Stocks will eventually crash. The key is to be financially and psychologically prepared to stay invested even when your 401(k) gets chopped in half, your job disappears, and your mortgage goes underwater.

Investing in the whole stock market is a great way to build wealth over the long run. But, just how long is “the long run”? As I am writing this on September 3, 2018, the U.S. stock market hit new all-time highs last week, after a bull market that has lasted, by some accounts, nearly 10 years. Today’s young investors may have no memory of the 2008 financial crisis, where the market declined by about 55%, from its peak on October 9, 2007 to the lowest point on March 9, 2009. For the unlucky who invested at the peak, it took about five years just to get back to even.

Although in the Great Depression, stocks declined by 90% and took 25 years to get back to even, it does not seem a depression of this magnitude will be repeated. However, something less severe than the Great Depression but as bad or worse as the 2008 financial crisis could occur. There is no way to time the market or figure out when it will occur, which is why sound financial advice looks at when you will need to spend your assets and decides the proportion of your assets that should be in stocks—diversified across the whole U.S. or global market.

I am a firm believer in the hypothesis that the duration of your time in the stock market is most important. When comparing investment gains over many years to those over shorter periods, the longer periods show greater gains. However, I have often wrote here that “the long run” is about 15 years or more. In fact, there is a recent example when stocks produced no real returns in a period longer than this: 1966 to 1982. Of course, if you stayed invested since 1966 you have seen tremendous real gains, but for investors then, the pain was profound because interest rates were high; you could earn 7% or even higher per year with 10-year Treasury bonds. As of this writing, the rate is only about 2.9%, which merely keeps pace with inflation.

If you believe the duration of investment is key, then if you receive a windfall, this means you should invest a lump sum proportionate to your asset allocation percentage into the whole stock market, despite the fact that we are historic market highs. At the same time, it is essential to be emotionally, financially, and logistically prepared for a 55% drop in stock valuations.

It is easy to look back on the 2008 financial crisis and ask why people sold their stocks rather than buying more and more. However, many Americans faced a triple whammy of losing their high-paying careers, having their mortgage payment go up and home value plummet, and taking a 40% or larger haircut on their 401(k)s and other investments (if any). Then, many cashed out their investments at fire-sale prices, just to delay foreclosure on their homes. Additionally, no one knew then that the recovery would happen so quickly and powerfully.

Being prepared for a 55% drop means having low overhead, such as a smaller home and older car. It means having a six- or even 12-month emergency fund to cover your living expenses, and enough money in low-risk accounts or investments. At all times, what you want to avoid is being emotionally swayed or financially compelled to liquidate your stocks during a temporary market crash.

Recently, a proposal has been discussed by U.S. Treasury Secretary Mnuchin and President Trump of adjusting capital gains for inflation when it comes to taxation of those gains. This has rightly been criticized as a tax break for the rich, but what has not been widely discussed is the hypocrisy and inequity of not including savings accounts, certificates of deposits (CDs), Treasury bills and bonds, and corporate bonds, which yield “interest” instead of “capital gains,” in the inflation-adjustment proposal.

Although there are no legal restrictions preventing most Americans from investing in stocks (equities), about half do not. Reasons include more pressing financial concerns, fear of loss, and a lack of understanding of how stocks work. Therefore, adjusting capital gains for inflation will mainly be helpful to wealthier Americans.

Capital gains already have numerous tax advantages over earned income, such as:

  • No 15.3% payroll taxes (7.65% employee and 7.65% employer share)
  • If older than one year (long-term), the tax rate is much lower or even 0%
  • Long-term tax rate tops out much lower (20% instead of 37%) for high earners
  • You can choose when to incur capital gains taxes (when to sell)
  • Capital gains tend to be received by high-earners, who gain the most from these advantages because they are in high tax brackets

Presently, interest on savings accounts, CDs, T-bills/bonds, and corporate bonds is taxed at the same rate as earned income and short-term capital gains. Except certain corporate bonds, these types of investments do not yield any capital gains, but rather yield interest only. Thus, none of the above benefits of capitals gains apply. Americans, especially those with lower incomes and net worths, are more likely to put their money in savings accounts, CDs, and Treasury securities rather than stocks. Therefore, they miss out not only on the capital appreciation power of stocks, which is much greater than low-risk assets over the long term; they also miss out on preferential tax treatment that already exists. To add an inflation adjustment on top of this is ridiculous.

Some may quip that stocks do pay something similar to interest, in the form of dividends, which are taxed like earned income and short-term capital gains. This is false; for most “buy and hold” investors in index funds and many individual stocks, the vast majority of dividends are treated as “qualified” dividends which are treated not like interest, but as long-term capital gains. Again, investors in stocks get preferential treatment.

Each year, banks, the U.S. Treasury, and other firms must issue Form 1099-INT to report how much interest income you received in the prior tax year on savings accounts, CDs, T-bills/bonds, et cetera. However, we should not forget that savings accounts typically pay low interest rates—sometimes as little as 0.03% annual percentage yield (APY), with the best accounts paying no more than about 2.0% APY. If we were to adjust savings interest for inflation, which is around 2.4% presently (or 2.9% including food and energy), this would be a loss rather than income! If we adjust capital gains for inflation, shouldn’t we adjust interest too?

Logisitcal challenges aside, if we were to go a step further, offering an above-the-line deduction (like we do with student loan interest) for lost purchasing power on Americans’ savings, capital gains would still be far too advantaged.

Due to the unfairness of how interest is treated, with no consideration of inflation, some have dubbed saving money a suckers’ game. Although a majority of Americans do not understand this, investing, on the other hand, is a winners’ game. The prudent step would be for the government to begin adjusting interest income for inflation but not capital gains. Even then, investors would still be receiving highly preferential treatment as compared with savers.

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As you increase your net worth by paying off high-interest debt, building an emergency savings fund, and investing in stock market index funds via a 401(k) plan, individual retirement arrangement (IRA), taxable brokerage account, and, if applicable, 457 plan and/or health savings account (HSA), you achieve financial freedom and work toward financial independence (FI), which is the ability to live off your portfolio returns without earned income. During this journey, certain types of insurance become unnecessary, while others become critical.

Here I will briefly discuss two types of insurance: automobile (car) insurance and health insurance.

As you accumulate assets, some insurance becomes unnecessary and of poor value—namely, insurance that covers expenses that are assuredly small, in relation to your emergency fund. However, insurance that covers potentially unlimited downside becomes vital, because all your assets could be stripped away without it. (Exceptions exist, such as your retirement accounts and primary residence, but this depends on state law and the circumstances—for instance, in some states your retirement accounts can be seized in a court judgment if you were driving drunk or criminally negligent, but not for other types of at-fault accidents.)

Auto insurance is divided into coverage that pays for damage to your motor vehicle (i.e., collision and comprehensive coverages) and coverage that pays for injuries and damage to others’ motor vehicles and property (i.e., bodily injury liability and property damage liability).

Many people take a loan out to purchase a new car, with little or no savings. They are neither financially independent nor financially free; consequently they need collision, comprehensive, and “gap” coverage. Collision covers damage to your car when you collide with an object, be it another car, a boulder, et cetera (although if another driver was at fault and has coverage, their insurance should pay for your car’s damage). Comprehensive covers damage such as a tree falling on your parked car, hail, or theft. These types of insurance both have deductibles, typically $500, and in a given incident they only pay the amount of damages that exceeds the deductible amount (with some exceptions, such as in Florida, by state law, the deductible for comprehensive is waived for replacing a broken windshield).

Both collision and comprehensive coverages only pay up to the fair market value of your car. This means these insurances do not cover potentially unlimited downside, but rather downside that is capped and predetermined. You can look up the present value of your car using Kelley Blue Book, providing the make, model, year, condition, and mileage. This value, minus your deductible, is approximately the maximum your auto insurance will ever pay out under these aspects of your policy. Consequently, people with plenty of savings typically do not need collision and comprehensive coverage, because they can just pay for auto repairs or a replacement car out-of-pocket.

We often heard about homeowners being “underwater” on their mortgage after the housing crisis, meaning they owed more toward their mortgages than the fair-market value of their homes, despite having paid a down payment and months or years of mortgage payments. This same phenomenon happens on a massive scale with buyers of new cars, because they lose quite a bit of value quickly, causing the amount owed to exceed the car’s value. Thus, people buy “gap” insurance to pay the difference between fair-market value and what they owe, in case their car is totaled. Obviously, having three extra types of insurance (collision, comprehensive, and gap) is costly and perpetuates poverty.

Liability auto insurance, on the other hand, covers potentially unlimited expenses. If you are at-fault in an accident, others’ injuries could cost hundreds of thousands or even millions of dollars. However, you can’t bleed a rock, as the saying goes; people without assets can always declare bankruptcy without losing much besides their credit score, which may already have been damaged to begin with. Although this is socially irresponsible, the more pressing and probable financial need for a low-net-worth individual is repairing or replacing their car, which is why collision, comprehensive, and gap coverage are often prioritized over high bodily injury and property damage liability limits.

Therefore, people approaching FI generally don’t need collision, comprehensive, or gap coverage, but probably should have mid-six-figures of bodily injury protection and $1 million or more in an umbrella policy to cover other scenarios that could destroy their progress toward FI.

A hidden benefit of auto insurance is that your insurer has lawyers and procedures to minimize what they pay out to injured parties, such as pretending the victims of an accident weren’t really hurt that bad, or making lowball offers for immediate payout that the victims will be tempted to take. If you were to self-insure, you would have to hire your own lawyer at great expense to you. However, if your liability limits are low, your insurance company might just pay the limits and walk away, leaving you on the hook to hire a lawyer to settle with the victims for their medical bills, lost wages, pain and suffering, et cetera, which will come directly out of your accumulated savings and investments because you didn’t have adequate insurance.

Health Insurance

Health insurance pays for your personal medical bills—a potentially unlimited expense. Like with auto insurance, low-net-worth individuals can declare bankruptcy to escape medical debts, but someone working toward FI cannot and would not want to do this.

Like with auto insurance, that has the hidden benefit of legal counsel, health insurance has the hidden benefit of negotiated rates. For example, when my grandmother was suffering a brain tumor (may she rest in peace), the hospital transported her by helicopter to another hospital 90 miles away, which was first billed at $47,000, and then reduced to a negotiated rate of $5,300 when Medicare and her insurer paid. An uninsured individual would be billed at $47,000, and could probably negotiate this down quite a bit, but not necessarily all the way to $5,300.

Many types of medical providers expect to work with insured patients, and may be surprised or not even accept patients who do not have insurance. In the United States, people buy or receive health insurance through various “pools,” the largest of which is employer-sponsored insurance, but with the Health Insurance Marketplace, Medicare (for seniors), the Department of Veterans Affairs, and several others providing insurance for millions of people.

In addition to the benefit of negotiated rates, health insurance being tied to your employer offers benefits of economies of scale (they can get a lower rate due to having many employees) and lower taxation. For example, if you pay a premium through your paycheck, this deduction is exempt from payroll and income taxes. Of course, there are also many downsides to the U.S. system.

A great option for those on the path toward FI is a “high deductible” health plan (HDHP). It offers downside that is capped and predetermined—your annual deductible limit, which might be as high as approximately $15,000. Beyond this deductible, it insures against potentially unlimited downside. People on the road to FI need health insurance, for the benefit of negotiated rates and to protect their unsheltered assets from 100% erosion. But, they don’t need a plan that pays for every minor expense. HDHPs also open the opportunity to contribute to an HSA, which is extremely tax-advantaged and can be invested in an index fund of the whole stock market, just like a 401(k), IRA, or taxable brokerage account. Although you may have better insurance via your employer, if an HDHP is a reasonable option, it makes sense for financially free individuals, but not for those who could not pay $15,000 or $30,000 toward their medical bills (don’t forget that your ailment could span two calendar years!).

Overall, auto and health insurance are necessary for both low- and high-net-worth individuals, but different types and levels of coverage are appropriate for each. Low-net-worth individuals always have the “you can’t bleed a rock” factor, so they might insure against small expenses they could not pay out-of-pocket, while leaving the bankruptcy option open for large expenses. Those on the path toward FI have the savings to cover small and moderate expenses, making some types of insurance unnecessary, while the concern of protecting their assets looms large.

People are generally confused about what to do with excess money. The words we use to talk about this are not helpful. Most people think of saving money by putting it in a bank. However, the key to financial success is investing money by putting it in a 401(k), an individual retirement arrangement (IRA), and a taxable brokerage account to buy stocks (real estate is another option if you have the requisite expertise).

However, saving money is important. You want to have savings to cover your expenses and unexpected financial needs. But, as your financial capital grows, an increasing proportion of it should be in stocks. This is why sound financial advice advises establishing an “emergency fund,” which is savings to cover several months of living expenses, before you start investing. Another prerequisite to investing is eliminating high-interest debt, such as credit cards.

Typically, people talk about a savings account being “safe” and investing being “risky.” In one sense, this is true. With a savings account, you can’t wind up with fewer dollars than you deposited, while an investment in stocks can result in losing money. However, in the long run, avoiding investing is the truly risky maneuver. Unfortunately, half of Americans avoid investing entirely, which is financially ruinous in the long term.

The best way to invest is to buy the whole stock market via a mutual fund commonly known as an “index” fund. Instead of picking stocks or market sectors, you can invest in the whole U.S. publicly traded stock market by purchasing shares in an index fund that invests in the approximately 3,500 publicly traded U.S. companies, proportionate to their value (that is, their market capitalization). Apple is the most valuable company, so as of this writing, about 2.9% of your money will be invested in Apple, 2.7% in Microsoft, 2.5% in Microsoft, 2.4% in Google, … 0.8% in Home Depot, 0.7% in Boeing, and so on.

Index funds of the whole U.S. stock market have very low fees and a high probability of greatly increasing in value over the long term (15 years or more). Although in any particular year, there is about a 25% chance of losing money and a 75% chance of making money, over longer spans the chance of losing money approaches 0%.

Additionally, it is sensible to hold an index fund of the “international” stock market; that is, all publicly traded companies not based in the United States (for example, the Vanguard Total International index). The largest of the approximately 6,100 stocks in this fund are presently Tencent (1.15%), Nestle (0.95%), Alibaba (0.8%), Samsung (0.8%), and HSBC bank (0.75%). Of the proportion of your money invested in stocks, many people suggest putting about 80% in the U.S. market and 20% in the international market. Others recommend 100% in the U.S. market (most notably Warren Buffett) and others recommend a 50%/50% split. Considering the whole earth, the U.S. market’s valuation is about 50% of the earth and all other countries are about 50%.

Many people think of investing as “gambling.” This is not correct. The saying, “the house always wins” is accurate; when you gamble, be it in a lottery, casino, or buying scratch-off tickets, you are more likely to lose money than gain. As you gamble more and more, your probability of making money approaches 0%. Investing is fundamentally different, because the odds are in your favor—your probability of making money approaches 100% the longer you stay invested in the whole stock market.

Not investing is risky because over time, you are going to wind up with far less money as compared with someone who invests in index funds of the whole U.S. stock market and optionally/additionally the international stock market. When we talk of equities (stocks) being “risky,” if referring to the whole stock market, this risk is time-limited. Over decades, the riskier path is actually sticking to “safer” choices like savings accounts, money market accounts, certificates of deposit, and bonds.

With investing, starting earlier is better, and investing for retirement is critical. Your 401(k) and IRA can be in a money market account earning next to nothing, or in index funds of the whole U.S. and international stock markets earning large, tax-deferred or tax-free gains. The choice is yours. (Although some 401[k]s do not offer an index fund of the whole U.S. stock market, in these cases it is reasonable to invest your 401[k] contributions in a Standard and Poor’s 500 [S&P500] index fund.)

Fidelity, Vanguard, Charles Schwab, and TIAA are the largest brokerage firms where you would select to buy an index fund with low fees (i.e., 0.25% per year or lower) for your taxable brokerage account and retirement accounts. In addition to investment returns, retirement investing is important because you are offered tax reductions and credits for doing so, but you can only invest up to a certain amount each year, so if you start later, you can’t go back and contribute for previous years.

Another benefit is that the so-called “unearned” income received via investing (namely, capital gains) is advantaged over earned wages in other ways, even in a typical taxable brokerage account—for example, you don’t have to pay Social Security or Medicare taxes on your capital gains, and you can choose when to receive the capital gains by cashing out in a tax year that is advantageous to you (known as “tax gain harvesting”).

One of the biggest financial risks for young and middle-aged adults is not investing. Although two-thirds or more of Americans do not understand investing and other basic financial concepts, the information can be learned on your own, from websites and books. However, weeding out widespread bad advice is difficult. Many financial professionals are trying to sell you on managing your money with them, for their own personal gain rather than your gain. Many financial pundits talk about investing in particular stocks to the public’s detriment, because it is simply boring to only talk about investing in the entire stock market, despite being preferable.

You can learn about finance and wisely invest in index funds of the whole stock market without anyone’s help, but you must put forth time and effort. Hiring a “wealth manager” or financial advisor can be dangerous to your financial health; you must be sure they are acting in your best interests, rather than for their own profit. Demanding they conform to the “fiduciary standard,” not the “suitability standard,” is a good start. Regardless of whether you hire a financial advisor, educating yourself is critical, and will pay off massively over the course of your life.

Payday should be just like any other day. If there is a spending decision to be made, the outcome should not be any different based on whether you recently received a paycheck or benefits payment that is not contingent on lack of assets.

A key factor in the path to financial independence is earning much more money than your expenses. The idea of orienting your discretionary purchases and bill payments around when you get paid is antithetical to this principle. The timing of when your paycheck comes should be a mere triviality.

There is a mindset toward spending money as quickly as it comes in. I am not sure where it comes from, but it seems to be clustered in families, social circles, people of certain age brackets or socioeconomic status, et cetera. Platitudes about needing to enjoy life and the certainty of one’s continued destitution are common. There is an idea that one should consume resources quickly, before they are seized, stolen or become worthless. This is evolutionarily and historically appropriate, but inappropriate for modern financial life in developed states like the United States, European Union, and People’s Republic of China.

There is a justified, populist backlash against “experts” chastising the public for their financial situations. For instance, when MarketWatch recently declared that Americans should have twice their annual salary saved by Age 35, the derision on social media was widespread.

Many people are in financially untenable situations through no fault of their own. They are not feckless or even necessarily financially illiterate, and are often work full time or even more than full time. This has been explored in great depth, such as on the Bad With Money podcast. For example, the cost of housing in the United States has become quite high relative to incomes, contributing to penury and inequality.

Many people inherit financially unfortunate circumstances. Although people are lucky to be born in the United States, the inequities of being born into education, wealth, et cetera are profound. It is not fair that some young adults have to work and pay rent at a young age while others get to live rent-free with family. It is not fair that children of financially independent parents enjoy financial security, better nutrition, more time with their parents, and greater opportunity, without justification based in human rights or merit.

Separating what you can change from what you cannot change is important. I think it can be done in a “judgement-free” way, but this is difficult even one evaluating oneself, and nigh impossible for an outsider. One can look at examples of those who have succeeded despite bad situations, although others have not been so fortunate and/or diligent.

Regardless, the mathematics remain the same. To become financially independent, one must somehow increase earnings, save a high proportion of income, and invest it in reliably profitable avenues—most commonly, equities or real estate. Along the way, getting paid has to completely lose its day-to-day, practical significance. For example, if your expenses are $2,500 per month and your net income is $2,700 per month, getting paid matters (assuming you have a low amount of liquid net worth). However, if your net income increases to $5,000 per month, getting paid might continue to matter if your expenses rise to $4,800 per month, but will quickly not matter if you keep your expenses at their prior level, due to accumulation of savings. Toward this end, a useful psychological “trick” is to automatically contribute a large portion of pay to your 401(k) and savings/investing accounts.

There are definitely exceptions to the principle that payday should be just like any other day. For example, if you are a recipient of Supplemental Security Income (SSI), you have to maintain assets of less than $2,000 to continue receiving benefits. Similar means tests apply to other benefits such as subsidized housing. Such recipients are in an ironic situation, as they move away from financial independence by accumulating assets, and consequently should keep their expenses close to their income. For everyone else, having low overhead is key. Hence, payday should be just like any other day.