The Keys To Managing The Unexpected

Co-produced with Beyond Saving.

Life is what happens when you are making other plans.

Making plans is an important part of managing your finances. You need to plan for your regular monthly budget, for major purchases, and you certainly should plan for your retirement.

Yet even the best-laid plans rarely survive contact with reality. You plan your budget out to save up money for that down payment on a home or to buy that car you’ve always wanted, and then something happens.

Your car breaks down, you have to travel to see a sick relative, your water heater explodes, your work hours get cut, or you stroll into work to find a box with your name on it and your final paycheck. All of these have happened to me at one point or another. And I don’t consider myself a particularly “unlucky” person. These types of things happen to everyone, and they are always unexpected. It is simply a part of life.

Guess what? Investing is part of life. I know I spend a lot of time waxing poetic about the virtues of income investing, but it is still a part of life. When you retire, you will still have unexpected expenses spring up, you will still have unexpected disruptions to your income, and sometimes you will have to redo your plans.

Many investors live in fear of what the markets will do. They panic at the prospect of dividend cuts. They worry about prices falling. They fear that their retirement portfolio will not be enough.

I won’t sugarcoat it. While investing you will face the unexpected. In your portfolio, prices will fall, dividends will be cut, that investment you were so sure of will disappoint – that is reality.

The good news is that it is something you can prepare for. You can prepare your portfolio and your personal budget to handle these challenges. Just like you no doubt have dealt with many other challenges in your life.

Sometimes, You Lose Your Job

Layoffs, rightsizing, workforce optimization, leveraging synergies, or whatever else those in the C-Suite love to call it, it all boils down to one thing for employees: You’re fired. Often through no particular fault of your own. The company no longer needs your services. In the good ol’ days, you would get a “pink slip” with your paper check. Today, you might get an e-mail or suddenly be unable to log into your company’s VPN.

Sometimes you might have a hint it is coming. Other times it might come out of left field. All of the time, it is extremely stressful and disruptive.

When you retire, you no longer have to worry about losing your job. However, you still have the risk of your income being disrupted. Dividends can be cut or eliminated, preferred dividends can be suspended, and even bonds default. When you are investing, there are no guarantees.

As when you were working, sometimes these changes are telegraphed, and you know they are coming, and sometimes they are a complete surprise.

Unexpected Expenses Will Come Up

In my family, we have a running joke about the ability of cars to peek into your checking account and decide to break down as soon as you have “too much” money.

The list of things that can break that you need to fix sooner rather than later is long, especially if you own your home. Major appliances, plumbing issues, electrical issues, etc., are things you need to be able to fix sooner rather than later. And they usually aren’t cheap.

As you age, you also might find that unexpected medical expenses become more of a routine than an exception. You’ll also find that inflation becomes more noticeable over decades.

Beyond the necessities, there might be a whole host of unexpected wants. You have a new grandchild – of course, you’d love to fly out to visit.

The Keys

You can bet that the unexpected will happen, but you won’t know exactly what it is or when until it does.

Looking back now, many of the unexpected things that occurred were ultimately very positive. Getting laid off seemed like a disaster at the time, and in many ways, it was. Yet without that experience, I would not be writing here today, doing what I love daily.

If I could go back in time, there are many things I could have done to make life easier. I would have been more patient with expanding my lifestyle. I would have built up better safety cushions. I would have bought more dividend stocks.

You live, you make mistakes, and you learn. Or, you can learn from the mistakes of others.

When you are retired, it can be easier. You can set yourself up for success to deal with the unknown problems that life will continue to throw at you. How?

Let’s look at the key rules you should have in place to protect your income portfolio from the unexpected.

Key #1: Diversify

When you are employed and working, the odds are that most of your income came from one source: your employer. If you lost your job, that was all of your income that got cut off. Maybe you can find a new job quickly – maybe you can’t. I found myself waiting tables for a fraction of my prior income because you do what you must do until you can find more permanent work.

When you are drawing income from your investment portfolio, you are in control. You can have 10, 20, 50, or 100+ income sources. The more income sources you have, the less it matters if one stops paying you.

Remember when you got laid off? Imagine if you had another 40 jobs to walk into and start working!

I’ve coined the “Rule of 42.” Every stock you buy is another income source. The more stocks you own, the lower the risk to your portfolio for company-specific issues. The Rule of 42 recognizes that for around 40-50 stocks, the incremental diversification benefit is greatly reduced. Source.

At 42 stocks, your average holding should make up about 2.4% of your portfolio. You might have some positions at 3% and others at 1.5%. But overall, one stock shouldn’t materially impact your life no matter how ugly it gets.

Don’t let 42 be your maximum. If you identify 50, 70, or 100 opportunities, go for it! The Rule of 42 is designed to be a guardrail against too few holdings, not too many.

Your goal should always be to accumulate more income streams. The more you have, the less it matters if one “fires” you by cutting its dividend.

Do a “common sense” test of your portfolio. Look at your largest holdings and your largest dividend payers. (Note: your largest dividend payer might be different than your largest position) Imagine in your head that they disappeared. Poof. No stock value, no dividend, just gone. I know dividend cuts are always unpleasant but is it:

1. Something you can shrug off and move on.
2. Something that would create a lot of stress and worry.
3. Something that would legitimately cause you to worry about paying your bills.

The answer should be #1. If it is #2 or #3, then you need to diversify more.

Key #2: Maintain Flexibility

When creating a budget, it can be tempting to try to account for every penny. While it is great to be accountable for your spending, you shouldn’t try projecting future budgets so precisely. Overestimate your bills, and plan to have a cushion.

I like to think of my expenses as three different baskets:

1. Non-negotiable: These are expenses like taxes, insurance, electricity, etc. Expenses that can’t easily be modified. Sure, I could move to a geographical location with lower taxes, but moving costs a lot of money. These are recurring structural expenses that can’t be cut. In all cases, my income must exceed these expenses.
2. Negotiable expenses: These are expenses I have some control over. I can eat steak and black truffles, or I can survive on mac and cheese. I need to eat something, but the range of foods and associated costs are significant. There are many areas of your budget where you could cut back if needed, and you can expand if you can. Everyone has to eat, everyone needs clothes, and everyone spends money on grooming, but one person might spend a couple hundred a month while another spends tens of thousands.
3. Discretionary expenses: The most fun things to spend your money on are the things that you don’t need at all. Traveling, hobbies, jet skis, vacation homes, boats, fancy cars, or anything you enjoy but don’t strictly need.

One of my goals has been an almost obsessive obsession with getting my “non-negotiable” expenses as low as possible. You can do this by making sure your home is paid for, paying off all your debt, and making sure that where you choose to live is appropriate to your income level. If you are struggling to cover these expenses, something needs to change.

The lower your non-negotiable expenses are, the more freedom you will have in your budget. Your negotiable and discretionary expenses can be flexed up and down. It is never fun to have to “tighten your belt”, but you won’t have to worry about being able to cover your essentials.

Maintaining flexibility in your personal budget will provide you the confidence you need to make investment decisions without dealing with the pressure of your personal budget.

Key #3: Have a Cushion

The more you make, the more you spend. It is our natural instinct to live the best life we can afford. It is also one that can lead to financial devastation.

I often state that I am “100% invested.” In my investment portfolio, I expect my money to work for me. I understand that the market goes up more frequently than it goes down, so I put my investment money to work immediately.

Let me repeat that: I put my investment money to work immediately.

It is important to distinguish your personal budget and your investment portfolio. For your personal budget, it is a great idea to have some money set aside in cash for emergency needs. Pick your expert. Some will recommend anything from 3 months to a full year of your expenses should be set aside in an emergency account. Some people like to have a home-equity line of credit or other revolving debt available for emergency situations.

I’ll leave the amount up to you, but you should have an amount of cash that makes you comfortable enough to deal with any emergency issue that comes up. You can deal with the expense and then worry about building your reserve back up by reducing your negotiable and discretionary expenses. Certainly, you want enough cash to cover any deductibles on your insurance and your essential expenses for a period of time.

These are funds that should never be sent into the market. They are for emergencies, not for putting at risk in investments.

Ideally, you want to have enough cash available in your personal finances so that you don’t need to withdraw cash from your investment portfolio every month.

Key #4: Include Reinvestment in Your Budget

Since you are here, it is safe to assume that you were responsible and put effort into saving for retirement. You didn’t spend every dollar you earned. You put aside a portion of your income to invest for your future.

Retiring is no different. You still have a future! When you are setting up your budget for retirement, allocate a portion of your dividends to be reinvested. I recommend a minimum of 25% – we call this our “Rule of 25.”

Consider Ares Capital (ARCC), a fine dividend investment since 2005. If you had invested $1 million in ARCC, you could have collected income that tended to be around $80,000/year. If you took it all out and spent it on whatever, your income would look like this: Source

A little variation with the special and supplemental dividends, but your income today would be only slightly higher than it was in 2005. There has been more than a little inflation since 2005, so your purchasing power would be lower.

Suppose instead that you decided to withdraw $60,000/year indexed to inflation and reinvested the rest: Source.

Eighteen years later, your investment would have produced over $188,000 in dividends, while your 2022 withdrawal would have been $93,000, less than half the income your investment produced. You would be sitting in a position where you could comfortably decide to withdraw a lot more if you wanted to.

This is a principle that all investors should be familiar with – the power of compounding and delayed gratification. We used one ticker in this example, but the principle applies to an entire income portfolio as well. Set aside a portion of your budget to reinvest for the future, and you will find your income is growing much faster than inflation.

Conclusion

Investors who don’t have a sound personal budget will all too often become reactive. They will reach for yield because they need the higher yield to pay their bills, they will panic and sell because they can’t afford steeper losses, or they might be too afraid to seize the opportunities the market gives them.

Good investing requires a long-term mindset. You need to make your investment decisions based on what is best for your income, not based on what you need right now. It is crucial that you prepare your personal budget to handle the unexpected so that when the unexpected happens in your portfolio, you can make the best investment decision.

A diversified portfolio will limit the impact that any one stock has on your income. When you have 42+ income sources, you are not dependent on any source. This will allow you to decide whether to buy the dip, sell and reinvest elsewhere, or hold and wait it out based on your assessment of the investment.

Maintaining flexibility with your personal budget will help ensure that you can handle any surprise expenses without having to sell your valuable income-producing investments. Keep your non-negotiable expenses low relative to your income, and you will find that finances become much less stressful.

Having a cushion is a vital part of any budget. The unexpected will happen, it is a matter of time. Knowing that you have a cushion that is sufficient to fund your needs will allow you to approach the market with a clear head.

Finally, include reinvestment in your budget. Just like you did while working. You still have a future, and if you focus on continuing to build your income, it will be one where you have the financial freedom to live the lifestyle you choose.

You don’t have to fear the unexpected. Prepare for it, and any financial issue can be overcome. Having numerous diversified income streams will provide you a powerful river of income that will allow you to manage life’s challenges with minimal stress.

That is what the Income Method can achieve.