MY JOURNEY TO FINANCIAL FREEDOM
Those who have read my posts over the years know that I started planning and striving for financial freedom shortly after I graduated from the university. It was a 15-year journey that required planning, work, discipline, and learning, and in 2007 I decided to quit my day job. I’ve written some posts focused on achieving financial independence, but this post is the story about how I lost my financial freedom nine years after I achieved it. Living through this experience was unpleasant, to say the least, and I’ve considered just keeping this story to myself. But there are some lessons to be learned so I’m sharing my experience here with the hope that others can learn from my mistakes and avoid painful financial losses.
KEEPING FINANCIAL FREEDOM
There’s a saying: “You only need to get rich once.” It essentially means that once you’ve attained financial freedom, you want to be careful not to fall back out of financial independence. It would be a shame if someone, after spending several decades working to build up enough wealth to enjoy financial independence, were to fall back into having to work for financial survival; the older one is the worse this would be. Many wealthy people are quite conservative with their investments, and they peal off enough of their assets into conservative or diversified asset classes to nearly eliminate the possibility of a disastrous financial collapse.
ADJUSTING TO FINANCIAL INDEPENDENCE
In May 2007 at age 38, I left behind the security of a biweekly paycheck which had more than covered my living expenses. If I had thought of this decision as a permanent retirement, then I wouldn’t have had the courage to stop working; it would have seemed too risky; my financial independence was going to be conditional on maintaining a certain amount in assets (i.e. minimum net worth). This was in large part because I didn’t want to squander 15 years of building up assets to put myself in a position of having to rebuild over many years. Thus, knowing that I could go back to a job, if necessary, made the decision much easier. In addition, there were several other psychological aspects to not working a regular day job; it would require a new mindset.
First, I didn’t have a plan for what I would do next, and, as a goal-oriented person, I was accustomed to having the next thing for which to strive. I thought about starting a business but had nothing concrete and nothing about which I was truly passionate.
Second, I felt some discomfort about drawing down funds from my nest egg to fund my living expenses. I had always lived below my means and was thus accumulating wealth each year. The idea of withdrawing from my investments wasn’t appealing and actually making the transfers out of my brokerage accounts felt foreign and somehow “wrong”. However, if, on average, my investments could grow faster than my spending then I’d feel much better.
Third, I perceived some pressures from family and society that I should be working. I should have a job, right? At the time, I was only 38, single, and using an online dating site. Normally, I don’t so much care what other people think, but what would I list for my job on my online dating profile? Retired? Unemployed? I considered my situation so unusual for my age that nothing on the drop-down menu could give an accurate representation. And perhaps, I didn’t want to give an accurate representation as I am still finding today at age 52 that many people can’t comprehend how it’s possible to not have to work.
It took me a couple of years to completely adjust to and be ok with the things that I mentioned above, and my financial independence continued happily for 7 1/2 years during which I maintained a lifestyle similar to the one that I enjoyed while I was still working. The lifestyle was completely funded by periodically selling some stock shares; despite this, the value of the portfolio was not materially different from when I left the workforce 7 1/2 years earlier.
ADOPTING SAUL’S METHODS
One year earlier (6 1/2 years into my retirement), I found Saul’s Investing Discussions which Saul had just started a few days earlier. This was in January 2014. After a few months of observing Saul, I began to concentrate my portfolio from about 65 holdings to around 20. By the end of 2014, my portfolio contained 19 holdings and was down about 9.6% from the beginning of the year. That year was a tough one; even Saul was down 9.8% so I was not fazed by this result. In fact, my confidence in Saul’s method grew despite the down year. I bought in to the method because it made sense and because Saul’s 22-year history showed that he had done it successfully. Furthermore, observing Saul’s decisions, which he explained as he made them, and seeing his results gave me a high confidence that Saul had not fabricated his returns.
So I started 2015 with a willingness to be more aggressive with my investing, and that aggressive strategy was partially rooted in leverage through the sale of short puts to purchase call options. The stocks in my portfolio soared during the first half of 2015, and, by the first week of August, my portfolio had doubled (+100.5% YTD) since the start of the 2015! Well, that ended up being a peak. At this point, I had about doubled my net worth since I left my job in 2007. Life was good and I felt as if I had figured out how to beat the market.
ICARUS FLIES TOO HIGH
The leverage that helped quickly propel the portfolio to new heights worked against me just as quickly. As the stocks in the portfolio first began to fall in August 2015, I created multiyear projections in spreadsheets which reinforced my belief/conviction that my stocks were undervalued. My increased conviction, combined with the extraordinary gains in the first half of 2015, led me to increase my leverage by selling additional short puts to fund the purchase of more long calls (LEAPS). As the stocks dropped further, the shares became increasingly undervalued so I continued to sell more puts and buy more calls.
So how much leverage did my portfolio have? By the end of October 2015, I had sold puts that had an assignment value (i.e. the cost to purchase the shares upon assignment) equivalent to 109% of my entire portfolio’s value. In addition, I continued to use the proceeds from selling of the puts to buy more call options. By the end of November 2015, I had received a couple of letters from a vice-president of my brokerage company; these letters warned me that my account had sustained some big losses and I should consider being more careful with respect to the amount of leverage I was using. I ignored these warnings, and my portfolio was incredibly vulnerable, much more than I realized, to declines in the stocks that I owned. Icarus was still not fully paying attention to the danger.
THE AMPLIFIED BIG DROP
By the end of 2015, the portfolio that was once +100.5% YTD was now down more than 20% compared to the start of 2015. By comparison, Saul reported a 2015 return of +16%. Clearly, the leverage that I used had backfired, but the -20% return was not catastrophic. To fully comprehend what was about to happen next, we need to list the stocks on which I had sold puts; they were SWKS, SKX, AMBA, PRAA, INFN, and LGIH (listed in order of most leveraged to least leveraged). In addition, I had bought call options on most of these names.
| 2015 Start | 2015 High | % Gain to High | 15Jan 2016 | Drop from 2015 High | |
|---|---|---|---|---|---|
| SWKS | $72.71 | $110.92 | 53% | $60.67 | 45% |
| SKX | $18.42 | $53.43 | 190% | $26.99 | 49% |
| AMBA | $50.72 | $126.70 | 150% | $39.55 | 69% |
| PRAA | $57.93 | $64.46 | 11% | $28.98 | 55% |
| INFN | $14.72 | $24.72 | 68% | $14.80 | 40% |
| LGIH | $14.92 | $35.54 | 138% | $21.74 | 39% |
By mid-January 2016, the main stocks in my portfolio and those that were the most leveraged had sold off between 39% and 69% from their highs (see table)! I had not previously considered that such a steep decline in my stocks was a possibility; these were already so “undervalued”, right? Well, I paid a very heavy financial price for not considering the downside and failing to prudently manage my risk. As the value of the stocks and call options that I owned deteriorated, the margin utilized by the short puts pushed the limit of what my brokerage firm allowed. The margin calls began in the second half of January, and I was forced to sell some long positions in order to close some of my short put positions. Being forced to sell at the bottom really sucks. I was reluctant to sell too many shares, and I kept all of the call options that I had bought. I also kept a fair number of the short puts as I hoped that my stocks would rebound leaving my portfolio with only minimal damage.
In the month of January 2016, my portfolio had fallen an additional 31%, yet I still held on to hope that my portfolio could still recover. I continued to hold leverage, and my portfolio held steady for the next three months as I waited for the May/June earnings results for my portfolio companies to lift my stocks back up.
The earnings results were a disappointment, and, by the end of June 2016, the portfolio dropped another 16% from the end of January. The decline from the Summer 2015 peak was about 77%, and the decline from the start of 2015 was about 54% (and remember that 2014 was also a down year: -9.6%). This was a crushing blow on several levels. First, I realized that my stocks would likely not recover in time for there to be any value in the call options that were set to expire in January 2017 (and financed by selling puts at the peak). Second, my remaining assets could no longer return enough to fund my living expenses, and my math showed that my assets would continue to dwindle and eventually run out a few decades before my death; my situation was not sustainable. I realized that my financial freedom was lost, and I needed to get a job which could prove difficult since I had been out of the workforce for nine years. I capitulated and closed out the majority of the short puts locking in the losses at the bottom; it was especially painful since I had sold the puts near the peak. Third, I was demoralized because I had squandered my carefully planned 15-year journey to financial freedom. I needed to step away from investing altogether. I don’t think I made any trades, researched any stocks, or even looked at my accounts for six months.
LESSONS LEARNED
I hope that this experience can provide some lessons to other investors so that they may avoid the painful financial experience that I went through. Let’s go through some of the mistakes that I made.
Avoid excessive leverage: Leverage cuts both ways. It amplifies gains as well as losses. Clearly, the leverage that I took on was excessive and very risky. I think it’s a good idea to set limits and stick to them. This may be easier said than done as it can be tempting to continue to add risk as one’s favorite stocks decline. I can tell you that getting a margin call is very stressful, and it can set you back years or worse. I consider myself fortunate that I didn’t get completely wiped out. Some investors use no leverage at all, and that may be the way to go for most.
Don’t leverage at the peak: Growth stocks can have big runs, but most of them will also have big, sometimes massive, drops. I’ve written a post about the big drops. Since 2018, my portfolio has had 4 drops of 35% or more. It is much safer, but not risk-free, to add leverage after a big drop. In 2015, I leveraged near a peak, and it was a disaster. In 2021, I leveraged near the bottom, and it did wonders for my returns on the rebound. I think it’s important to remember that what may seem like a bottom may not be one. No one can be sure if the stocks will keep falling and for how long. I don’t completely ignore the fear when I’m feeling greedy.
Pay attention to the downside: Look at the reward but also look at the risk. I find it helpful to calculate and quantify the maximum downside. When selling puts, I multiply the share equivalent by the strike price to get the maximum loss (i.e. if the underlying stock goes to zero); I then divide this (considering all the short puts in my accounts) by my total portfolio value. In 2015, this ratio was 109%! That was at the end of October. It’s important to remember that the ratio goes up (up is bad) if the stocks drop, driving down the value of the portfolio (i.e. the numerator stays the same while the denominator declines). In May 2021, I allowed the ratio to get to about 37%; I now consider this very aggressive but it was only about 1/3 of the proportional leverage that I had in October 2015. A typical leverage (using short puts) amount for me these days is 15%. My portfolio is currently (9Aug 2021) near a peak, and I currently have zero short puts; I now tend to cut back my short put leverage at portfolio peaks. Here’s a post on “prudently” using leverage. Please note, though, that for some investors prudence is using no leverage at all.
When stocks begin to fall, be particularly careful: Some investors may have a tendency to add to a stock when they see it fall. The thinking here can be that if it was worth buying at $100/share, it’s an even better deal at $80/share. Time to double down, right? Time to back up the truck? I’ve heard investors say and do this. Sometimes it can be a good idea to add, but, more often than not, there’s something wrong. The stocks may well have much further to fall. This is the time to question assumptions and not immediately get overzealous. In August 2015, when my stocks started dropping, I built multiyear growth forecasts for my portfolio companies. I was clearly biased when I did this, and my models showed how “undervalued” my stocks were. I didn’t consider that the most recent revenue growth rates might not project forward. Furthermore, some of my companies were cyclical businesses with a customer concentration risk. My models reinforced my previous beliefs and led to overconfidence on my part.
Stay within your comfort zone: When an investor has trouble sleeping, it’s a sure sign that he’s taken on too much risk for his own tolerance. This feeling is likely caused by a fear of financial loss linked to all the underlying needs and wants that could be lost.
HOW THE STORY ENDS
Well, the book on my investing “career” isn’t fully written. My disaster in 2016 is a dark chapter in that book. After my capitulation and break from investing that began in June 2016, I eventually landed a full-time job. The job was interesting and fun. It also stopped the cashflow burn so my investments could recover without periodic cash withdrawals. When I started back at work, I thought that it would take many, many years for my portfolio to recover to the previous peak. To fully recover from a 77% drop, requires more than a quadruple or two doublings. At annual return of 10%, it would take more than 14 years! When I returned to investing in the first quarter of 2017, I assumed that I might need to work for 10 years before retiring again.
Some people I know were shocked that I would go back to using stock options. After all, I almost wiped myself out completely. I continued to use options and invest in what I thought were the best companies. Amazingly, my portfolio regained the previous 2015 peak by the middle of 2018, in less than two years. Sometimes I still can’t believe how this was even possible. Using options definitely helped, but I attribute most of the success to investing in the best growth stocks that I could find. Crowdsourcing the research via Saul’s Investing Discussions board was essential as well. Since the end 2016 through the writing of this post (9Aug 2021), my portfolio has returned a CAGR of 87.9% (a cumulative gain of 1730%) and now sits multiples above the 2015 peak when I had a 100.5% YTD gain in that year.
While my job was interesting and fun, I retired once again in early 2019. With the lessons of my financial disaster, I don’t think that I’ll lose my financial freedom a second time. Hopefully, my experience and lessons will be helpful to other investors.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.