Tap into our expertise. Once a month we publish a blog on various financial planning topics.
DISCLAIMER: This post is NOT investment advice. It is NOT a recommended portfolio for your situation. Your portfolio should be based on your personal risk tolerance, time frame, and preferences. None of those topics are covered in this post; this post only analyzes one individual’s portfolio (mine).
KEY TAKEAWAYS:
- Your ideal portfolio should be based on your personal risk tolerance and goals.
- Your risk tolerance and goals should be reviewed periodicity as your situation changes.
- It’s okay if your portfolio is not “perfect” due to preferences or investment limitations.
- Enjoy the holiday season!
You’re a wealth manager, right?
First off, happy holidays!
Now is time of the year that we get to see friends and family that we may not have a chance to see as often as we would like during the year. For me, this generates a lot of conversations about being a financial advisor. Usually the conversation immediately turns to portfolio management. Yes, WJL does that, but it’s a small component of the financial advice we offer. We provide flat-fee comprehensive financial services. WJL incorporates all aspects of a client’s finances to develop a plan to help them become financially independent and reach their goals (a summary of what we do is at the end of this post).
Even after I explain this the conversation inevitably comes back to investment advice. “Stock tips,” fund selection, and asset allocation are just more fun to talk about than taxes, annual rebalancing, and goals (most people don’t even know what their goals are!). WJL’s investment theory is pretty boring. It is based on the Efficient Market Hypothesis (EMH)—that over the long term, average market returns cannot be beat by picking individual stocks or timing the market. The goal of portfolio management is to properly diversify, lower expenses, and match asset allocation to risk tolerances. A separate post explains the EMH in greater detail. You can also read books on the topic or find the same information on internet sites that are not sponsored or selling you a product.
“Great,” they say. “Sounds good but what do you, Sean, actually invest in? Do you walk the walk?”
Well, much like our clients, I bring my own investment preferences and limitations to the equation. My portfolio is not the ideal portfolio if I were starting with a blank slate, without my investing limitations (such as limited 401K options) and investing preferences (my preference for direct real estate investing). That’s okay. Just as in working with our clients’ portfolios, the goal is to work around issues and build the most efficient portfolio possible.
Okay, I’ll answer your question
By asset class, here is how I am invested and why:
Individual Stocks (1.5%)
Let’s begin with individual stocks since it’s the most talked about component of the portfolio. While it makes up only 1.5% of my portfolio, it makes up 98.5% of the conversations I have with friends about finance, even after I have explained that investing in individual stocks is a fool’s errand!
Owning individual stock is in direct opposition to the EMH theory, whereby all available information should already be priced into the stock price so stock picking should not be possible. Still, it’s fun to invest in individual companies you believe in, so I have a small account to make trades. But I keep this account small because I know the odds are not in my favor.
My academic and professional recommendation is to not pick individual stocks, but if you are not a 100% efficient decision-making robot, and few of us are, please keep it a small percentage of your portfolio.
Cash (1.4%)
Cash is an unproductive asset that decreases in value over time due to inflation. Currently a “high-yield” saving account pays around 0.6% while year-over-year inflation as of October was over 6%. I don’t think an inflation rate this high will continue for long, but whatever cash you held this past year now buys 5% less stuff that it did a year ago. Yikes!
Still, we all need to hold some cash to pay for short-term needs such as bills, emergencies, or an upcoming larger purchase. In my case, the cash balance is my emergency fund and a reserve for unforeseen costs related to the direct real estate investments. (More on that in the next section.)
An outside advisor reviewing the portfolio pie chart would most likely have an issue with the low percentage in cash. Fair point. In addition to the cash on hand, however, I also have a home equity line of credit (HELOC) to fall back on if more liquidity is needed. The only cost of the HELOC was a one-time $50 fee, with no requirement to use it, so getting one set up should be a goal for most homeowners.
Direct Real Estate Investments (23.9%)
Real Estate can be a valuable tool to fight inflation. We provided a dedicated post on the topic a few months ago outlining the best way for investors to gain exposure. Spoiler: it was through Real Estate Investment Trust mutual funds (REITs).
If REITs are the preferred investment tool, why do I have all this direct real estate?
Because I fell hard for the American Dream. In college, I would joke about someday starting a rental real estate company named “Ladutko Enterprises,” affectionally named after the owner of the house my roommates and I rented for two years in college. As a finance major, I could not believe the return we estimated for owning the property compared to what we paid in rent.
As soon after graduating as possible, I purchased a house that could later be turned into a rental. This happened when I was 25. Over the next two decades, whenever I was able to save up enough money, I added properties, all with professional property managers to manage them. A good property management company can provide cost efficiency by having full-time maintenance people who are billed out a lot more reasonably than if you were to hire your own contractor. And, plus, do you really want a call at 5 am about a leaking toilet?
Even with property managers, these properties are not completely the passive investments. When things are going well, I spend about 2 hours every week managing the properties from my end. If there are issues, the time can quickly increase.
My properties have been around a while, and they represent a pretty good cash flow, which is my primary return on these investments. It took a long time to get to this stable cash flow though. It wasn’t until I owned about four properties that the “bad” properties could be offset by “good” properties. Now that the cash flow is mostly stable, the properties fulfill the role in my portfolio normally filled by bonds.
The other component of the return is the equity in each property (defined as the value between the market price and the amount owed). It grows at a consistent slow pace as the mortgages are paid down and properties appreciate, but equity in real estate is about as illiquid as it gets. If needed, the equity could be pulled out through a cash-out refinance or line of credit, but this would be slow, costly, and painful.
As explained in the earlier post on direct real estate investing, real estate is not a passive investment. It is a passion for me and not a suitable investment for everyone. Investing in real estate has helped me reach my financial goals and I’ll never give it up, but it has caused more than a few sleepless nights.
Because of this heavy investment in direct real estate, direct real estate investment is performing the role that role of REITs in my portfolio.
Bonds (6.2%)
Bonds are right up there with individual stocks for what we find clients are most passionate about. People either love them or hate them, but mostly they hate them.
The haters argue that current interest rates, and therefore the cash returns bonds offer, are so low that bonds are not worth investing in. When considered as a stand-alone investment option, they are probably correct (although bonds do pay more than savings accounts).
What bonds do offer, specifically US government issued bonds, are positive returns when equity markets crash. This negative correlation is created by investors “flight to safety” during market disruptions. When investors become concerned about the market and risky assets, they move money into US-issued debt because it is viewed as the safest possible investment. The graph below shows the past 25 years of returns for equities (measured by Vanguard Total Stock Market Index Fund) and US Treasury bonds (measured by Vanguard Intermediate-Term Treasury Fund).
The haters will be quick to point out the much, much lower returns bonds provided compared to equities. A 100% equity portfolio will offer a higher rate of return over the long term but with much more volatility. The goal of bonds in a portfolio is to offer diversification and a smoothing of returns.
Notice what happens when equities crashed the hardest, in 2001 (-10.57%), 2002 (-10.97), 2003 (-20.96), and 2008 (-37.04). In those years treasuries offered some of their highest returns. An asset increasing in value when the rest of your portfolio seems like it is on fire can provide a great deal of reassurance. This is the true value of having treasuries in your portfolio.
The flight to safety, however, does not apply to all bonds, only to US government bonds. Corporate-issue bonds usually correlate more closely to equities because investors fear that during a recession, companies will default on their debt due to declining sales. While corporate bonds may pay a higher return, they behave more like equity investments with value declining when stocks go down.
We at WJL recommend investing in three types of low-cost bond funds: intermediate-term Treasury Funds, short-term Treasury, and Treasury inflation-protected bond funds. My bond investments follow this guidance and are equally split across those funds.
Equity Funds (66.8%)
This is where the smart money is: broad-based, low-cost index funds, either through exchange-traded funds (ETFs) or mutual funds. Equity mutual funds make up 67% of my portfolio, by far the largest component.
Within equity funds, there are different classes we target in US funds: Large Capitalization (or “Cap” for short), Mid-Cap, Small-Cap, and Real Estate Investment Trusts (REITs). Although these definitions are subjective, some firms, including Vanguard, use the classifications developed by the Center for Research in Security Prices (CRSP). CRSP was founded by academics at the University of Chicago’s Booth School of Business over 60 years ago. Their classifications are roughly based on the numbers below:
Large-Cap Funds: typically invested in equity stocks with a total market capitalization above $10 billion.
Mid-Cap Funds: typically invested in equity stocks with a total market capitalization of between $2 billion and $10 billion
Small-Cap Funds: typically invested in equity stocks with market capitalizations between $300 million and $2 billion.
According to classic investing theory, Small Caps have the highest projected return since the group includes more startups with greater growth potential. However, it also includes companies that will not make it, creating increased risk (usually measured by volatility). On the opposite end, Large-Cap stocks are made up primarily of established companies with less growth opportunity. This limits their returns, but also lessens risk. Mid-Caps are in the middle of the two extremes. At least that is how the theory goes.
Over the past 30 years, however, Mid-Caps have been the return leader. Over the past 10 years, Large-Caps have been the leader. And no one knows which will lead in the next 10 years. This is why we try to build portfolios with equal balances of each.
Lastly, let’s talk about international funds. Investing in international funds increases your diversification, thus lowering your risk. Developed and emerging international markets have different levels of risk and potential returns than domestic funds. Emerging markets particularly have increased opportunity for faster growth compared to developed markets, as the economies are expanding faster. But they also come with more risk.
My portfolio is unbalanced within the equity mutual funds due to an active 401K with limited good options outside of a Large-Cap fund. When I’m able to gain more investment options, I will rebalance to more equal weighting between Large/Mid/Small Caps.
What is “correct” portfolio construction?
The riskiness of my portfolio will depend on your views of real estate. For investors who see direct real estate investment as wildly overhyped and risky, this portfolio, with only 6% in bonds, is on the risky end of the spectrum.
At the other end are investors who consider direct real estate more like corporate bonds (remember these are riskier than Treasury bonds). They would see 70% equity and 30% bonds/real estate as a conservative portfolio for my age. This, of course, would not be a 70/30 portfolio WJL would build for our clients, first because we do not recommend people go into direct real estate investing and, second, if we were building a 30% bond portfolio, it would consist of Treasury bond funds.
And this is the point: two portfolios do not have to have the exact same weightings of investments to be “correct.”
Portfolio construction should only occur after you have identified your goals (short and long term) and spent a healthy amount of time thinking about your risk tolerances. Take the time to discuss and document your goals and why you are invested the way you are. Then review it every year to make sure it makes sense.
Until next time, spend less than you make, invest the difference in low-cost index funds, be kind to your neighbors, and you will succeed in reaching your financial goals and in making the world around you a happier place.
If you feel you could use some assistance along the way, please email us or leave us a comment below we’d be happy to talk about how we can help
Summary of the services WJL provides:
Here is a brief overview of what we do to help our clients identify and reach their financial goals:
- Asset Allocation: Provide an analysis of your entire portfolio (not just what we manage) and develop a proper asset allocation based on risk tolerances, time frame, and goals. Help clients work through their values, preferences, and motivations.
- Rebalancing: After proper asset allocation has been achieved, provide annual maintenance to ensure your assets remain within the targeted allocation. We help ensure this across our client’s entire portfolio.
- Behavioral Mistakes: Help our clients avoid common behavioral tendencies, such as panic selling during a market decline. Help them achieve better portfolio returns than when they make decisions without professional guidance.
- Cost of Cash: Educate clients on the cost of holding cash while keeping their portfolio well-diversified within the risk levels appropriate to the client.
- Expertise: The WJL staff includes CPAs and CFPs, each with more than 20 years of financial management experience. We identify and spot opportunities that might be missed.
- Tax-Efficient Planning: Many advisors offer tax-efficient investing of the assets they manage, but since WJL handles the actual return for our clients as well, our planning is comprehensive and considers both short- and long-term goals.