Correlations And Your Life
Much of personal finance is driven by conventional wisdoms and “rules of thumb”. These usually distill down to simple heuristics and while they are great guidelines, on average, they don’t always capture the tailored nature of personal finance.
These common rules are usually pretty conservative; certainly conservative enough to cover the majority of individuals. But, just because airlines space seats to accommodate the 95th percentile human, that isn’t very helpful if you’re 6’ 5”. And even if you’re not outside of the 95th percentile in regards to personal financial situations, it doesn’t take much deviation above the average before those seats start to feel a little too cramped for comfort.
As such, it’s a worthwhile exercise to not only be more introspective about the decisions one makes regarding their finances, but to also stress test common scenarios that may impact your ability to reach your financial goals.
Here are a few common “wisdom-isms” that often get regurgitated by the general public without second thought:
Maintain an Emergency Fund of 3 to 6 months of living expenses
Any large expense within the next 3-5 years (or less) should be held in a savings account
Stocks always outperform bonds
This post isn’t necessarily here to dissect each aspect of personal finance’s conventional wisdoms, but rather to encourage readers to think a little more deeply on whether, and how, these apply to you as an individual.
Rule #1: Think In Probabilities
One common misconception that I commonly see is that emergency funds apply to home or auto repairs.
The truth is, these events are all certainties. If your home has an A/C unit that is 20 years old or your car can be classified as a “beater”, then it breaking in the near term is an expectation, not an emergency.
This type of ‘damage’ is cumulative and there is an expected end of life for each item you possess. In theory, each appliance that you own could have an associated actuarial table.
Your car, just off the lot, has a very low likelihood of needing imminent repair. For much of it’s early life, the probabilities of an expensive repair remain quite low. That likelihood increases slightly with each passing year or mile driven. And once it hits the 10 year mark, those probabilities begin increasing quite rapidly, making a large cash outflow more and more likely. If it’s expected, then it can’t, by definition, be an emergency.
In reality, one could assess each potential trapdoor in their life. In this sense, nothing becomes an emergency, but rather a probabilistic outcome.
“Emergencies” should refer to the unknown unknown. And the more accurate you can build your inventory of potential adverse events (and their probabilities), the less you are exposed to true emergencies.
The resulting influence should be focused more on asset allocations, rather than a separate bucket designated for “emergencies” (hereafter referred to, simply, as "events").
For instance, by the end of your vehicle’s life, you should probably already have funds allocated towards repairs and eventual replacement. Where we allocate this money in the meantime will be the focus on the next topic.
Rule #2: Think In Correlations
Pulling this thread further, the events briefly explored above can be assessed against their timeliness with respect to the risks you’ve exposed your capital to.
Let’s keep the vehicle example going:
Say your car is now 10 years old, and hasn’t had any major repairs and by all accounts still runs great. A prudent saver should probably start (or has already started) thinking about future funds needed to cover necessary repairs and eventual replacement of the vehicle. This can be done in a separate account, but it doesn’t have to be.
So we have a car that doesn’t have any need for imminent repair. What should we do with our repair/replace fund? Stocks? Cash?
One thing we can consider is how correlated an event is to the market?
It turns out that equity returns have nothing to do with your car’s likelihood of breaking down. As such, a saver might choose to allocate more of that event’s fund towards equities.
In contrast, other events might show positive correlations with the market. If you work in a cyclical industry that sees large layoffs during market corrections, it would probably be wise to keep a larger allocation of safe assets (like cash) in order to lessen the impact of drawing down an already declining portfolio. Conversely, if you work in the medical field, for the government, or in education; you’ll likely be pretty well insulated from economic downturns, resulting in less need for cash in an emergency fund.
We can also consider the correlations of events with respect to each other. If you have a 5 year old car and a brand new A/C unit in your home, the odds of each of those breaking is individually very low, but the probability of those breaking at the same time are virtually microscopic.
Rule #3: Stress Test
It helps to do some math occasionally. One common notion is that any pre-planned expense that’s scheduled in the next 3 to 5 years should be allocated to cash. The reasoning seems fine: you’d hate to see that cash vanish when you need it most.
And while a 100% equity exposure certainly isn’t recommended, some exposure to stocks might be fine - even beneficial, maybe.
Consider a couple that has $100k saved for a down payment on a house that they plan to purchase in the next 5 years. At today’s rates of 4.5% interest on medium term treasuries, that couple could allocate their house fund to 33% stocks and the original principal would (in theory) be protected from even a 50% market correction.
And referring back to correlations, it’s reasonable to assume that the stock market and housing market are pretty well correlated. If stocks do well, then the housing market should also perform well. Conversely, if stocks did happen to fall 50%, it may be reasonable to expect that the housing market will also be weak. In the former, stock returns should help maintain purchasing power better than had the entire fund been in cash. In the latter scenario, you would still have your original principal and potentially a better entry point for your house purchase.
The goal of the stress test is to see how you’ll fair under different situations. You may decide that you don’t need an emergency fund at all - many financial independence ‘gurus’ have completely dropped their e-fund once their portfolio got large enough to weather any storm they might face.
Summary
If we think about the risks we’re exposed to in life, we can more effectively tailor our financial picture to match our personal needs.