In a recent blog post on using a HELOC to save interest costs on your mortgage, I mentioned that I had basically converted my $10k emergency fund into a variable rate HELOC. A reader called me on that and asked how I could do that and still claim to be risk-averse, so I figured it was time to explain what I mean by “risk-averse”.
My main financial goal right now is to build my savings to a point where my investment income will cover my monthly expenses. Let’s call that point “financial independence”. At that point, I can still work if I choose to, but a job will no longer have any control over my life. I will be in control, and control over our own lives, or autonomy, is a very big component of our happiness.
Not too long ago, I figured out that I could attain this goal of financial independence in a reasonable amount of time without any investment gains at all simply through saving a large percentage of my income and by lowering my monthly expenses. So when I’m looking at some financial move, I check that move against this goal. So for me, “risk” is anything that could endanger this goal, or push out the timeline that I’m currently looking at.
For example, investing my savings in the buy and hold strategy is risky from this perspective because the market could go down unexpectedly, generate large losses, and push out my timeline. So I avoid that strategy and instead go with strategies like No Lose Stocks and Long Shot Options that guarantee very limited losses compared to my overall savings.
Applying this yardstick to the HELOC, the worst case scenario would be that the bank cancels my HELOC, and I need the $10k for an emergency. If that happened, I would pull the $10k from an IRA. I currently have both a Roth and a Traditional IRA. The Roth IRA allows you to withdraw money that you have deposited without paying income tax or penalties, so that option would only cost me $10k. The Traditional IRA requires paying taxes and a 10% penalty when you make a withdraw, so that option would cost me about $13.5k. A loss of $10k or $13.5k is not going to significantly affect my timeline. Seen from this light, not having a $10k emergency fund in cash is not a risk because it doesn’t endanger my goal.
Before anyone goes off thinking that financial independence requires a huge salary, or that it means I’ll be “rich” when I am financially independent, I’d like to point out that my goal will be attained on a fairly small amount of money. A central theme of happiness research is that wealth, stuff, and money are not requirements for happiness. So I’m voluntarily keeping my spending and accumulation of stuff low, which won’t affect my happiness, in order to achieve my goal, which will affect my happiness.
Since I don’t plan to be rich when I’m financially independent, that might affect which IRA I should be withdrawing from in the case of an emergency. The purpose of a Roth IRA is to get tax-free income (and you don’t have to wait until you’re 65). To be financially independent, I only need enough income to cover my monthly expenses. If my monthly expenses are low enough, then I probably won’t be paying much in taxes anyway.
When I reach my goal, I won’t have any FICA taxes to pay, so I’ll already need 7.5% less income than I currently do. Then the standard deduction for 2009 is $11,400. The personal exemption is $3650, and so for my wife and I, that’s $7300. Total that’s a currently allowed tax-free income of $18,700 per year (which gets indexed for inflation). So if I can get my monthly expenses under ($18,700/12 months) $1558.33, then I’d be paying zero taxes. That might seem crazy low, but I keep track of all my spending in a budget and my current monthly expenses are $2600, $800 of which is a mortgage payment (principal and interest only). So after I pay off the mortgage, my monthly expenses will be only only $1800. So if I were financially independent in the current tax environment, and didn’t have a mortgage, I’d be paying 10% in taxes on about $250 a month, or $25 a month.
Monthly expenses of $2600 would require a savings fund of $780k earning 4% per year. Monthly expenses of $1800 would require a savings fund of $540k earning 4% per year. So by paying off my mortgage, I can become financially independent for $240k less than otherwise. In addition, that $800 that used to go towards my mortgage, will instead go towards my savings and my goal.
What this has really made me consider is whether or not I need to pull all the deposits to my Roth IRAs out and pay them against my mortgage. If I don’t need the tax-free income later, then I might do better to get the reduced monthly living expenses now in order to achieve my goal faster.
Since a very large financial loss would jeopardize my savings and my goal, I maintain insurance to protect against those kinds of losses. Generally, though, I only insure against risks that I can’t quantify or that after quantifying prove to be too big to bear.
A loss that would be too big to bear would be the loss of my house for example. If my retirement fund is only $540k, and my house is $180k, then replacing my house out of pocket would be a large financial burden. So I will maintain homeowner’s insurance even after the mortgage is paid off.
Risks that I can’t quantify include health costs and accidental damage to other people’s property.
For health risks, I maintain health insurance, but I’m only concerned with insuring against catastrophic loss. So I have a high-deductible HSA plan that covers costs 100% after the deductible is met in any given year.
For accidental damage, it’s possible that I could be at fault in a car accident with a number of vehicles or with a very expensive vehicle. Either way I can’t really quantify what the upper bound of that amount would be, so I maintain the highest levels of liability insurance. But I don’t carry any collision insurance on my car or my wife’s. I know how much those cars are worth and how much it would cost to replace them, and we can cover those costs out of pocket.
Currently we also have life insurance, but the amount is only enough to get the survivor to the financially independent point. We don’t maintain “lottery” level life insurance. And the policy is term life. So once we get to the point that we are financially independent, this insurance will be dropped as it will no longer be needed.
Getting back to the emergency fund and HELOC question again, at a mortgage rate of 4.625%, keeping the $10k in my bank account instead of paying down my mortgage would cost me $38.50 per month. Essentially, that $38.50 per month would be an insurance premium that guaranteed me $10k in coverage. Putting that in perspective, I pay $40 per month for homeowner’s insurance and that protects me from more than 10 times as much loss. So for me, the better option here is to pay down the mortgage and take the relatively small loss in IRA funds if it ever comes to needing the emergency fund.
Risk-averse, not Loss-averse
There is a difference between being risk-averse and being loss-averse. I am risk-averse when it comes to risks related to my happiness. However I’m willing to risk losing small amounts of money (a few thousand) if it means I can more quickly get to my financial independence goal and reduce my happiness risk. So I regularly try out different things that might lower my monthly expenses in the long run.
For example, I recently tried out Cricket wireless because they are cheaper than my AT&T plan. Unfortunately the Cricket service reception at my house is too poor for me to use it. I spent $85 trying that out. But I had set that money aside to lose, so it wasn’t a risk to my happiness. This is similar to what I do with Long Shot Options. You could look at the service and say that I’m losing money every month since I’m spending the interest earned on my core capital on options that will most often expire worthless. But my perception of this is that I’m not losing my core capital, or endangering my goal, and so my expectations are not violated.
I read an interview with Taleb recently that talks about how he manages the perception of loss.
At the beginning of the year he sets aside a certain amount of money to cover any surprise expenses, like lost or damaged property, parking tickets, speeding tickets, or any other annoyance. At the end of the year, anything left goes to charity. So if he does get a parking ticket, it’s no big deal because he’s already paid for it, and expected not to have that money anyway. His day isn’t ruined.
In fact, he may have a better day than someone else would. Consider the situation where you’re driving around trying to get a parking spot so you can get into a show before it starts. Time is running out, but there are just no spots left, except the handicap ones, or maybe some other ticketable spots.
For Taleb, I imagine the answer is simple, just park in a ticketable spot and enjoy the show. If it turns out he doesn’t get a ticket, it’s that much better, but there’s no pain if he does get a ticket. For someone else, they’ll probably drive around until they’ve already missed part of the show. Maybe park very far away, or risk it and park in a ticketable spot. Then throughout the show, instead of enjoying themselves, they’ll be wondering if they’ve been ticketed yet. They won’t be enjoying the show at all.
So the trick is to quantify your risks and potential losses to make sure they can’t harm you. If they can harm you, then insure against them. Then mentally reframe a potential loss as the expected scenario, and become used to that as your reality. Then you can live life without worrying about losses. Any losses you suffer will be expected, and any non-losses will be pleasant surprises.
Its about managing your expectations and not defying them. In my opinion, the worst thing to risk is your happiness.