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Layers to this

I’m going to start this post by making the baseline statement: time is the most important factor when it comes to investment returns.


Maybe this is over-simplified; there are too many factors dependent on the investor to determine what factor is the ‘most’ important. We all have our own purposes and goals with investing.


But this post is for long-term investors. Those that are not trying pick stocks, trade in and out of positions, chase returns, etc.


This post is for the person who is committed to spending less than they make, investing excess money in a way that is conducive to their goals, and letting the markets do the work.


If you disagree with this approach, then you’re tacky and I hate you.


Just kidding - my concept of layers below probably works no matter your strategy, as long as the strategy is long-term.


There are exceptions to every rule, including my concept of layers below. But, my post is a suggested order of operations that you can think through or try to create, and make adjustments for your personal situation as you see fit.

The layers I am talking about are different lines of defenses that protect you from ever having to touch your investments - that way, they can grow undisturbed. One of the WORST things you can do to your investments is interrupt the process of compounding returns - so let’s talk about how we build layers to prevent that.


Layer 1: Income


Ah yes - a young professional’s biggest “asset” - your ability to earn. This is likely your strongest layer, both the amount and the stability. Therein lies the two items you should be paying attention to with this layer:


Amount: how much are you making? I think we should all stop focusing on making as much as possible - everybody is in a different profession and we all have different goals. But, you should focus on finding the target income that helps you accomplish your goals, and continue to build the subsequent layers in this post from there.


Stability: is your income stable, or at risk? There are many things fighting for your dollars, like disability, job layoffs, recessions, etc. You can fortify the stability of your income by making yourself irreplaceable in your position, or very appealing to other companies if your current position is lost. And by using insurance to protect you from unforeseen circumstances.


The last thing I’ll say about this is if you’re in a partnership, make sure you work as a team. Consider both stability and size of income for you and your spouse / partner, and determine how each of your incomes complement the other. Dual income couples typically have a stronger first layer due to it being less likely to lose both sources of income at the same time.


How are you growing the size and stability of your income?


Layer 2: Emergency Fund


Call an emergency fund whatever you want, but ultimately, this is safe money that is always accessible to you and will not fluctuate in value.


The best emergency fund is parked in a savings account, preferably high yield (although there is barely such a thing in today’s environment).


But won’t I actually be LOSING money due to inflation? Yes.


So I should invest it, or get some type of return - right? No.


The purpose of this account is not for growth. It is for protection. It costs money (in the form of loss of purchasing power due to inflation) to have protected money. Do not listen to the bad advice that your safe investments need to be achieving a return. The cost of lost purchasing power is well worth it when you consider the alternative of having to sell investment assets at inopportune times. Selling investments because you don’t have an emergency fund could cause you to recognize losses in a market downturn and/or cut off the compounding investment growth of these assets. They are out of the market and lose the ability to recover - locking in an investment loss until you find the money to invest again.


Each dollar has a job - the dollar in your emergency fund’s job is to be available to you at any time without the risk of losing the principal amount.


The best offense is a good defense when it comes to investing.


Layer 3: Access to Debt


Maybe this is controversial? But I’m a big fan of debt when it comes to purchasing something you need. I’m not a fan of debt when it comes to buying something you don’t need.


Let me point this out - I’m not talking about your credit card. If you’re at the point where you need to be using a credit card to fund a purchase, you should really be reconsidering.


For this paragraph, I am talking about using low interest debt to bridge a gap between making a purchase and covering that purchase.


For example - maybe you are buying and selling a house at the same time. You don’t know exactly when your sale will close or if you’ll have the cash in hand to buy the new house. But, you know that the cash from the sale will cover the down payment and closing costs - it's just a timing issue.


You could either sell some of your investments or take a distribution from a retirement account to bridge this gap (recognizing taxable income as well as pausing investment growth in the meantime), or if you have access to debt you can take a bridge loan.


Some banks allow you to borrow on what is called margin - this is using your investments as collateral to borrow some money for a brief period. This could be a great option and allow your investments to continue growing, purchase the new home, and pay off the margin loan in the couple months after the sale closes. The cost of interest I would suspect is much less than giving up investment gains and any taxes or penalties from accessing the money.


Some other examples of “good” debt I may recommend for a bridge loan include:

  1. A home equity line of credit

  2. A Care Credit for medical costs

  3. Margin Loan as mentioned above

  4. MAYBE a 0% credit card introductory period. You better be certain it will be paid off before that 0% goes away

I’ll point out that a 401(k) loan is not great for this - although you pay the interest to yourself, you’re taking money out of the account and thus losing the potential investment growth in that account.


This third layer is tricky and you may be thinking “sounds dangerous” - and I agree. But so is taking distributions from investments and retirement accounts, and if you’re in a bind this could be a great short-term fix to avoid that. Again - this shouldn’t be reckless but a well thought out option of what is available to you, and how you can pay it off ASAP.


Layer 4: After-Tax Investments


I would consider this option before layer 3 in certain situations, but generally these are your “nonqualified” investments. Also known as a standard investment account, with no special provisions like retirement or Health Savings Accounts.


The benefit of these accounts is no penalties or lock up periods to access your money. The tradeoff is giving up some tax advantages that you could receive in a retirement account or HSA account, but it is a great way to keep some long-term money growing in the stock market while maintaining access to the money.


The downside of tapping this money is, again, selling at a loss or cutting off the compounding growth - as I said from the start, time is most important. That is why there are quite a few layers before having to go this route.


But, once we start doing any kind of long-term investing, your focus should be on not touching this money. If the money wasn’t meant to be long-term, then there is a good chance that it should not have been invested. It should have been used to create previous layers so that you are better preparing yourself for this layer.


When it comes to investing, in the short-term anything can happen. In the long term, magic can happen. You just have to allow these investments the time to achieve that magic.


Layer 5: Qualified Investments


This is the nucleus of your investment strategy - don’t let anybody, or anything touch this. These accounts are generally your retirement accounts (IRAs, 401(k)s, etc.) and your Health Savings Account.


Specifically with your retirement accounts, you made an agreement with the IRS: I won’t touch this money until I turn 60. I promise to follow through on this, and in return you promise to give me some sweet tax benefits.


Beyond the taxes, the benefits of these accounts is the long-term nature of them. They can grow indefinitely. Or can they?


I’ve seen too many distributions for retirement - you get whacked with income taxes as well as a 10% penalty. Not only this, but sometimes this can push up your tax liability and impact other income items reported your tax return, having a ripple effect. I’ve seen it happen and it is not pretty.


You made an agreement - and therefore you should be very confident that you can hold up your end of the agreement before entering into the account. You need to be able to give these accounts the time they need to bring you the benefits they promised.


The stakes are higher here due to taxes and penalties - the tax “advantages” are quickly reversed to tax disadvantages when you start mistreating these accounts, or using them too soon.


Final Thoughts


In my opinion, you have to earn the right to invest - and the way to do this is by making sure your future investments are protected. Make sure you are creating a plan and working towards their protection: otherwise those investments will likely end up doing you more harm than good.


Don’t get me wrong - I am very much in favor of working on all of these layers simultaneously. But, you must make sure that there is an emphasis on the first two layers. Without them, you can run into a lot of trouble, headaches and expenses.


Instead of thinking about the perfect investments that will make you a lot of money - think about how you can create more time to allow your investments to grow untouched.