The role of room for error

If you ask most people with little investing experience how much they want to make, the answer is usually something like "As much as possible". Likewise, if you ask about their target date, they will say "As soon as possible!" Yes, sure, we all want to be wealthy today, not tomorrow. That's not how things work though.

Let me be the first to say I am not the biggest fan of "life plans". When you go to see the average financial planner, they will set up some parameters, using your current age, income, expected retirement date, etc., and say "Okay.. the market average returns are X%, and you have Y years. You will want to have Z% of your salary to spend in retirement, of which W% should be covered by the national pension, so there is a gap of G JPY. In order to get that, you need to start saving C JPY per month now".

That's great and all, but what if you don't really want to retire? What if the future market returns are different from the past? What if the returns do average what is expected, but your retirement just happens to start during a major recession?

Don't get me wrong - I think you should save and invest - I just don't think you should have hard targets and dates in mind so much as a mentality to curb your lifestyle, create a margin to save and invest, and build your wealth. How and when you use it should remain flexible.

The main issue I see is that once people realize and accept that investing in stock market index funds really is the most reproducible path to wealth in the long term, they say "Well, in that case, let me just invest 100% in stocks!"

I'm not saying that this is never the right answer - in fact, that's basically what I do - but it's not for everyone. In fact, it's probably not for most people. I know it's okay for me because I have seen the market drop more than 30% multiple times and I haven't lost any sleep over it. I have an emergency fund and s stable income from working, and realized both mathematically and emotionally that the stock market can and will flail around. I know that money is in the bouncy castle, and I am okay with that.

Yet I have spoken with many people who just can't help themselves. They check their 401k balance every week, and feel sick when it goes down 5%, much less 30%. They start imagining eating porridge every day during retirement, not being able to send their kids to college, etc. Then, of course, they think it was a scam all along and want to sell at the worst possible time. They thought they had an appetite for risk and wanted to go all in to maximize returns, but ended up selling at the bottom of the market - which is literally the worst thing to do.

Those people made the mistake of not factoring in their emotions. If your emotions are going to make you want to sell at the bottom of the market, then the best strategy for you is not to invest 100% in stocks. There is no shame in holding more cash. For example, you might keep a portfolio of 45% cash, 5% gold, and 50% stocks. Will it grow more slowly than pure stocks? Without a doubt - but it will also grow faster over the long run than getting out of the stock market at the worst possible time.

Even for the most confident of us, leaving room for error is important. There is no guarantee that the stock market will perform the same in the future as it has in the past. I truly believe that anyone who says "It's different this time!" is flat out wrong - but hey, maybe it really is different this time.

Even though robots didn't take our jobs, and the internet didn't do away with classrooms, even though 5G didn't revolutionize the world... maybe AI, cryptocurrency, or some as-of-yet unseen force or technology will emerge and change everything forever. I doubt it, but you never know. If you couldn't handle that happening, then maybe keep more cash, and save more in general.

I don't save what I would need for retirement, I save a lot more than that. Why? Well, money in the bank is flexibility. If I need to stop working due to an injury, or pay hospital bills for a sick family member, or ... whatever. Projections on a spreadsheet are nice and logical, but the world is messy and unpredictable. You never know what is going to happen tomorrow, but you can control today.

In my case, I am a risk taker in that I invest almost all my money into stocks, but I am also risk adverse in that I save a much larger percentage of my income than I have to. I would advise people to think long and hard about not only whether they have enough of a cash position, but also about whether they can shave a little bit off of their living expenses to save more.

Saving need not have a specific purpose. Maybe my attitude will change and I'll decide to retire early. Maybe I will lose my sight and be unable to work. Maybe a huge earthquake will topple my house. Maybe Russia will attach Japan next week. Nobody knows what might happen. For example, I knew about the 2008 Lehman shock about a year before it actually happened - but I didn't know the exact timing when everything would come tumbling down, how bad it would be, or what other things would be affected.

I know now that inflation has resumed in Japan after decades of deflation many people will be thinking "Save more?! Are you crazy?" - but I have known a lot of people who claimed they couldn't save while spending money they clearly didn't have to.

I used to be in charge of enrollment at the DC fund where I worked, and I recall drinking with a coworker after work one day. He asked me "Do people really invest in that thing?" "Sure", I told him, "but not everyone". He insisted that he couldn't spare even 5,000 yen per month, while he proceed to spend about that much at the bar with me. I suggested a relatively painless option "Look, when you get your nest raise, just start contributing the minimum of 3,000 yen per month, and then every time you get a raise after that, put half of the salary increase towards the fund - your take home pay will still increase, just not by as much". Our company had a matching policy, so if he had put the 3,000 yen into the DC, the DC balance would have increased by 6,000 yen each month, while his take home pay would have decreased by something like 2,000 yen. Even if he just held it as cash in his DC, he would have gained over 4,000 yen per month. I doubt he would have even noticed that 2,000 yen loss in his take home pay, but he would have been accumulating he would have been saving 72,000 yen per year. Even just keeping that in cash, he would have accumulated 720,000 yen in 10 years even if he never increased the contribution. That's not a huge amount, but it's a whole lot better than nothing in return for a barely noticeable reduced increase in take home pay.

A more recent anecdote involves a person I know who has a decent salary but basically every bit of their income is promised to something. They have a large house, basically the maximum they could afford with their dual income, they have multiple children, and two cars. They confided in me "Boy, I sure hope my bonus ends up being at least as large as last year's bonus!" I mean, we all hope that, but i still asked "Why?" Their answer was "Well because I took the kids to Disney Land and we stayed at the hotel there... it cost a lot of money" - so not only are they spending future income now by buying houses and cars on loan, but they are spending their bonus money on vacations as well. I explained my strategy as follows "Well, I assume I will get no bonus. That way, if it turns out to be zero this year, I am not going to struggle. If it turns out to be 1 man, I am happy is wasn't zero. If it turns out to be the same as last year, then I am pleasantly surprised". They looked at me like I was a crazy person, so I said "Okay, for budgeting purposes I assume it will be 60% of last year's bonus - but I also assume that 90% of that will go towards savings". Realistically, the risk they were running was that if the economy is bad, then company performance may be bad, and then the bonus will be smaller than expected. Since the money has already been spent, they will have for put things like groceries on the credit card in order to make their mortgage and car loan payments. While I am aware that some large traditional Japanese companies have bonus payments that are more or less predetermined, the fact that Japanese credit cards have a "bonus" repayment option is to me an atrocity. Sometimes even these large companies run into financial difficulties and need to cut bonus amounts. Spending your salary (or bonus) before you get it is the opposite of having a margin of error. It's not my place to tell other people how they should handle their finances, but I I can speak to what I would do in a similar situation, so said "If I was planning to take the family to Disney Land nest year, I would start saving now, and build my own 'bonus'. If your real bonus comes, you can use it for following year's trip".

What's my point? You can probably suffer a lot more loss in short term income than you think, and savings add up quickly. With DC, iDeco, and NISA, Japan now has the tools to really help you save and invest in tax smart ways. You just need to be willing to take a small hit now to build a safety net. If you can't bear a loss of 5,000 yen per month then how on earth are you going to handle a sudden job loss or other disaster? We all need to expect the unexpected and build a margin for error into our life.