RPF0176-Practical_Asset_Allocation
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00:00:51.300 | Today on the show, we talk about an asset allocation strategy that might actually be useful to you.
00:00:59.300 | You ever gone to a financial advisor and we ask you a bunch of those questions
00:01:03.300 | and you fill out the little profile that gives the numerical score and then we declare to you,
00:01:07.300 | "Well, you are a balanced investor."
00:01:09.300 | And then we give you the funny little asset allocation pie chart.
00:01:12.300 | Yeah. Useful in some regards, but doesn't make that much sense to most people.
00:01:17.800 | So today, let's start with something that might make a little bit more sense.
00:01:23.300 | ♪
00:01:39.300 | Welcome to the Radical Personal Finance podcast.
00:01:41.300 | My name is Joshua Sheets and I'm your host.
00:01:43.800 | Today, I'm going to pull back some of the mysteries of asset allocation.
00:01:48.300 | We're going to talk about a model that I think will actually be useful
00:01:52.300 | and that you'll be able to apply continually throughout your life.
00:01:55.300 | You can apply this to all of your assets no matter where they're located
00:01:59.300 | and no matter what type of assets because it's more a system of thinking
00:02:03.300 | than something specific for you to do.
00:02:05.300 | ♪
00:02:11.300 | This is one of my major beefs with the financial industry
00:02:13.800 | and certainly there is a need and a place for us to use formal asset allocation strategy.
00:02:20.300 | There is definitely a need and a place for it.
00:02:22.800 | And primarily, that is based upon modern portfolio theory
00:02:27.800 | and it's primarily based upon how can we create a portfolio that will function
00:02:33.800 | and meet the desired goals and outcomes with a minimum level of risk.
00:02:39.800 | However, in my experience, it's not intuitive to most people.
00:02:46.300 | And worse than not being intuitive, it doesn't really connect and give you,
00:02:53.800 | the client or the consumer, anything actionable that you can do.
00:02:58.300 | So I want to share with you a different alternative idea.
00:03:02.300 | And this is not new.
00:03:03.300 | I am not the creator of this.
00:03:05.300 | It's completely been stolen from the financial world.
00:03:09.300 | But I do think it's useful and I do want to present it to you.
00:03:12.300 | And essentially, it's thinking about your money in terms of a matrix
00:03:17.800 | where one axis is based upon the length of time that you plan to be investing for a goal
00:03:25.800 | and the other axis is the amount of risk that you're willing to bear
00:03:29.800 | for a certain amount of – for a certain investment choice.
00:03:34.300 | And if you think about this and then you start to plot different goals onto this matrix
00:03:39.800 | and then you start to plot financial products onto this matrix,
00:03:43.800 | then you'll be able to put yourself in a situation where you can clearly see
00:03:50.800 | which financial products or which approaches will match certain goals that you have.
00:03:57.800 | Now, this concept is very simple.
00:04:01.300 | But don't let its simplicity pass you by and – such that you ignore it and don't apply it.
00:04:07.300 | Here's the matrix. Let me give it to you.
00:04:09.300 | Visualize a matrix, a set of boxes that is three boxes by three boxes.
00:04:15.800 | So for a total of nine squares.
00:04:18.300 | And on the X-axis – so we're dealing with the columns here.
00:04:22.300 | The first column up and down is your short-term goals and your short-term dollars.
00:04:28.300 | The middle column – so still on the X-axis, middle –
00:04:31.800 | depending on which mathematical terms you're more comfortable with.
00:04:33.800 | The middle column is your medium-term goals and your medium-term dollars.
00:04:38.300 | And the final column on the right, the far end of the X-axis,
00:04:42.300 | is your long-term goals and your long-term dollars.
00:04:47.300 | So short-term, mid-term and long-term.
00:04:50.800 | That's the X-axis, the columns up and down.
00:04:53.800 | The Y-axis, the rows – if you're just thinking about it in the terms of a matrix.
00:05:00.300 | The rows – the bottom row is your safer dollars or your safer goals or your smaller goals.
00:05:11.300 | The middle row is your aggressive dollars or your aggressive goals.
00:05:18.300 | And the top row is your home-run dollars, your home-run investments, your home-run goals, things like that.
00:05:25.800 | Now, the reason I'm going back and forth between investments and goals is primarily in the financial industry.
00:05:31.800 | This is a method of organizing different approaches to different investment products.
00:05:37.800 | Because, for example, investing in CDs or guaranteed investment contracts offered by an insurance company
00:05:47.800 | is different than investing in stocks.
00:05:51.800 | And that's different than investing in stocks through a retirement account such as an IRA.
00:05:58.300 | And investing in stocks through a broad-based index fund is very different than investing in stocks
00:06:04.300 | through structuring a leveraged options trade of some sort.
00:06:09.300 | Flipping real estate is different depending on your market.
00:06:16.300 | It's different than just simply buying a few rental houses here and there that you're planning to keep for the long term.
00:06:24.300 | So because they're different, you need to approach them differently and not expect one asset to do what another asset can do.
00:06:31.300 | Time horizon is incredibly important.
00:06:34.300 | And when you're trying to match up goals, investment goals – because remember, the only reason that we invest
00:06:40.800 | is because we have a goal that we want to fund in the future.
00:06:44.300 | And the only reason we don't consume money today is because we would rather consume it in a different form
00:06:51.800 | or a different fashion at a later date.
00:06:53.800 | That's the essence of what investment is.
00:06:56.800 | We choose not to consume today so that we can invest for more and better later.
00:07:03.300 | So what we need to do is we need to match our goals, the desired outcome that we have for a particular investing decision,
00:07:09.300 | with the investment vehicle that we are utilizing for that decision.
00:07:16.300 | So thinking about a short-term goal.
00:07:18.800 | A short-term goal would be something like having money available for an emergency fund.
00:07:23.800 | The reason that's a short-term goal is because you always need to have the money available to you.
00:07:29.300 | This is also a goal for which you need something that is safe.
00:07:36.300 | It's a safety goal. It's a protection goal.
00:07:38.800 | So investing for an emergency fund, you need an asset class that is short-term in nature and that is safe.
00:07:49.300 | And in this context, I'm defining safe as non-volatile,
00:07:53.300 | unlikely that the market value of the investment is going to go up and down dramatically on any given day.
00:08:00.300 | So this is why if you are saving money in an emergency fund,
00:08:03.800 | that you'll just simply choose to do this with, say, cash in your house or cash in a savings account or cash in a money market fund,
00:08:12.300 | some sort of cash or cash equivalent that is very tangible and very easily accessed by you.
00:08:19.300 | Now, the same emergency fund goal could actually cross over into a midterm goal.
00:08:27.300 | And the way that it could do that is if you had – if you defined your emergency fund in a larger number.
00:08:35.800 | So if, for example, you said I want to have one year's worth of expenses available to me at all times.
00:08:41.800 | But since I'm measuring this goal in the context of expenses, I know that if I need a year of expenses,
00:08:46.800 | I'd like three months of expenses to be immediately available to me.
00:08:50.800 | So in order to take care of that, I'm going to go ahead and keep one month's worth of expenses or two months of expenses
00:08:56.800 | in currency, cash, dollar bills, or whatever your local currency of choice is.
00:09:02.300 | I'm going to keep that in a safe in my home or a safety deposit box in my home.
00:09:06.800 | And then I'm going to keep one or two months' cash in a savings account.
00:09:10.800 | But then once I've got three months of that covered, I don't need an additional nine months sitting in the savings account.
00:09:16.300 | So I'll go ahead and move over toward a – it still needs to be safe because I don't want any fluctuations in the value of this money
00:09:23.800 | when I'm funding a specific emergency fund goal.
00:09:26.800 | But I can go ahead and move over toward a middle-term type of investments.
00:09:31.800 | And these lines, in case you are very precise and it bothers you when I'm using different numbers, short-term, mid-term, long-term,
00:09:38.800 | without defining them, you have to define them.
00:09:40.800 | So whether you define short-term as zero to two months and mid-term as two months to two years and long-term as two years and plus,
00:09:50.800 | that would probably not be what I would do.
00:09:52.800 | I would probably use – short-term would be zero to a few months and medium-term would be a few months to a decade.
00:09:58.800 | And long-term would be a decade plus, something like that.
00:10:01.800 | But this is fuzzy. This is just a mental model.
00:10:04.800 | It's not something that's specific that you can really plug into.
00:10:08.800 | It's just a mental model.
00:10:09.800 | So – but if I rolled that over to more of a mid-term goal than a short-term goal,
00:10:15.800 | then I would go ahead and potentially buy some short-term CDs.
00:10:19.800 | Maybe I'd set up a CD ladder at my local bank knowing that I had a certain amount of money that's coming due every three months
00:10:25.800 | and split this out into a series of four CDs, each of which is a three-month CD.
00:10:30.800 | And then as that three-month CD comes due, then I go ahead and buy a six-month and build it out until I build a CD ladder
00:10:36.800 | where I have one of my CDs that's continually coming mature every three months.
00:10:41.800 | That would be one way to approach it.
00:10:43.800 | And so depending on the nature of the goal, if I have a short-term goal, I'll fund that with a short-term investment.
00:10:53.800 | Now, if we go to the opposite corner of our matrix, so we're going from safe and short-term all the way to long-term and home run,
00:11:03.800 | now we're going to have a long-term large goal.
00:11:08.800 | And let's say that instead of using commonly the idea of a home run being retirement, let's just say it's mega wealth.
00:11:19.800 | We're saying, "I have a long-term goal of being mega wealthy.
00:11:23.800 | Well, how do I fund that?
00:11:25.800 | I need to think through what type of investment is going to be a long-term investment that could be basically my home run dollars."
00:11:34.800 | That would be different for each of us.
00:11:38.800 | For me, on my matrix, I would usually put business ownership in that scenario.
00:11:43.800 | You might put stocks or mutual funds there or some other type of strategy.
00:11:50.800 | I like to think about my safer dollars as the money that's pretty much going to be guaranteed.
00:11:57.800 | In sales presentations in the past when I was explaining this to clients, I would use the concept of baseball.
00:12:02.800 | Singles and doubles are my safer dollars.
00:12:04.800 | Aggressive dollars are the triple or the swinging for the home run, and the home run was just knock the ball out of the park.
00:12:10.800 | If you identify your assets specifically and understand, are these the safer dollars, the aggressive dollars, or the home run dollars, and what am I investing for?
00:12:27.800 | Am I investing for a safer goal, an aggressive goal, or a home run goal here?
00:12:30.800 | Then it will make things make a lot more sense to you.
00:12:33.800 | Now, not every one of these boxes has to be filled.
00:12:37.800 | So, for example, you could have home run short-term goals, and this is where the example starts to break down.
00:12:46.800 | It's very good when thinking specifically about an investment opportunity, but it breaks down when you think about goals because not all –
00:12:55.800 | what's the mid-term home run goal and what's the mid-term aggressive goal and what's the short-term home run goal?
00:13:02.800 | So I think about this primarily in terms of investment solutions, but again, investment solutions are connected to goals.
00:13:09.800 | They should be.
00:13:10.800 | But you might have a short-term home run goal.
00:13:12.800 | Again, I mentioned some sort of leveraged options trade.
00:13:15.800 | Maybe you've set up some kind of scenario where, yeah, you could lose it all, but the multiple is just so massive you're just going to go for it.
00:13:23.800 | And if it comes through, it will be a massive success.
00:13:29.800 | If you start thinking about this and identifying and allocating your assets appropriately to what you're trying to accomplish, then you can make intelligent asset allocation decisions.
00:13:41.800 | The other thing that this will impact is your asset location decisions.
00:13:48.800 | So remember, in making investments, generally we need to choose what the investment is and then we need to choose where to locate that investment.
00:13:58.800 | And the best example of this would be the discussion of retirement accounts.
00:14:03.800 | You can't actually invest in an IRA.
00:14:07.800 | An IRA is not something that you can invest in.
00:14:11.800 | An IRA is merely a tax – it's an idea.
00:14:14.800 | It's a legal entity through which you can invest in something, invest in shares of ownership of a company called stocks or a bond.
00:14:25.800 | You can invest in a bond or you can invest in a CD contract through an IRA.
00:14:30.800 | So those location – asset location decisions are going to be – do we locate this asset and this investment within the context of an IRA?
00:14:39.800 | Do we locate this asset within the context of a 529 plan?
00:14:43.800 | Do we locate this investment within the context of a life insurance contract?
00:14:47.800 | Do we locate this asset and investment within the context of a legal entity or not?
00:14:53.800 | Best example there, think of real estate.
00:14:55.800 | I can always choose to buy real estate in my own name.
00:14:57.800 | I could choose to locate the real estate within a legal entity that I've created that's mixed together with other parcels of real estate or I could choose to separate it.
00:15:07.800 | These would all have advantages and disadvantages depending on what the goal was.
00:15:11.800 | So we want to think through this in terms of asset allocation and asset location based upon the goal, short-term goal, mid-term goal, long-term goal.
00:15:22.800 | Am I trying to shoot for just a consistent singles and doubles?
00:15:26.800 | Am I – safer goals, aggressive goals?
00:15:29.800 | I'm shooting for a triple or do I want a home run?
00:15:33.800 | Am I – and I'm willing to take the risk.
00:15:35.800 | Am I willing to step up to the plate on this deal, swing and very likely strike out but maybe connect and get everyone in or do I need to pull back and hit the conservative play?
00:15:49.800 | That's basically it.
00:15:53.800 | That's all I want to talk about today, a very short episode because I just want to convey this concept.
00:15:58.800 | But I want to encourage you to think about it and ask yourself what your goals are and what you're trying to do.
00:16:03.800 | And this connects back if you think to Friday's Q&A, the most recent show before this one.
00:16:09.800 | If you think back to Friday's Q&A and the question was what's the fastest way to become a 1%er, well, there we're shooting for a home run.
00:16:17.800 | And the fastest way to become a 1%er is not when you're shooting for an aggressive investment, something like stocks.
00:16:23.800 | A broad-based index fund, index mutual fund in the stock market is not going to be a home run investment.
00:16:31.800 | It's a more aggressive investment than is, again, a portfolio of laddered CDs or laddered bonds.
00:16:38.800 | But it's not the home run that is a tech company.
00:16:41.800 | And a home run that is the tech company is ideally much shorter term.
00:16:47.800 | That's very different than saying I'm going to build an empire in the local services business.
00:16:53.800 | I'm going to build a plumbing contractor empire.
00:16:56.800 | Well, that's not going to be unless you have some plan for how you can leverage it into a very short-term idea and into a very short-term success through buying out your competitors or aggressive marketing or something that you figured out that's going to make it shorter term.
00:17:12.800 | Building a massive plumbing business empire is going to be more of a long-term scenario than building the next hot app.
00:17:19.800 | So I submit to you, think about this in the context of your own scenario and think about what your goals are.
00:17:28.800 | Are these short-term goals, medium-term goals, long-term goals?
00:17:31.800 | And then think about what's going to be the best way to fund those goals with safer investments, aggressive investments or home run investments.
00:17:39.800 | Then identify the goals and identify the assets.
00:17:42.800 | And this will drive your asset allocation and asset location decisions.
00:17:48.800 | Try it out.
00:17:50.800 | Make a matrix, nine squares.
00:17:52.800 | Put your goals on there.
00:17:53.800 | Put your assets on there.
00:17:54.800 | Don't worry about filling every square.
00:17:56.800 | There's no reason to fill every square.
00:17:59.800 | But once you have this as a mental idea, then I think you can use it and apply it to different scenarios.
00:18:05.800 | And it will make things simpler for you.
00:18:09.800 | And you can judge the various merits and demerits of different strategies, different financial products, different tools, etc.
00:18:16.800 | That's it for today's show.
00:18:17.800 | One quick announcement here as we go.
00:18:19.800 | Those of you -- I'm making a switch over to -- thank you to those of you who have been signing up as patrons of the show.
00:18:25.800 | I've sent out an email to all of the former irregulars.
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00:18:45.800 | And sign up there.
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00:18:48.800 | All of the previous irregulars were contributing $10 a month for that membership level.
00:18:53.800 | Go ahead and stay current on the $10 a month level, and I will continue to give you the benefits that I am now giving for $25 a month to all of you who were formerly involved with the original membership program.
00:19:06.800 | I figured out the technology to be able to integrate those, and I'm ready to switch that over.
00:19:09.800 | So I've sent you an email.
00:19:10.800 | If you have questions on that for your account, go ahead and feel free to email me, Joshua@RadicalPersonalFinance.com.
00:19:14.800 | And I will take care of that.
00:19:16.800 | Thank you all so much for listening.
00:19:18.800 | And that's it.
00:19:21.800 | That's all I got.
00:19:22.800 | So instead of making you wait through the music today since it was a short show, I'm going to pull this down, pull the music out, and here we go.
00:19:27.800 | Thank you for listening to today's show.
00:19:29.800 | If you'd like to contact me personally, my email address is Joshua@RadicalPersonalFinance.com.
00:19:36.800 | You can also connect with the show on Twitter @RadicalPF and at Facebook.com/RadicalPersonalFinance.
00:19:43.800 | This show is intended to provide entertainment, education, and financial enlightenment.
00:19:50.800 | But your situation is unique, and I cannot deliver any actionable advice without knowing anything about you.
00:19:58.800 | Please, develop a team of professional advisors who you find to be caring, competent, and trustworthy, and consult them because they are the ones who can understand your specific needs, your specific goals, and provide specific answers to your questions.
00:20:19.800 | I've done my absolute best to be clear and accurate in today's show, but I'm one person and I make mistakes.
00:20:26.800 | If you spot a mistake in something I've said, please help me by coming to the show page and commenting so we can all learn together.
00:20:34.800 | Until tomorrow, thanks for being here.
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