Protecting your downsides is the way to maximizing your upsides
August 13, 2020
Warren Buffett is one of the most successful investors of our time. Out of the many wisdom nuggets Buffett has shared, the two rules of investing are one of the long-time principles for many investors.
Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1
Most people know the saying, but very few do it. I’m far from a decent investor by any means, but I became increasingly obsessed with the rules as I find the same patterns in not just investing but also day-to-day money management.
When it comes to managing my finances, an unpopular notion I opt in is to protect my downsides. In many cases, I believe that protecting downsides are far more crucial than maximizing growth and returns.
In the article, The Long Run is Just a Collection of Short Runs, Morgan Housel stated that in order to invest in the long run, you need to stay in the market as long as possible. To stay in the market long enough, managing short-term risks is essential so you need not withdraw your investment for emergencies.
Putting the same concept into a wider context, the same works in running a business, growing a career, and having a life in general. To accomplish long-term growth, we need a solid foundation that protects us from unforeseen events, which at the same time, allows us to take more risks. In other words, having a downside protection gives you the advantage of taking more calculated risks in the long run.
Just like there are a thousand ways to skin a cat (sorry, kitty), there are many ways to manage risks. The first step is to make sure we’re providing value in some way or another (working at a job or running a business) that people will pay for. And the value needs to cover our basic daily needs.
After that, I’d suggest having money set aside, which is what I have an opinion about.Most personal finance publications and gurus talk about setting money aside. However, the idea is vague and often hard to put into practice. We don’t treat money rationally — that makes managing it hard enough. Let alone the vague idea of “saving a portion of your income aside” — that doesn’t help at all.
So I’m here to share how I do it and most importantly, why I do it the way I do it. In my personal case, I split “setting money aside” into three parts:
The first step is to save up an emergency fund. It’s a common practice that you would know if you have ever read any personal finance blogs. The objective is to cover emergencies that might happen so you don’t go into debt.It’s absolutely okay to start small from saving even just $1,000 for emergencies. The goal is to slowly add up your emergency fund. There are articles and videos explaining this in length, so let’s move on.
Next, create what YNAB calls the true expenses. YNAB stands for You Need A Budget and it’s a budgeting tool I use and love. So what do true expenses even mean? Let me explain.When we build our budget, most people account for everything they need to spend every month such as rental, transportation, foods, etc. The reality is that there are other things we spend money on — we just don’t pay for them every month. Most people overlook or ignore these true expenses because of that. Expenses like tax payment, birthday gifts and celebration, new gadgets, and more.
Here’s an example of my true expenses on YNAB:
Allocating cash for these unavoidable expenses is essential to keeping your finances healthy. When the bills are due, you have the money ready. As time goes on, the true expenses budget will eventually replace the commonly known emergency fund when you allocate money for expenses like medical bills, car repair, speeding tickets — all the unfortunate events that you know will happen but just not sure when.
Bill Gates had a unique approach during his earlier days as the CEO of Microsoft when managing the finances. He said:
I came up with this incredibly conservative approach that I wanted to have enough money in the bank to pay a year’s worth of payroll even if we didn’t get any payments coming in. I’ve been almost true to that the whole time.
His conservative view on money allowed Microsoft to focus on the next 10 years instead of worrying about whether they had enough money for the next quarter. And we can apply the same approach to our personal life.
Instead of seeing your money as an individual's finances, treat it like you’re running a company and set up the runway fund. It’s a concept used in businesses, especially startups to tell how long a startup can last without money coming in.
In other words, your runway fund is basically the money you prepare for times when you lose your income.
Start by adding up all your monthly expenses, including the true expenses. Next, sum up the cash you have and divide it by the monthly expenses number you just got. You should get a number that represents the number of months you can survive with no income.
Another way to get this number is by using Toolkit for YNAB (if you’re using YNAB). It’s a Chrome extension that lets you customize your YNAB budget. One of the features it has is calculating the Days of Buffering.
The calculation will show how long your money would last if you would never earn another dollar based on the average spending of your selected period (one month, three months, six months, or a year). Here’s my days of buffering with one-year spending history lookup:
For simplicity sake, I recommend you use a round number for this. For example if John has $5,000 in cash as his runway and his monthly expense is $2,500, he has a 2-month worth of runway.
Some venture capitalists recommend having a two-year worth of runway fund but it really depends on you. Personally, I think a one-year worth of runway fund is enough given that you have good money habits. Right now, I have a six-month runway and my goal is to hit 12 months gradually while channelling some extra resources to invest in the market.
I didn’t go full swing to save up for a 12-month runway because I’m willing and able to downgrade my lifestyle if anything happens to me. Part of it is because most of my current expenses are flexible — for example, I’m renting instead of buying a house. I’ll refocus on building my runway fund again when these expenses become more of a financial obligation.
It’s way harder to build a runway fund compared to both the emergency fund (smaller in amount) and true expenses (stackable from month-to-month). A sizable runway fund usually takes longer and more effort, but the security and stability you get from it is incredibly rewarding.
It’s easy to see that I’m super conservative and risk-averse with money. In fact, I’d say that having all these strategies in place is just the beginning.
The ultimate security is to have multiple streams of income, and the way to accomplish that is to create value (just like what we mentioned earlier) and scale it. But before you do that, you really need to have a foundation in place and hence, we’re back to protecting the downsides.
Just like people busy filling up a leaking bucket, maximizing growth without stability is taking one step forward two steps back. You might not need to do everything I laid out above, but it’s a good reference to measure how strong your foundation is if you’re considering taking more risks.
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