates a steady and consistent source of cash flow. The goal has to be to generate enough inflation-indexed income to replace our W-2 income at a moments notice.
Investing solely for growth is not adequate to insure against these risks. Paper gains are fleeting. Assets that must be sold are too risky. And contrary to conventional wisdom, stocks are not a good hedge against inflation.
When do we lose our job? When the market and the economy are booming? No. The more likely scenario is we lose our job when the economy is slow, profits are being squeezed and stock prices are down.
I believe the job of our portfolio is 1) to protect us against financial risk; and 2) to create wealth. These two things are not mutually exclusive. If you accept my definition of wealth, which is the ability to maintain a certain standard of living indefinitely over time, then wealth is not measured by the number at the top of your statement. It is instead, measured by the inflation-indexed income your portfolio can generate.
It is my deeply-held belief that your focus should not be on how to grow your portfolio, although that is certainly a by-product of income re-invested. Rather, “How do I create MORE sustainable, inflation protected income?”
What do you think? What is your definition of wealth? Has it changed as you approach retirement? Does the ability to maintain an agreeable standard of living indefinitely without worry make sense to you as a definition of wealth? Leave your thoughts and comments below.
1. Richard W. Johnson, Gordon B.T. Mermin, and Cori E. Uccello. “When the Nest Egg Cracks: Financial Consequences of Health Problems, Marital Status Changes, and Job Layoffs at Older Ages” Working Paper Center for Retirement Research at Boston College, Number 18; Released December, 2005.