IN THE FIELD of epidemiology, researchers have long used the term “tipping point” to describe how epidemics occur. At first, an ordinary disease moves slowly, not gaining much attention. But then, seemingly overnight, it snowballs into something far larger.
Within the world of public health, this concept is well understood. But about 20 years ago, the author Malcolm Gladwell took a closer look and pointed out that tipping points can be found in a whole host of other situations far beyond epidemiology.
That includes finance. Consider Lehman Brothers. In June 2007, it reported a profit of more than $1 billion, a company record. And yet, just 15 months later, it was bankrupt and sold for scrap. Despite its sterling reputation, established over 158 years, the firm unraveled virtually overnight.
With the benefit of hindsight, there had been some early warning signs. In its writeup about Lehman’s record profit in mid-2007, The New York Times mentioned a loss related to subprime mortgages—but it wasn’t until the eighth paragraph of the story. Even then, media reports quoted Lehman executives describing the issue as “small” and “contained.” There was no indication that this “small” issue would bring down the entire company just a year later.
Why spend time talking about Lehman? While the details may not be generally applicable, it’s an example—and not an isolated one—of a financial tipping point. It’s worth studying for the same reason we study the 1929 stock market crash and the Great Depression: These were unusual events, but they remind us to take steps today to avoid financial stress tomorrow. To that end, here are five ideas to help you fortify your own finances for the long term:
1. Gather the facts. In the past, I have talked about the “Big Four”—your income, expenses, assets and liabilities. If you know these four numbers, you’ll have a solid grasp of your financial situation and you can answer most money questions. If you don’t have these numbers readily available—and don’t have time to gather them—consider hiring a bookkeeper to pull together the information for you.
2. Once you know the big four, ask yourself two questions. Am I okay now? And will I be able to handle upcoming financial obligations, such as a home purchase, college tuition or retirement? To find out, make a simple set of financial projections. It can be eye-opening. In my experience, this kind of exercise often ends up leaving folks sleeping better, not worse.
3. If you’re employing one of the retirement rules of thumb, such as the 4% rule or the 80% income replacement rule, be sure they apply to your situation. These rules can sometimes be too simplistic, especially when they’re age-based. Should Bill Gates really follow the same financial roadmap as every other 62-year-old? I think not.
4. If you want to guarantee you’ll never run out of money in retirement, there is one way to do it. Each year, simply limit your spending to a fixed portion of your portfolio’s value as of the end of the prior year. For example, if you had $1 million at the end of last year and your spending rule was 5%, you would withdraw $50,000 this year and no more.
This is the way schools and colleges operate. As long as they stick to their spending rules, it serves them extremely well. But in exchange for this near guarantee, there’s a catch: If your portfolio declines in value in any given year, you have to be willing to take a pay cut the following year.
5. Recognize that there are escape valves in our financial system if things aren’t panning out. In Lehman’s case, their financial mess was beyond human comprehension. But when ordinary folks run into a simple cash crunch, there are lots of solutions.
If you have federal student loans, you could explore an income-driven payment plan, forbearance or refinancing. If tuition for your children is crushing your budget, call the bursar’s office. Colleges are businesses and they will negotiate—even if they say they won’t. If you have bills that end up with a debt collection agency, you may be able to settle the obligation for less than the full amount owed. Even the IRS will be flexible: It has programs that allow you to pay both income and estate taxes over time.
Adam M. Grossman’s previous blogs include All of the Above, Not My Thing and Nothing to Chance. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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