IFB168: An Asset Allocation Guide for Lifetime Wealth

Announcer (00:02):

I love this podcast because it crushes your dreams of getting rich quick. They actually got me into reading stats for anything you’re tuned in to the Investing for Beginners podcast led by Andrew Sather and Dave Ahern. To provide step-by-step premium investing guidance for beginners. Your path to financial freedom starts now.

Andrew (00:32):

Welcome to the Investing for Beginners podcast. This is episode 168 tonight. We’re going to talk about asset allocation. We still do have Dave with us here tonight. But I’m going to be asking him some questions on asset allocation. It’s something he’s been working on behind the scenes for several months. And so it’s a very important topic. We get questions related to this all the time. I think a lot of times, investors don’t know that they need to learn about asset allocation. Embedded in their question might be thoughts about asset allocation. So, Dave, first we’ll start. Let’s say somebody is either just gone inheritance as an example, or maybe saved for many years, and you know, we’re talking about life savings, and they’re getting close to retirement. So in either situation, there might be different ways of looking at the portfolio. So when somebody is looking at a situation like that, where they have a significant sum and either, you know, the timeline’s kind of shrunk or the sum they have now needed to last them for the rest of their life.

Andrew (01:44):

Let’s say, what kind of things are, give me an example of something different from somebody else who’s maybe putting a portion away every month and what, why that’s, why that’s different in that case?

Dave (02:00):

Well, it depends on the timeline, and that’s something that you brought up. It comes down to the timeline and where you are and what your goal is. So for example, let’s say that somebody comes into an inheritance and they have quite a bit of money, but maybe they’re 10, 15 years away from retirement. They want to use that money to last until they go into the great gig in the sky, or however, you want to put that that has a big impact on what it is and how you set up your portfolio. And some of the things that I’ve been learning about the asset allocation are seemed intuitive and seem natural. But when we sit down and have to put numbers to situations, it becomes a little more difficult. And one of the things that you have to think about is, for example, let’s say that you’re ten years away from retiring

Dave (03:00):

And you got a big chunk of money, and you want to do something with it. Well, there are several things you have to think about. The first thing you have to think about is how much risk can I tolerate? So, in other words, how much volatility and how much ups and downs can I take and how much do I really, when I, I guess, gamble on drawdowns or the stock market is falling right before I retire. And that would be the, to say the least, and extreme bummer. And so when you’re thinking about your portfolio, you have to think about how, kind of, how kinds of, what kinds of things do I want to allocate my money to. So for example, if you’re closer to retirement, starting to think about having safer funds or having less of volatile stocks to invest in is something that you want to strongly consider looking at an allocation of there’s the popular portfolio, which a lot of people talk about, which was for a long time, was kind of considered the standard.

Dave (04:10):

And that was the 60 40. And really what that meant was depending on where you were at your timeline of retiring, you would want to put 60% of your money in stocks and 40% in some sort of fixed income, whether it was bonds or anything of that nature, CDs, bank accounts, things of that nature, whatever we’re going to be safer, more stable income earners that are not going to be as volatile. And the reason for all that is because over the long term, as Andrew and I have talked about, stocks are going to have greater returns. The flip side of that is they also have more volatility. In other words, you’re going to see periods where the stock market overall is not going to do as well. For example, we just all went through a horrible period in March where we thought the sky was going to fall and everything crashed in some cases, 30, 40, 50% in days, which is unheard of now, it’s all rebounded very quickly, for the most part, not everything.

Dave (05:14):

There are still subsectors that are still are struggling. I E banks and insurance companies, but by and large, especially if you’re in tech, those have all soared through over the last five or six months. But by and large, there’s been, there was a huge drawdown and then it’s kind of all rebounded, but that’s now that’s not always been the case in the two thousand when the market burst it did rebound, but it took a while for it to rebound. And then, all of a sudden, we turned around and had a great financial crisis in 2007, 2009. And you saw in that case anywhere from 30 to 50%, 60% losses, and then it took years for that to get back. I read today that if you had lost all of your egos if you had gone through a drawdown in 2000, it would have taken until 2013 to get back to the same level.

Dave (06:10):

And that’s with being invested in equities and stocks. Now the bond market has it generally is correlated reversely of stocks. So generally, when stocks go down, the bond market goes up and it, it kind of functions on a Teeter totter. And that’s why when you are looking at a portfolio like that, the 60 40, for example, that helps you balance everything out so that when your stocks are going through a rough time, your bonds can do better and can help keep the portfolio going. So the stock market generally overall has returned between eight to 10% over the last 80 to a hundred years. When you look at a portfolio breakdown of something like a 60 40, for example, the returns on that kind of portfolio over the same period has been around eight to eight and a half percent, depending on which equities you choose.

Dave (07:14):

And so that tells you that it doesn’t make as much money as a hundred percent portfolio would, for example, but it does do pretty well with a lot less volatility. In other words, when you go to bed at night, you’re not laying up laying in bed stressing about wondering if the five stocks that you have in your stock market and your stock portfolio are going to crash tomorrow because you’ve been reading about all these horrible things that are going to happen, or it already had to start to fall. And you wonder if it’s going to continue. And so when you’re looking at constructing portfolios, those are some of the questions you have to think about. So how close you are to retirement, how much volatility can I handle? How many ups and downs can I handle? And also, what kind of risks do I want to take?

Dave (08:04):

I’m not a huge proponent of more risk means more returns. I’m more thinking of risk along the lines of how much money can I possibly lose over some time before rebounds and how the patient can I be with the bonds that I’ve chosen and how long can I allow those things to be down before they recover as a whole if you’re in the market. You stay in the market, Andrew and I have talked about this many times where things go down, even if you buy at the lowest point or the highest point and woos, if you stay in a market, you’re still going to win. So overall, you’re going to do well. But when you’re talking about asset allocation and all those aspects of it, as much as it, as we want to talk about picking stocks, it also comes to how you kind of diversify your portfolio, such that you have different kinds of assets in your portfolio.

Dave (09:05):

Now, there are a million different kinds of variations on all the different asset allocations that you can go 60, 40 used to be the standby. I was listening to a video of the interviewed John Bogle, who was the director, the creator of Vanguard, and is really kind of the, I guess, the early proponent of the idea that you need to have some sort of asset allocation, kind of like what we’re talking about. And he was saying that 70, 30, or even 80 20 in today’s world is probably similar to the 60 40. And that a lot of that has to do with the impact of the low-interest rates and the Fed’s involvement in trying to prop up the markets over the last 10, 12 years. And so he thinks that some of that had changed, but generally, as a rule, to go back to what we were talking about the beginning before I went on a tangent, sorry about that.

Dave (10:03):

I was looking at the asset allocation that you want to have, and how much of your portfolio you want to put in the stocks now; along with all that, you have to choose the different stocks and the different bonds that you want to have in the portfolio. Now you can simply just go with one stock ETF and one bond ETF if you want to go that simple. But if you want to try to beat the returns that the market is going to get, then you have to choose different stocks, and you have to choose different bonds and have different kinds of, of mixes of all those things to help you get the best that you can get.

Andrew (10:45):

That was a lot. It’s good. Let’s, let’s back up for a second. I think there are obvious things that I can pick about once you mentioned that with the recommendation at the end, but I feel like we don’t talk about bonds enough. You know, there are good benefits for diversifying your asset classes, particularly when, as you said, you don’t have a long enough timeframe necessarily to either way out a stock market crash, or, you know, if you need income or you need some of that money, whether you have the patients or not, sometimes you have to sell out. And so if you have too much in stocks, I can see where, you know, you would lock in some losses, and that would not be ideal. So can you talk about bonds? And, you know, sometimes our, you know, generally, as you said, bonds can go in versus stocks, but sometimes they can also fall in price even when stocks fall in price. But when bonds fall in price, it’s like a way different story than when stocks fall in price. So can you talk about bonds a little bit? They have those features Why they’re different from stocks and then why that’s beneficial for asset allocation.

Dave (11:59):

Yeah, I’m so, bye Are probably one of them, I guess on the side of one of the least understood assets that people get involved with, and there’s a myriad of ways that you can get involved with bonds. You can go the corporate bond route; you can go the municipal bond route. You can go down the rabbit hole of looking at treasuries and all the different intricacies of all those, but the main, I guess, aspect of, of a bond is

Dave (12:35):

The fact that it’s a, it’s a debt. So what it is is this think of it as a loan. So when you hand over your a hundred dollars to buy a treasury, for example, the United States government is giving you an IOU for that a hundred dollars. Now what’s happening is, is that you’re not just going to give them a hundred dollars just because you’re a nice person. You’re giving them a hundred dollars because you expect something back in return. And the return generally comes in the form of a coupon or a dividend or anything of that nature. So really what’s happening is, is that when you buy a bond, you’re buying income that you’re going to get every six months from the bondholder, whether it’s the United States government, or whether it’s Microsoft, it doesn’t matter. They’re going to pay you for the privilege of you loaning them that money.

Dave (13:32):

And now, depending on how long the duration is of the particular bond, you’re going to get that money back. So if you give them a hundred dollars, you’re going to get a hundred dollars back. Now you can buy and sell bonds on a Mo open market, just like anything else. Now, the trick with buying and selling bonds is that it is generally, you gotta, you get it. You’re going to have to flow it out there, with a big chunk of money, because by and large, most bonds are sold in the thousand to $10,000 range for groups of them. And so you’re not always able to just buy a share as you can stock. So when you buy the bonds, you have to, you have to pay the full sticker price, or par value is what they call now. Sometimes the par value of those will they trade just like socks do.

Dave (14:25):

And sometimes they rise, and sometimes they fall. And it, a lot of it depends on the interest rates, and when the interest rates are low, then the prices of stock, I’m sorry, bonds will rise and vice versa. You know, that also inversely correlates with the yields of the bonds. And that really what that means is the returns that you’re going to get on the bond. And as the yields go up, you get a greater return. And as the yields go down, you get a lesser return. And because of that whole correlation to interest rates, the stock market is kind of inversely correlated with that. So, in other words, when the interest rates go down, then the bond markets suffer, but the stock market generally surges. Le and vice versa because of the way of the debt works because the way the debt works is when you borrow something at a low-interest rate, it means you can use that money, and it costs you less to pay it back where it is when you’re borrowing the money, and it costs you more to pay it back.

Dave (15:36):

It becomes less efficient. And so when you’re dealing with debt, which is what bonds are, and we’re not talking about like a car loan, or, you know, Guido’s not going to come knocking at your door. If you miss your payments, you’ve already made the payment for the debt, and you own that debt, and they are, they have to pay you back for it contractually. So when you’re talking about investing in bonds, really what you’re looking at is, for the most part, people invest in bonds, looking for a return via a dividend or a coupon payment. And that’s the main source of income. You can make money off of trading from the price growth or fall of bonds, but most people invest in bonds for the fixed income. And the reason why you call it a fixed income is because when you buy a bond, and it has a 3% coupon, that means that they have to pay you a 3% return over the life of the bond that you buy.

Dave (16:41):

So let’s say that you buy a ten-year bond, then over the life of that bond, if you buy it a thousand dollar bond, they’re going to pay you $30 over the, over the ten years of that bond and that’s fixed income. It won’t go up. It won’t go down. That will never change. The 3% that you’re going to get from the yield on that bond will not change. The yield can change based on the price of the bond. So as it rises or falls, that yield could change, but the $30 that you’re going to get will stay the same era regardless. And so that’s why they’re referred to these things as fixed income. And so when you’re looking at investing in those types of securities, just like investing in a stock, you’re looking for that return. And the nice thing about investing in bonds, especially when the market is so fluid.

Dave (17:37):

And there are so many things going up and down is that is guaranteed money that, you know, you’re going to get every single six months and every year you’re going to get your payment from your bonds. And, if you have more than one bond that pays you $30 over ten years, you’re going to make more income. But as you look at increasing that portion of your portfolio to bonds, that means that you can generate more fixed income from those bonds. So does that help answer the question? It does. I guess the one thing I would feel nervous about, you mentioned how interest rates and bond prices could move with each other. Why the interest rates can, can move the bond prices. So, you know, that sounds like the stock market. Why is it different?

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Dave (18:38):

It’s, it’s, it’s different in the fact that different bonds are going to move differently. So a perfect example of this is something that is called a junk bond. Now, a junk bond or another term for it, which is maybe not so derogatory as a high yield bond, high yield bonds are more closely correlated to the stock market than other corporate bonds are. So, for example, if you’re looking at a bond that has a junk rating, I’ll give you a, so we’ll throw this out. Tesla has bonds that they sold that were junk-rated. Those are cool, more closely tied to the performance of the equity of Tesla than let’s say, for example, Microsoft, which has a AAA rating and their bonds are very, very, very safe. Now their stock price is, you know, has some volatility to it, but if their stock price goes up or down, the bond is not going to change much because of that.

Dave (19:41):

And the reason for that is the bond is tied to the debt of the company and the stronger the company is. And the less chance of default there is for the company, the less correlation there is to the stock price of the company. So, for example, because Microsoft has such a strong balance sheet and is such a strong financial position, it does not correlate the bond and concerning the stock market. In contrast, Tesla, because they are for all the different reasons that we’ve talked about before, they’re a very, very financially unstable company. And the bonds are closely related to that because if the company goes bankrupt, then the bonds have a very good chance of not getting paid. In other words, if you paid a hundred dollars for a bond of Tesla, there’s a, there’s a very good chance that if the company goes bankrupt in a, they have to sell everything, there’s a chance you won’t get your money back. Whereas if Microsoft is in the same situation, you’re assured of getting your money back. And so they’re there and why’s the correlation of bonds to stocks. Does that make sense?

Andrew (20:56):

That makes a lot of sense. Yeah, that was a great explanation on that. So I guess moving forward, you know, we’ve presented a big problem with, you know, let’s say a limited timeframe where we’re talking about asset allocation of a large amount. Maybe you need to draw from the money. Maybe you don’t, but a limited timeframe or a similar kind of need where volatility needs to be reduced. So, you know, we’ve presented the problem. You’ve presented a solution of allocating partly towards fixed income, like bonds, and how that can help during stock market drawdowns. Is there anything else we’re missing from that picture so far?

Dave (21:45):

There are a couple of things. So the first thing is not only do you have to think about how the portfolio is constructed, I E versus equities versus some fixed income. There’s; also, you have to think about the assets that you have under each umbrella. So, for example, if we’re talking about stocks, I am very comfortable thinking about companies that are involved in financial industries, whether it’s banks, insurance, companies, those kinds of things. If I have a portfolio full of all, just banks, for example, my returns are going to be very closely tied to that particular sector of the market. And that can lead to a lot of volatility. It can lead to a lot of poor performance, especially if that particular sector of the market is beaten up for a long period. Let’s take, for example, looking at the travel industry recently; if you had the majority of your stock picks in that aspect of the market, you would struggle for a while.

Dave (22:54):

Recently, the carnival has started sailing cruises in Italy. I saw that in the news today and there, their stock price did, did well today. Still, the longterm prospects for that company are closely tied to everything that’s going on with COVID and same thing with the airlines, the same thing with the movie theaters, all those kinds of things that are tied to entertainment are very closely aligned to what’s going on with the pandemic. And so when you have a large majority of your portfolio tied into one sector, then you’re going to run in, you could run into potential problems. Likewise, the same would fall with bonds. If you have all of your portfolios in bonds are all in junk bonds, then they’re all going to be closely correlated to what happens in the stock market, because of what we were talking about a moment ago with Tesla and Microsoft.

Dave (23:51):

Likewise, if you have all of your bonds allocated to only corporate bonds, then you’re going to suffer a war returns because you don’t have enough allocation in other things that can make you a little bit more money, albeit with a little more risk. So you have to kind of, you have to learn how to try to balance it. And I’m going to go back to something. Warren Buffett said Warren Buffett when he talked about, let me rephrase that. When he talked about asset allocation, he felt like in the early stages of his career, that Alice asset allocation was something that people that were not comfortable investing in the stock market was, was something that they would wean on, but has he got older? He didn’t. I noticed, and I noticed that his portfolio in Berkshire Hathaway, as well as you’re halfway itself diversified.

Dave (24:54):

And you think about all the companies that Buffet owns now he owns insurance; obviously, he also owns railroads and banks, but he also owns things like a dairy queen and construction companies and tool, era airline companies that make tools for, for airlines. He has a wide range of different businesses under his umbrella now, and the same thing with his investments in the stock market. And so he has he’s diversified so that his companies now are, can handle different kinds of stresses, the things going on. And that’s one of the things that people sometimes get so focused on; maybe all the stock picks that they forget about the asset allocation part of it. And the other part of it is sometimes they focus so much on the asset allocation that they forget about the stock-picking part of it. So you kind of have to have all of those things combined.

Dave (25:49):

And then the third thing you have to think about is how you rebalance the portfolios. And there are several methods of doing this. And some of the things that I’ve come across in my research is a lot of people look at, for example, I have, I have a 401k. When I worked at Wells Fargo, I have a 401k, and they automatically adjust the portfolio for me every six months. And what they did was, is they took part of the portfolio that was doing well, and they would sell that and the money that they would make from that they would use to buy things that weren’t doing so well. So by doing that, they were selling high and buying low, which is what all investors want to do. It was awesome. At first, I didn’t realize that, but then, it struck me one day when I was talking to the financial advisor that I worked with, and I was like, wow, that’s brilliant.

Dave (26:45):

And so that’s one of the things that a lot of people don’t think about when you start with your asset allocation, it’s not just setting it and making your stock picks, picking your bonds. And then, off I go to the races; you have to look at it from time to time to make sure that those aspects of the portfolio are staying within the realm of what you want to stay in. Because what could happen is, for example, let’s say you buy a company, a and the stock goes crazy and goes through, through the roof, and maybe it was 10% of your portfolio. And then you turn around, and five years later, it’s now 42% of your portfolio. So now all of your wealth is tied up in this one particular company. Well, God forbid something happens with that company. And now all of a sudden, you lose everything, and it can happen. It’s happened. It could happen. But if you look at balancing and rebalancing the portfolio periodically, it doesn’t have to be every month, and it shouldn’t be every month. Still, if you do it six every six months, or if you do it once a year, then those kinds of things can help you keep the portfolio in the percentages that are at least in the realm of percentages that you want to to keep the goal going, you know, the ball going where you want it to go.

Andrew (28:06):

I think, yeah, that’s such a huge, like a huge, not caveat, but it’s, it’s a huge distinction that needs to be made. I mean, there’s a big difference between 40% of a portfolio, and you still have 25, 30 years to retirement, right? Where you’re still going to be putting in a lot of money into a 401k or a Roth IRA. And you have a lot of catch up money and deposits and stuff like that, where that huge position size will start to decrease as time goes on, whereas where you’re talking about 40% of somebody’s lifetime wealth, and maybe that, that needs to be the phrase we use When we talk about, you know, whereas asset allocation, not only like most helpful, but it’s like life support in a way, you know, like if you’re talking about lifetime wealth and managing lifetime wealth, whether through an inheritance, whether through life savings accumulated over decades, right? That’s a huge thing, right? And one little, one big major piece of anything that you discussed, that’s missing can lead to huge losses of lifetime wealth. That can be way more detrimental than the fact that we, you pick a wrong stock tomorrow or something like that. Right?

Dave (29:27):

Exactly. And if you make, if you make a mistake, Can you pick one bad stock, and it doesn’t perform. And it happens to all of us; there’s nobody perfect, including myself. And we will make mistakes from time to time. But the trick is to learn from them and cut your losses and move on. But if you allow things to grow out our proportion, then those kinds of situations can become a problem. And those are the kinds of things that when you’re managing your portfolio, you have, you have to take into consideration because like you were saying, there’s so much to risk, and there’s so much possibility. Now when you’re like me, and you’re 53, and you’re closer to retirement than Andrew is, you know, he’s still a young man. You make a mistake with one company, and it doesn’t do as well. You have time to recover, but when you’re getting like I am, and you’re getting closer to the, to the goal of being able to lay on a beach and, you know, drink my ties all day then paying more attention to those things is, is a lot more vital.

Dave (30:43):

And you are having to think about how I want to allocate the money that I have because it has a bearing on not only the money that you have now but the money that you’re going to have 15, 20, 25 years from now. And if you want to leave money to relatives, if you have a kid you want to help pay through school or any of those kinds of things, those are all things that you have to take into consideration and think about how you want to manage and adjust all these things. And it’s not just about buying something and selling something. It’s also about the choices that you make and what kind of sectors you want to put the money in and what kinds of risks you want to go with. And there’s nothing wrong with going with, you know, more bonds than, than equities, if that’s what you’re comfortable with, but it comes down to what are your goals and how do you want to set things up? And how much of this do you want to manage?

Andrew (37:19):

So I know we’ve been working behind the scenes on, on something related to this. Maybe this would be a good time to talk about and kind of intro what’s been going on behind the scenes.

Dave (38:10):

Yeah, absolutely. So Andrew and I have been thinking about this for a while, and we have felt like there has been a need to help people with constructing portfolios and looking at asset allocations and different aspects of building a portfolio. So I have put together a newsletter that we’re going to release once a month that has different ideas of different companies and stocks, as well as bonds and helping them construct a portfolio that they can follow along, that I will be putting my own money into as well. And this is really more geared towards people that are looking for help building a portfolio and not just picking stocks but helping look at the different asset allocations they could have. And how do I construct a portfolio? And as we’re getting closer to the finish line, this will be something that can help people that are struggling with that aspect of investing.

Dave (39:20):

And these are things that I’ve been doing for a while now. And this is something that Andrew and I have talked a lot about, and we feel like this is the right time to try to help people with that are kind of in the same situation than I am that they’re closer to the retirement age. And they want to look at, they have larger funds that they want to use, and they want to look at trying to find great picks that they can use as well as bonds, as well as, you know, a safer aspect to the portfolio. And they just have different goals. And we thought that this would be a great way to help people.

Andrew (40:00):

So what’s it called.

Dave (40:02):

Fat Pitch Fundamentals.

Andrew (40:05):

Yep. I’m excited about it. Obviously. I love the hat tip to Warren buffet being inpatient events. They’re there with the fat pitch aspect. I will be contributing to the newsletter, as well. I will be covering industry weightings of the S and P 500 and the very first issue I’ll also be covering the currency developments with the US dollar and also looking at geographic segments.

Andrew (41:06):

And so I think the newsletter we’re providing does offer great value from that perspective. You get to hear from me; you get to hear from Dave. And I know Dave is going to have a lot of great insight into a lot of the problems that come with asset allocation and how to deal with that while still incorporating all of the principles and fundamentals that we try to teach on the podcast. Things like buying stocks with a margin of safety emphasis on the safety things like being patient for the longterm, but also understanding that, you know, you’re trying to limit volatility. I think all of those things are, can be hard to manage, but we’re hoping with what we’ve come up with that it’s, it’s something that, that pushes that forward for a lot of people.

Dave (42:01):

Yeah. Thank you. I think I think that’s a very eloquently says what we’re, what we’re trying to do. It comes down to; we feel like that there’s a need, and we want to try to help people. And we feel like this is probably the best way that we can go about trying to, to throw something out there that can help people with, with the struggles that they’ve been having.

Dave (44:11):

All right, folks. Well, that is going to wrap up our conversation for tonight. I hope you enjoyed our conversation on asset allocation, and you guys weren’t a finger too. If you have any questions, please let us know we’re here to help. So without any further ado, I’m going to go ahead and sign this off. You guys go out there and invest with a margin of safety emphasis on the safety. Have a great week, and we’ll talk to you all next.

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