At some point, we should expect this historic market will have a tumble. The S&P 500 has dropped 30% to 50% five times in my lifetime. When it drops, sometimes it can take more than a decade to get back to even. At its worst, the S&P 500 pulled back 83%! If you retire in one of these periods, it might mean jarring cuts to your standard of living. Some very thoughtful people believe one of those periods could start any day now – how do you sleep knowing that?
The same way you get in the car when you have some place to be. There are about 10 million autos accidents each year. Considering the hours we spend driving, we should expect to have a few accidents in a lifetime – maybe tomorrow! Yet, we drive anyway. I think it’s because we know that by following a handful of rules, we can dial the risk down significantly. If you follow speed limits, if you don’t drive under the influence, if you don’t text and if you rest when you get drowsy – you’ve greatly decreased the odds of a serious accident. Add insurance, and you can remove the financial risk. You can’t get to zero risk unless you just never get in a car, but then it’s almost certain you won’t get to where you want to be, at least not on time.
In investing there are also rules that can reduce risk and increase the probability of reaching your destination on time and feeling good. You can eliminate investment risk by not investing, but then you are not likely to arrive at your destination. We love the challenge of this balancing act, to seek the best compromise between fear and certainty for clients that will get them to their destination on time with as little risk as possible. Here are ten things we believe help us do just that for our clients:
- We clearly define the real objective of investing. It is to make sure our clients have enough money to pay bills, enjoy life and share with loved ones at some time in the future. Outperforming arbitrary benchmarks is not the objective.
- Knowing the objective, then we can identify the real risk. Risk is failing to have the amount of cash you need or desire at the time you need or desire it. That’s what we want to avoid. Risk defined as day to day market movements is interesting, but not all that relevant.
- Step one and two have to do with future cash flow planning. Before considering investments, we increase the probability of having plenty of money in the future by being smart about present cash flow. We increase savings rates, reduce consumer debt, reduce fees and expenses, and become purposeful about where the cash is going.
- After cash flow, we work on the balance sheet. We separate assets into offense and defense. We include everything clients own that can generate spendable cash in the future like a business, real estate, everything… not just stocks and bonds. Defensive assets are those that can provide near certainty that we won’t lose money needed in the short term. Offense assets should offer higher returns that, despite some volatility, compound to provide needed spending money decades from now.
- Once we allocate between offense and defense based on the circumstances, we rely on a variety of high quality investment tools to get the job done. We are open-minded about which tools they are, but we verify their effectiveness.
- For defense, those tools currently include things like cash, short term government bonds, corporate bonds, and municipal bonds. We use insurance issued products like fixed or indexed life insurance, and fixed or indexed annuities. We use a mix of these tools because together they give us a high probability of meeting client’s objectives while protecting principal for the short run.
- On offense, our tools include large US passive index funds or ETFs. We invest similarly in international markets. We also use active managers, trading strategies, and alternative holdings that we believe are effective at protecting principal when things get bad and generating good returns for patient investors. Those include value stocks, quantitative trading strategies, commodities and real assets, and trend following. We use a mix of these tools because together they give us a high probability of meeting client’s objectives by significantly outpacing inflation when given time to perform.
- For larger portfolios or accredited investors, we include well vetted private investment opportunities to further diversify and reduce correlation to public markets.
- In every asset category, we search for proven professionals and providers that are deeply vested and long successful in their specialty.
- We don’t watch CNBC.If we have done our job, the last thing we need is mass media or social media creating fear and doubt about our long-term plan. That’s when the big mistakes are made. Instead we read books and thoughtful articles and seek out industry veterans to constantly learn.
What do we expect from all of this? We expect to significantly increase the odds that clients will make it to their destination on time and feeling good. We expect bad things will happen, but we will be ready. We expect to sleep well at night, even if no plan is perfect.