Long Term Budgets

#stayrich To stay rich, you must spend much less than you could every day for the rest of your life... This is a law as iron as gravity.

To stay rich, you must spend much less than you could. You must do this every day for the rest of your life. If you wish your heirs to stay rich, you must teach them this practice.¹ Stop and think about this. How will it feel to have wealth, and not spend it? Anyone who fails to internalize this lesson is doomed to work forever. I guarantee it. This is a law as iron as gravity.

You may see neighbors and family who spend their money quickly. Ironically, due to the nature of wealth, they may be able to keep this up for a decade or two! You may feel envy at their lack of cares. But any entity which spends faster than it earns will end in ruin.² If you have a problem with this, get over it! The alternative is losing your wealth!

Reframe your internal view of money to be safety, security, and options. Money is for spending, but spend much of it later, and save most of it for the future!

It's impossible to achieve wealth early in life and spend it down to zero precisely at your death. That's just not the way the math works. In the end, you will either have way too much, or way too little. I know which one I'm aiming for!

The first key lesson for achieving and stewarding wealth is understanding what spending truly is and is not. Spending is anything that makes your net worth drop. Earning is anything that makes your net worth rise. This is different that your accountant’s definition. This is different than the IRS’s definition. But this is the definition we will use, because we must sharply define our ultimate goal.

Investing, therefore, is the act of trading cash for ownership, in the hopes of future earnings. Or, it is the act of trading ownership for cash, in the hopes of preventing future spending. Your luxury car, therefore, is not an investment. It is spending. Your personal residence is also probably not an investment. Unless you purchase the absolute minimum asset to meet your actual need for shelter and transportation, you are spending.³ Beware of spending masquerading as investment! It’s hard to pull out a credit card often enough to spend down a great fortune. But no one is ever more than a single bad judgement away from ruin when they are “investing.”

Ok. Enough philosophy! Let’s get down to budgets! How much is reasonable to spend each year? If you are not yet FI (financially independent),⁴ then this is pretty simple. Save at least 50%, and preferably closer to 75% if you are a high earner. At this rate, just a few years of a modest lifestyle will put you on track for a lifetime of higher spending.

If you are already FI, congratulations! Stop and celebrate! This is a massive milestone! This is the beginning of an ever increasing trajectory for your lifestyle, even though you may occasionally see a dip. In your first year of FI, it's generally safe to spend about 3.6% of your liquid net worth.

There are situations where that percentage might be higher. Talk to your insurance agent. If they tell you that you are less than 30 years from end of life for the last of your heirs, then your spending can be higher. If you have investing superpowers and can out-earn the stock market consistently for multiple decades, you can safely spend more.⁵ If you have a financial advisor who can outperform the stock market, you can push this higher. Kidding! That person mostly doesn’t exist! If they could really outperform, why would they bother with you? They’d already be wealthy, and they’d have fired you as a client a long time ago. Really. The next Warren Buffett isn't working for your local wealth advisor. I promise.

But that's OK! A person who earns average returns for decades will actually do better than the vast majority of investors. Repeat this to yourself. Average is great, and chasing outperformance generally means underperformance.

There are many situations where your initial withdrawal rate might be lower than 3.6%. If you are focused on wealth building, you might choose to start lower, so that your money grows faster. If you don’t invest aggressively in either the stock market or asset classes that keep up with the stock market, then you will need to start lower.

What percentage is safe after that first year? If you are still working, then as long as your earning is a high fraction of your spending, stay at that initial rate. But if you stop working, or your work becomes your side hustle to your increasingly successful portfolio, then there are three basic strategies you'll find online, two of which are pretty useless.

1. Adjust your spending each year by inflation, and don’t change it otherwise. This is a silly strategy, because this strategy will slowly turn you into Mr. Scrooge, sitting on an ever increasing pile of wealth and never improving your lifestyle.

2. Keep your spending to precisely 3.6% of the current value of your portfolio. This is a silly strategy, because you will be required to spend wildly in bull markets, and cut your spending overnight by 75% or more in bad times! No one wants to live like that.

3. There’s a middle ground. For this strategy, let’s adjust our spending upwards or downwards by 20% plus inflation each year. Last post, we noted that this was the minimum noticeable change that one feels. If we can stay under the target while increasing spend by 20% plus inflation, great! If we have to leave our spending as is and only adjust for inflation, fine. And if we need to lower spending by 20% plus inflation, we’ll do that instead. Taking a spending cut won’t happen often, but it will happen a few times in your lifetime.⁶ Each year, we will lower our target withdrawal rate by 0.1%. So if we started at 3.6%, year two is 3.5%, and so on. This gradual lowering the bar is for safety in the long run. By year 24, we will hit 1.2%, which is plenty safe, and we won't have to go any lower.⁷

   There are a few other similar named strategies. CAPE, Guyton-Klinger, and this strategy all trade away your ability to quickly up your spend during good times for the guarantee that you won’t have to quickly cut your spend during bad times. You may have noticed that almost all massive busts in the markets are proceeded by massive booms, and these strategies force you to stay cautious and not buy into the hype of a bubble.

   Occasionally, there are massive busts in the market that aren’t preceded by a bubble, but many of those see a quick recovery, as the market panics and then walks the panic back. So by never overreacting to either the upside or the downside, we are insulated from the year to year gyrations between hype and fear in the markets, and get to experience a stable, mostly even lifestyle.

When confronted with the idea of great wealth, many people have an emotional reaction. Some go wild with greed, imagining themselves having and spending it. Some go wild with envy and anger, imagining someone else having and spending it. To resist these destructive urges, understand that wealth is a great gift, but that it is not solely yours. Your portfolio may seem abstract, because you interact with it as numbers on a screen, but that screen controls real consequences in the real world for real people.

Understand that you are highly compensated, and you may take a portion of this gift for yourself each year.⁸ But the vast majority of it must remain invested for next year and the next generation! If you spend it down, real people will take down real factories and plow under real farms to pay for your toys and vacations. Real jobs and real productive capacity will be lost. If instead, you wisely steward the wealth, then a steady stream of riches will flow to you and yours forever, and the human project will continue onwards and upwards.

1. No, you won’t be able to set up some crazy trust that rules from beyond the grave. One of two things will happen, either your heirs will figure out a way to subvert your rules, or your rules will bring your heirs to ruin. Your only choice is to train them and trust them. You won’t be there.

2. Yes, this applies even to the US Federal Govt, but due to accounting definitions that twist the words “spend” and “earn” past all common sense, it’s actually not only possible for the USG to run a deficit in perpetuity, it’s a requirement for the system to function! But that’s a post for another day.

3. Yes, there’s an investment component here. You are a hairless primate and without appropriate protection, you will die. But a nice van by the river solves these problems. Your house is way more than you need. That’s ok! But understand that you are spending here. If you have zero emotional connection to your home, and purchase it solely for the purpose of flipping it at a profit, fine, it’s an investment. But are you lying to yourself? Are you?

4. How do you know if you are FI? If you have less than 25 years worth of your current annual spending saved up, you are not FI. If you have more than 33 years, you are definitely FI. If you have between 25 and 33, you are either definitely FI or definitely not FI, but it’s really hard to tell right now because exponential returns combine with the chaos of markets to embody the butterfly effect. A tiny change in trajectory will massively change your outcomes in a few decades.

5. What? You can do this? Why are you not already a successful hedge fund manager? Seriously! Quit your job and open a fund! Right now! Oh? Suddenly not so confident? Yeah, that’s what I thought. These people exist. But just as there are very few gold medal Olympians in life, there are very few consistent out-performers in the markets. For every million who set out to outperform, only a few actually do. Remember, by definition, all investors must add up to the market. In practice, a few geniuses eat everyone else's lunch, so the vast majority of investors lose a fair amount to make those geniuses into billionaires.

6. This is why I emphasized flexibility in your spending so much in an earlier post! Occasionally, you will need to cut your spending. If you try to arrange your investments to make sure you never have to cut, you will fail and end up poorer in the long run anyway.

7. I tested this spending algorithm using Monte Carlo analysis for millions of years of simulated stock market returns, where the stock market was generated using a student-t mean reverting distribution derived from stock market returns going back to 1871. In 200 year runs, it resulted in failure less than 1% of the time. Given that no model is perfect, aiming for less than a 1% failure rate seemed like a waste of time, because risks that weren't captured in the model were dominant at that point.

8. Try to give some large fraction of that portion away each year, as that is healthy and will buy you great happiness when you get good at it! We'll talk about giving in another post!