Capital_Preservation_And_the_Order_Of_Investing
00:00:00.000 | Hello, everybody. It's Sam from Financial Samurai. And in this episode, I want to talk
00:00:04.240 | about two subjects, one, capital preservation, and two, the right contribution order between
00:00:11.080 | your investment accounts. Now, obviously, 2022 has started the year kind of shaky. S&P
00:00:18.240 | 500 was down two and a half, 3%, the Nasdaq corrected by 10.7%. And individual tech stocks,
00:00:26.800 | some of them have just gotten slaughtered. I mean, they've completely round-tripped since
00:00:31.940 | starting in 2020. Based on my 2022 stock market predictions, 5,008 on the S&P 500, I'm going
00:00:39.800 | to still hold on to that. So right now, we've probably got 7% plus upside, which actually
00:00:44.860 | seems reasonable. But now that I think about it, you know, at the beginning of the year,
00:00:49.280 | 5% upside, if that were to come true, and you're putting all that risk for 5% upside,
00:00:54.880 | it just doesn't seem that worth it, right? Because clearly, we could have corrected 5%,
00:01:01.000 | 10% easily. And for what, for 5% upside? It's something that we should all think about when
00:01:06.680 | we're putting our hard-earned assets, our hard-earned savings to work. Now, on the flip
00:01:12.600 | side, you know, how much downside could there be? I was thinking 10%, right? And that's
00:01:18.040 | happened for the Nasdaq already in the first 20 days. Now, for the S&P 500, I still think
00:01:24.240 | probably 10%. So in other words, I don't think there's going to be a massive bear market
00:01:28.760 | or crash. I just think, yeah, 10% sounds reasonable. Based on high valuations, based on slowing
00:01:35.520 | earnings growth, based on slowing margin expansion growth, the S&P 500 earnings for 2021 were
00:01:43.360 | up I think 50%. 50%. And as a small business owner, I see that too. Because 2021, you know,
00:01:50.240 | you got a really big rebound in demand, consumption spending, ad spending, and so forth. But 2022,
00:01:57.880 | I think it's just totally going to moderate, partly thanks to the law of larger numbers,
00:02:02.680 | where the year-over-year growth rates tend to slow down. So let's talk about capital
00:02:07.000 | preservation investments now that volatility is back and uncertainty is back. So we've
00:02:11.880 | got hard cash you put on your mattress, treasury bonds of all durations. Hope you guys got
00:02:17.000 | some $10,000 savings bonds, I bonds, Series EE bonds, you know, pay like 7.1%. So that's
00:02:25.600 | the other thing. Okay, 7.1%, I would think 80% of investors would take that for the S&P
00:02:32.200 | 500 in 2022. 7.1% is pretty good. And this is the other thing, when you invest in capital
00:02:38.400 | preservation investments, you might not get a great return, you probably won't get a great
00:02:43.380 | return based on what these investments are low risk, low return investments. However,
00:02:49.280 | the gains you actually do get are not investing in risk assets that could go down a lot, right.
00:02:56.120 | So instead of buying an I bond with a guaranteed 7.12% interest rate, for example, you bought
00:03:03.060 | some tech stock that went down 40% because it missed revenue estimates by 3%. And I'm
00:03:08.960 | talking about, of course, DocuSign just got crushed. And so it is a defensive way to make
00:03:14.040 | a little bit of money, but it's also a defensive way not to lose a lot of money. Now, if we
00:03:19.600 | go further down the risk curve for capital preservation investments, we've got annuities,
00:03:24.560 | I don't have any of those AAA rated municipal bonds, I've got actually a ton of those. This
00:03:30.560 | is after I sold my house in 2017. I reinvest a third of the proceeds in municipal bonds,
00:03:36.120 | they've done well, steady eddy, you know, very tax efficient, no state income, no state
00:03:41.240 | tax, no federal tax, triple rated corporate bonds, right. Corporates, they issue bonds
00:03:47.320 | like crazy, especially in a low interest rate environment. And obviously, every single corporate
00:03:52.380 | quality is different. Apple, huge, massive cash balance sheet, you know, they're one
00:03:57.160 | of the top rated, you know, and they pay a dividend, not bad. And the stock has done
00:04:00.440 | phenomenally well. Gold and other precious metals, right, when things are hitting the
00:04:05.760 | fan, you want to own real assets like gold, maybe some silver, you know, if you are a
00:04:11.400 | fan of, let's say, watches, gold watches, rose gold, yellow gold, all that, they've
00:04:16.400 | done pretty well. If you look at the prices over the past 10 years. Now we have fine art,
00:04:23.000 | wine and other rare collectibles. And then we have target date funds, real estate and
00:04:28.120 | hedge funds. Again, this is about capital preservation and going along from the least
00:04:33.320 | risky to the most risky capital preservation investments. Hedge funds are interesting,
00:04:39.400 | because investing in a hedge fund in my 401k actually saved me a lot of grief back in 2000
00:04:45.640 | when the Nasdaq burst, right, this is like the first time the dot com bubble, I invested
00:04:50.400 | like 40% of my 401k in the and or tech fund, and somehow they were able to short the market
00:04:56.040 | and actually was up in 2000. But since then, obviously, the fees right 2% and 20 kind of
00:05:03.000 | tough. It's a drag on returns. And given it's been a bull market since 2009. Overall hedge
00:05:08.920 | fund returns have been poor, because at the end of the day, they're trying to hedge. But
00:05:13.480 | going forward, maybe maybe 2022 2023 will be the year of hedge funds, as investors look
00:05:20.600 | to preserve their capital and make moderate returns, given so many of us have done so
00:05:26.560 | well, even in the just past three years. But fees, fees, fees, fees, tough, which is why
00:05:33.280 | I think most of us should invest 80 plus percent in index funds and ETFs, and just set it and
00:05:38.480 | forget it and follow a capital allocation model. Now, in terms of what percentage of
00:05:43.520 | your net worth you should have in capital preservation investments, it's hard to say
00:05:48.160 | because there are so many different types of capital preservation investments. My steady
00:05:53.600 | state risk free allocation is 5% of net worth for the less risky capital preservation investments,
00:05:59.760 | right. So I know that if all goes to hell, I'm going to be okay, because I can live off
00:06:04.640 | 5% of my net worth, you know, risk free includes cash, Treasury bonds, certificate of deposit,
00:06:10.360 | money market accounts, US savings bonds, and triple A rated municipal bonds. And the bond
00:06:16.960 | portion of my passive income investments accounts for about $3,000 a month. So I really encourage
00:06:22.640 | all of you to review your net worth now, this week, and see what percentage of your net
00:06:28.120 | worth is in capital preservation investments, then you should figure out what percentage
00:06:34.280 | of your net worth is in risk assets. And if the risk assets go down 10, 20, 30%, how are
00:06:41.200 | you going to feel you're going to be okay, you're going to be able to survive, because
00:06:44.720 | investing is the long game. The other thing to think about is how will your investments
00:06:50.520 | affect your mental health, the more you have, the more you're going to think about your
00:06:55.640 | money often, because the more you could lose, yeah, you could gain more. But when you lose,
00:07:01.280 | and you have a lot at stake, it is really a mental mind bender where you start questioning
00:07:07.680 | the reason why you're working so hard at work, if your investments are losing money, and
00:07:12.080 | you can't even make enough from your day job to get ahead. I mean, these are the things
00:07:16.760 | that we all thought about in 2000. In 1997, in 2008, and nine and 10. When you are working
00:07:26.160 | your butt off, and you can't seem to get your net worth to grow, it is a really disconcerting
00:07:32.040 | feeling. So for 2022, I'm kind of reserved to lose 10% on my investments. It's just a
00:07:39.040 | mental state that I'm in. So that when things go bad, I'm just like, ah, okay, I'm losing
00:07:44.800 | money. We've had a great run, but let's be appreciative of how far we've come. Things
00:07:49.540 | don't go up in a straight line forever. Let's just be okay, because a lot of money and financial
00:07:54.420 | independence and wealth creation is mental. You need the mental fortitude to keep on going.
00:08:00.040 | And you need the mental fortitude to not panic. So by having a percentage of net worth in
00:08:06.160 | capital preservation investments, it'll help you not panic, it'll help you give the liquid
00:08:11.400 | courage to take more calculated risks. Now, since the S&P 500 and the Nasdaq, and a lot
00:08:17.640 | of single stocks have done so poorly to start 2022. One of the main questions I keep on
00:08:23.280 | getting is, you know, what should I do with my money? Should I sit on it? Should I invest
00:08:27.460 | in single stocks? Should I invest in that cryptocurrency, whatever it is? My answer
00:08:31.920 | is pretty consistent. And that is to follow an asset allocation model over the long term.
00:08:38.960 | Try not to deviate from it, continuously invest in good times and in bad time. Because over
00:08:44.440 | the long run, if you invest money during correction in bear markets, it generally pays off if
00:08:49.800 | you hold on to it long enough. In my 2021 review, I revealed that I have 14 different
00:08:56.320 | tax advantaged and taxable investment accounts. And that's across four people, right? So we're
00:09:01.520 | talking Roth IRA, custodial Roth IRA, custodial investment accounts, solo 401k, 401k traditional,
00:09:08.480 | no, no traditional IRA, rollover IRA, Roth IRA for the kids, and then 529 plans and so
00:09:16.000 | forth. So it's really complicated. And I think this is what you're going to find if you have
00:09:20.280 | a family, if you get older, and you start investing in all these different tax advantaged
00:09:25.880 | vehicles. And if you start opening up different accounts with different banks to get some
00:09:31.440 | better terms and better rewards. So let's say you have money coming in every single
00:09:36.280 | month, the right contribution order between your investment accounts is to contribute
00:09:42.000 | up to the maximum contribution amount in your tax advantaged retirement accounts. So this
00:09:47.000 | means 20,500 for your 401k and 6000 for your traditional and Roth or Roth IRA. It's weird
00:09:55.840 | that it's only 6000 still in 2022. When the 401k maximum contribution went up 1000 bucks,
00:10:03.160 | you know, inflation is here. So what's up with that, guys, but that's what it is for
00:10:08.400 | 2022. And the idea is you continue to contribute the maximum, whatever the maximum is, and
00:10:14.280 | over a 1020 year period, you're going to wake up and I think you're going to be astounded
00:10:18.840 | by how much you will accumulate in these tax advantaged accounts. Now, if you want to achieve
00:10:23.800 | financial freedom earlier, it's kind of an interesting scenario because you can't touch
00:10:29.120 | that money without penalty until 59 and a half. So ideally, you make enough money where
00:10:34.320 | you max out your tax advantaged accounts and contribute at least 20% after tax after tax
00:10:41.080 | advantage retirement account contributions to taxable investments, because at the end
00:10:46.240 | of the day, it is your taxable investment portfolio, or various portfolios and other
00:10:53.100 | investments that are going to provide and generate the passive income for you to survive
00:10:57.960 | and have the courage to leave your job early. And the reality is, the contribution is capped
00:11:04.160 | for tax advantaged accounts, but uncapped for your taxable investment accounts. And
00:11:08.680 | these include alternative assets, real estate and so forth. Therefore, your ultimate goal,
00:11:14.520 | I really believe this is to try to accumulate three times more in your taxable investments
00:11:21.520 | than in your tax advantaged accounts. So you got $100,000 in your 401k shoot to gain $300,000
00:11:28.720 | in your taxable investments. And by the time you're 5060 this ratio, this is really I think
00:11:34.360 | a very important ratio to think about instead of just thinking I'm just going to contribute
00:11:38.720 | to my 401k and IRA. No, no, no, you got to get out of that mindset. And think about that
00:11:43.840 | as automatic, as if you're brushing your teeth once or twice or three times a day, it's just
00:11:49.560 | automated, you got to do it. And then if that money is there for you after 59 and a half,
00:11:55.240 | awesome, it's like a bonus, but you never counted on it. And more than likely, more
00:12:00.200 | than likely, you're going to get to that age and you'll be like, well, let's just have
00:12:03.960 | that money compound further, because you've been able to build your taxable investment
00:12:08.800 | portfolio. Now, not everybody obviously has the cash flow the income to contribute the
00:12:13.880 | maximum to the tax advantaged accounts, and then also contribute another 20% plus to taxable
00:12:19.360 | investments and so forth. So let's talk about different scenarios. One scenario is a correction
00:12:24.920 | or bear market scenario. And I think this is one of the reasons why people are emailing
00:12:29.120 | me asked me, I'm just going to play softball the other week. And people are like, Sam,
00:12:32.880 | what should I do with my money? Because, you know, the markets are correcting. So during
00:12:36.780 | corrections or bear markets, it's easier to sit on your cash and do nothing. However,
00:12:41.920 | the risk of doing nothing is that you eventually miss out on a recovery. And in the history
00:12:47.800 | of the stock market, and real estate and other investments, generally, these risk assets
00:12:53.520 | have recovered, they have recovered. Therefore, it is recommended to always be contributing
00:12:58.240 | something no matter the market conditions. So as the saying goes, time in the market
00:13:02.760 | is better than timing the market, right? So dollar cost averaging is great for when things
00:13:09.540 | are going poorly. So if your funds are limited, all else being equal, contribute the most
00:13:16.000 | to the tax advantaged account that is farthest away from being tapped. For example, let's
00:13:21.320 | say you're 47 years old with 13 years left to be able to tap your 401k without penalty.
00:13:27.040 | You also have a one year old who is 17 years away from going to college. To overcome your
00:13:32.660 | fear of investing and doing nothing, perhaps the right investment contribution order is
00:13:37.960 | to contribute the maximum gift tax limit to your child's 529 plan first. With such a long
00:13:44.600 | runway, your chances of having a positive return increases. And hopefully you can zoom
00:13:49.480 | out you right you zoom out, you look at the stock market, real estate market and so forth
00:13:52.760 | and realize that over the long run, things turn out fine. And then once you contribute,
00:13:58.480 | let's say $16,000, which is the gift tax limit for 2022, you then work throughout the
00:14:04.160 | rest of the year to contribute the maximum to your 401k, especially if you're above the
00:14:09.480 | 24% marginal income tax bracket. If you're not just try that is we're talking about the
00:14:13.760 | orders here. Now, of course, the order in which you contribute to your investment accounts
00:14:18.340 | is also dependent on the various portfolio amounts you have. For example, if your 17
00:14:24.320 | year old daughter has a $300,000 529 plan, well, she is set. Now let's look at your 401k
00:14:31.800 | balance at age 50. It's only $200,000. Well, you're not set. So therefore, the right order
00:14:37.640 | is to concentrate all of your cash flow to maxing out your 401k and contributing to your
00:14:44.360 | taxable investment accounts. And the only way to know whether you're on track for your
00:14:49.880 | age is to make honest assessments about your future income needs and expenses. Over the
00:14:54.760 | years, I've tried to provide guides, you know, a couple posts include 401k savings by age,
00:15:01.240 | recommended 529 plan amounts by age, they give you guides, they're not, you know, the
00:15:05.720 | end all be all, but they give you guides for how much you should save and have invested
00:15:10.200 | by age so that by the time that event comes, whether it's going to college, or retiring,
00:15:17.040 | you're good to go. A final scenario I want to talk about regarding the proper order of
00:15:22.360 | contribution between taxable and tax advantaged accounts is the early retirement scenario.
00:15:28.280 | If you plan to retire early and have limited funds, then the most appropriate investment
00:15:32.240 | contribution order is to build your taxable investment portfolio. Also work on building
00:15:38.000 | your real estate portfolio and all other non tax advantaged investment accounts. Given
00:15:44.240 | you can't tap your 401k and traditional IRA without a penalty before age 59 and a half,
00:15:48.960 | you need to build your taxable accounts in order to survive off the passive income. However,
00:15:55.440 | before you retire early, you should still contribute at least up to the maximum 401k
00:16:00.240 | match if you have one right it's free money, never turn down free money. That's a sub optimal
00:16:05.480 | move. If you have enough funds to max out your tax advantage retirement accounts and
00:16:10.000 | contribute to your taxable investments, then you should do both and keep on going. Your
00:16:15.280 | 401k and IRA will act as your retirement insurance policy in your 60s and beyond. And if you
00:16:21.160 | get desperate and really need the money, you can always borrow from your tax advantaged
00:16:24.960 | funds without penalty, or you can withdraw from your funds early and pay a penalty. Obviously
00:16:30.160 | not ideal, but the the money is there if you want it and you really need it. And if you
00:16:35.840 | have a reasonable amount of retirement income, but still plan to earn supplemental retirement
00:16:40.600 | income after achieving financial independence, then you should open up a solo 401k. Don't
00:16:46.040 | forget about the solo 401k. I forgot about opening up one back in 2012. When I left work,
00:16:52.400 | you know, I was just so thrilled to be done. I just wanted to travel and relax. The last
00:16:55.600 | thing I wanted to do was, you know, make money and then contribute more to my retirement
00:17:00.120 | accounts because I thought I was retired. But obviously, within a year later, I was
00:17:04.000 | like, this is just too boring. I wanted to do something and learn and be productive member
00:17:08.800 | of society. So if you're a freelancer, a solopreneur, whatever, open up a solo 401k,
00:17:14.800 | and you can contribute the employee maximum plus a percentage of your operating profits.
00:17:19.440 | I'm going to conclude here because the episode is getting quite long. But check out the couple
00:17:23.720 | of posts I've written various other scenarios. And it's good to have a discussion. Remember,
00:17:29.120 | nothing is guaranteed when we're investing money. So we need to have the proper asset
00:17:34.200 | allocation. Further, our demands for our retirement funds will be different at different life
00:17:40.040 | stages. So having that mix of taxable and tax advantage accounts is important. And I
00:17:44.800 | think you should really really focus on building that taxable investment portfolio as large
00:17:51.040 | as you can. Thanks so much, everyone. If you enjoyed this podcast, please share it, leave
00:17:55.440 | a positive review and I'll talk to you guys later.