A pre-mortem financial checklist is very powerful because it was created during rational and calm thought.
You want to have a pre-mortem financial checklist for things such as:
- What to do if you get into a car accident
- What to do if your baby or toddler is choking
- What to do if an intruder is breaking into your house
- What to do if you’re having a heart attack
- What to do if your spouse passes away suddenly
The importance of a pre-mortem checklist cannot be understated because when disaster strikes, we often CANNOT think clearly. As a result, we tend to make suboptimal choices.
Most people go through a post-mortem checklist, scrabbling to figure out what to do AFTER an event occurs. But can you really make the best decision when you can’t get out of a burning car because your seatbelt won’t unfasten? You might be so panicked that you won’t even remember that your cellphone is in your pocket.
The people who didn’t have a pre-mortem checklist during the last global financial crisis in 2008 got screwed. They likely panicked sold and missed out on a subsequent massive bull market.
It’s important to have a pre-mortem financial checklist to make more money during the long run and smooth out the negative cycles. First, let’s take a look at financial history.
Historical Bull & Bear Market Cycles
Below is an excellent chart that highlights the historical performance of the S&P 500. What’s particularly interesting about the below chart are the regression trend lines.
The middle red regression line shows the monthly average returns. It is currently saying that we are ~112% above the average. If history is any guide, we will either revert back to trend or severely undershoot trend.
The two dotted lines above and below have the same slope as the red regression line. The top line is based on the peak of the tech bubble and the low line is based on the 1932 trough. The dotted lines simply give us an idea of how high and low we can potentially go based on history.
The last time we were over 100% above the regression line was in 2000. But during the 2000 tech bubble, tech companies had no cash and no profits. Today, the largest tech companies are all highly profitable with massive balance sheets.
The bottom line from this chart is that all S&P 500-related investments in 2021 and beyond pose an elevated risk of loss. At the very least, investments made in 2021 or beyond have a higher chance of underperforming historical averages over time.
Now that we know where we are in the economic cycle, let’s go through my pre-mortem financial checklist.
Pre-Mortem Financial Checklist Before Things Get Bad
1) Make sure you have enough cash to last through a downturn. Since 1980, the three bear markets have lasted between three months and 2.1 years. Therefore, it’s best you have enough cash to cover three to 36 months worth of living expenses. Personally, I’d shoot for at least 12 months worth of expenses in cash given we’re close to a record high above trend. With cash yielding ~18% or greater nowadays, cash no longer feels like a drag.
2) Make sure your portfolio is diversified enough to match your risk tolerance. If you have a regular stock and bond portfolio, you should understand what the historical returns are for various compositions and be OK with the potential upside and downside. Due to a 10+-year bull market, I believe most investors overestimate their true risk tolerance either because they’ve never lost more than 20% in one year or they’ve simply forgotten what it’s like.
3) Write out your investment objectives. With each investment objective comes an investment time horizon. Once you clearly understand your time horizon, you can better match your risk tolerance. For example, if you’re investing for your child’s college education 16 years away, you can afford to be more aggressive with your investments. However, if you’re planning on purchasing a home within the next 12-24 months, then you should likely be more conservative.
Part of writing out your investment objectives include writing out a regular financial progress report to discuss with your loved ones. If you’re single, you’ll find the process of writing to be incredibly enlightening.
4) Run a Financial SEER Analysis. After you’ve studied historical returns and written out your investment objectives, it’s time to quantify your risk tolerance through Financial SEER. Our minds often belie our actions. Financial SEER forces you to come to terms with how many more months you must work to make up for your potential investment losses and adjust accordingly.
5) Make sure your work relationships are strong. The people who get fired first during a downturn are those who are most disliked, followed by those who are the worst performers. If you do not have a wide and strong safety net of colleagues who will go to bat for you, then you best develop these relationships now well before you need them.
Take colleagues out for lunch or coffee. Go to happy hour even though all you want to do is go straight home and rest. I have personally survived ~20 rounds of layoffs during my time in finance and I can assure you that high performers are not safe if they are reclusive and/or prickly.
6) Have at least one alternative source of steady income. The more income streams beyond your day job, the better. But you must have at least one alternative income stream that can help cover your basic living expenses as you try and survive tough times.
Ideally, this alternative income stream can grow if you spend more effort. For example, you might be a freelance writer making $500 a month with 10 hours of work. You could easily put in 40 hours of work a month to earn $2,000 if necessary.
Side hustle opportunities, dividends, and returns all tend to decline during a bear market. Therefore, look for countercyclical income and investment opportunities as well.
7) Collect on outstanding debt now. Defaults skyrocket during a recession. If you have any outstanding loans, you should consider collecting when times are good. If you like to invest in debt instruments, perhaps it’s best to only invest in loans with short maturities, rather than ones that may expire in the 13th year of a bull market. The same goes for private equity or real estate investments.
8) Consider raising rents. Only professional landlords with zero emotions can capture the maximum amount of rent when times are good. For most mom and pop landlords, we feel badly raising the rents to keep up with inflation or stay even with the market, so we don’t. However, individual landlords should absolutely treat their rental properties like a business. If you do not raise the rents to keep up with the market when times are good, you’ll have a tougher time raising the rent to market when times are bad.
For example, I have one rental that hasn’t had its rent increased in three years because I feel bad doing so. It could probably earn at least $300 more a month, or $3,600 a year, but I’m unwilling to send them an e-mail notification. Yet, I’m willing to fight tooth and nail to refinance my primary mortgage down in order to save $250 a month in interest to improve my family’s financial situation. Go figure.
9) Reconsider your safe withdrawal rate. If you are already retired, see if you can reduce your retirement withdrawal rate and still live a comfortable lifestyle. For example, if you’ve been regularly drawing down 4% of your portfolio, see if you can live off a 3% withdrawal rate and save the 1%.
Even if you match your withdrawal rate to the risk-free rate of return, it still might be too high because your investments will likely lose money during a bear market. Therefore, the more of a buffer you can build in retirement, the more you can withstand a bear market.
In a bear market, your withdrawal rate will most likely go down as you adapt to the new environment. The last thing you want to do is withdraw from your portfolio as it is losing over 20% of its value.
10) Don’t retire until things get bad. Retiring in a bull market is more dangerous than retiring in a bear market. The main reason is that we tend to extrapolate our returns and withdraw more aggressively when times are good. If you retire in a bear market, the chances of things getting much worse are low. But if you’re able to retire in a bear market because your investments and alternative income streams cover your desired living expenses, any incremental improvement in the markets and in the economy is just gravy.
You get to make max money during a bull market. Take advantage of the good times for as long as possible until things turn bad. Only after 1-2 years of living through a bear market should you consider giving up your main source of income.
Bad Times Don’t Last Forever
On average, bear markets have lasted 14 months in the period since World War II, while market corrections have lasted an average of five months. The S&P 500 index has fallen an average of 33 percent during bear markets in that time. The biggest decline since 1945 occurred in the 2007-2009 bear market.
Although going through a bear market is painful, the stock market has made money 95 percent of the time over rolling 10-year periods since 1926. Over a rolling 20-year period, it’s made money 100 percent of the time.
Unfortunately, we will all eventually run out of time. Running out of time is why I’ve put together a bull market and bear market checklist. Ideally, I want us to live our best lives possible all of the time. Weathering a stock market downturn is a must.
Having to spend time to recoup losses is a terrible waste of time. As you get older and wealthier, you no longer want to worry about money anymore. All you want to do is spend time on what really matters.
The one last piece of recommendation I have for you is to stay on top of your finances like a hawk. In the past, using an Excel spreadsheet to track your finances each month was good enough.
Today, I suggest using Personal Capital, the best free financial app to not only track your finances, but x-ray your portfolio for excessive fees, make sure your risk exposure is appropriate, and help you plan for retirement using their sophisticated simulation models.
I’ve been using Personal Capital since 2012 and have seen my net worth more than 5X during this time period. As a bear market looms nearer, I’ve used the app to ensure that I have a defensive portfolio. It’s free to sign up and use.
Invest In Real Estate More Strategically
Real estate is my favorite way to achieving financial freedom because it is a tangible asset that is less volatile, provides utility, and generates income. Stocks are fine, but stock yields are low and stocks are much more volatile.
The combination of rising rents and rising real estate prices builds tremendous wealth over the long term. Meanwhile, there are more ways to invest in areas of the country where valuations are lower and net rental yields are higher thanks to crowdfunding.
Take a look at my two favorite real estate crowdfunding platforms. Both are free to sign up and explore.
Fundrise: A way for accredited and non-accredited investors to diversify into real estate through private eFunds. Fundrise has been around since 2012 and has consistently generated steady returns, no matter what the stock market is doing. The real estate platform has over 300,000 investors and manages over $3 billion.
CrowdStreet: A way for accredited investors to invest in individual real estate opportunities mostly in 18-hour cities. 18-hour cities are secondary cities with lower valuations, higher rental yields, and potentially higher growth due to job growth and demographic trends.
I’ve personally invested $810,000 in real estate crowdfunding across 18 projects to take advantage of lower valuations in the heartland of America. My real estate investments account for roughly 50% of my current passive income of ~$300,000.
Have a pre-mortem financial checklist for your own good. And if you plan to retire, have a pre-retirement checklist for a post-pandemic life as well!
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