Asset Allocation
"Only buy something you'd be happy to hold if the market shut down for 10 years." - Warren Buffett
Asset allocation is all about choosing where to invest and making sure your investments align with your values and provide you with the cash flow you need to reach your financial goals. Investopedia.com defines asset allocation as "an investment strategy that aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance, and investment horizon."
The most common asset classes of investing are:
- Cash/liquid assets - savings accounts or money market accounts
- Stocks - Large cap, small cap, growth, value, international, etc.
- Bonds - Corporate, government (federal/local)
- Property/Real Estate
- Commodities/Other
The aspects you want to consider regarding asset allocation are:
- Time frame - short-term and long-term
- Goals - cash flow expectation
- Risk tolerance - unique to each individual
While the basic "don't put all your eggs in one basket" analogy works with asset allocation you want to be cautious of a few things:
- High fees - There is absolutely no need to pay money managers to "manage" your investments (see Fidelity study if more proof is needed)
- Mutual Funds - While the appeal with this option is that they provide diversification, that diversification comes at a significant cost as the funds are actively managed and attach high fees. You might not know there are fees with this option as you never have to pay a bill, but the fees are taken out of your returns. Keep in mind though some 401K plans only offer mutual funds as options and if that is the situation you face you can:
- Talk to HR about the possibility of including option for low-cost Vanguard index fund
- Allocate funds to this option up to the company match (what you get in matching funds should exceed amount spent on fees) and look into opening a separate brokerage investment account for investing additional funds into low-cost index funds.
- ETF - This stands for Exchange Traded Fund which generally do not have unnecessary fees like mutual funds. Unlike mutual funds, ETFs are passively managed.
- Bonds - known as a safe investment, with lower risk comes lower return and depending on the current market and inflation rates you could end up losing purchasing power and be worse off than holding your funds in money market accounts.
- Individual Stocks - We're big fans of dividend growth value investing and choose to partner with a number of dividend paying businesses (stocks). We do this because we are passionate about business and finance and devote a large chunk of time to learning and keeping up on the operations and management of the businesses we hold. This is NOT for everyone though obviously and is riskier due to reduced diversification.
Having a mix of individual stocks and low-cost index funds works for us, but as Warren Buffet advises
"Put 10% of the cash in a short-term government bonds and 90% in a very low-cost S&P 500 index fund."
Depending on the current economic situation and inflation rates savings or money market accounts may be better than bonds, but the main point of Buffett's message is sound - Be safe with a portion, and invest the rest! Make your money work for you!
We utilize the following strategy:
Short-term allocation:
- Cash/liquid - Emergency Fund - Have a minimum of 3-6 months of expenses saved in a money market account. This serves as a buffer and should be increased depending on your risk tolerance and/or foreseeable life events such as if you know you are going to have to buy a car within the year, saving for a down payment, having a kid, big medical expense, etc. you'll want to increase the buffer.
Long-term allocation:
- Investments - Once your short-term buffer is met now comes the long-term investing. This is where you want to think about cash flow return and your risk profile. Some may say that stock market investing is risky, but over the long-term it is one of the safest investment options available because you aren't losing value/purchasing power with inflation. Instead of investing in the market you are really investing in a portfolio of businesses that you believe are well positioned to perform well for the long-term. Diversification is key as it is better to be owed $1 by 100 people than $100 by 1 person.
- We utilize Vanguard Index Funds as a safe diversified low-cost index fund. The fees are very low and the dividends from the individual companies are aggregated and paid out proportionally as if you were holding the individual businesses. We hold a collection of all three of the Vanguard funds which encompasses a portfolio of businesses in the following markets:
- VT - World stock market
- VTI - United States stock market
- VOO - S&P 500
- We utilize Vanguard Index Funds as a safe diversified low-cost index fund. The fees are very low and the dividends from the individual companies are aggregated and paid out proportionally as if you were holding the individual businesses. We hold a collection of all three of the Vanguard funds which encompasses a portfolio of businesses in the following markets:
The other asset classes we haven't touched on are real estate and commodities. We've dabbled a bit in both and here are our thoughts on each:
- Real Estate: Owning an asset such as a house and renting it out can generate high cash flows that are appealing, but require a good chunk of cash up front for the purchase or mortgage (which we don't recommend having on a rental property). Keep in mind there is A LOT of work that goes into property management both with the maintenance requirements and management of tenants. Sure you can pay a property manager to do the work for you, but after you factor in their fees, maintenance expenses, property taxes, taxes on the rental income, mortgage (if applicable), etc. all those add up and significantly cut into the return. The returns may be still higher than what you would find in the stock market, but it's hard to truly compare the two as stock market investing is purely passive income and rental income requires a lot more time. As Eli likes to remind me with regards to his ownership of Wells Fargo (WFC) shares, WFC is never going to call him in the middle of the night to have him go fix the leaking toilet or hot water heater. With rental units sadly those calls are a reality.
- Commodities: We DO NOT like commodity investing. The hype around gold, silver, etc. is a risky business and we do not utilize this asset class for any part of our overall investment strategy.
Some will suggest target date funds or restructuring your assets depending on your age, but we don't subscribe to that viewpoint. If you are content with the cash flow being generated and that cash flow is covering your expenses be happy. As you are nearing retirement you may want to reconsider what big expenses you have coming up and/or increase your cash/liquidity buffer so you aren't forced to sell at a low price due to a down-turn in the market, but overall keeping with low-cost index options you'll do well for the long run.
"If you're an investor, you're looking on what the asset is going to do. If you're a spectator, you're commonly focusing on what the price of the object is going to do." Warren Buffett
A few things to keep in mind when there is a down-turn in the market:
- Stop focusing on your net worth and instead focus on cash flow. If your investments are generating enough cash flow to cover your expenses...be happy! Stop listening to the talking heads on TV and have peace knowing you're doing fine.
- Lower stock prices means businesses are on sale. Assuming the underlying business operations and management are solid you can be happy knowing if you have cash on hand to invest you are now buying at a discount. Even if you don't have cash to invest, know companies are buying back shares all the time and when they buy back shares at a lower price all remaining shareholders benefit. It's a win-win unless you've burned through liquidity and are forced to sell.
