simplicity

A simple method of asset allocation

Posted on April 4, 2020April 4, 2020 by The Tortoise

As I started to write this post, I decided not to rant about the Corona Virus and its effects anymore. The last two posts were dedicated to the topic and frankly it is becoming a little bit weary to add to all the deluge of information and opinions on it.

Let’s look at the current situation as nothing unexpected, at least financially. Being a financial blog, let us generalize this to another black swan event, and not worry about the statistics of no. of confirmed cases vs. deaths etc.

What is a Black Swan event?

A quick Google search yields the following:

An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. This term was popularized by Nassim Nicholas Taleb’s book “The Black Swan: The Impact of the Highly Improbable.”

Lets leave it to that and consider we are in the midst of one such situation.

The keyword in the above definition is “would be extremely difficult to predict”.

No matter what financial experts say about the markets, about investments, using sophisticated algorithms to trade stocks, the fact remains that such events are not predictable by even the multi-PhDs of Finance.

In the beginning of 2020, most of us did not know that a black swan event is so much closer, although experts have been predicting recessionary clouds for last 2 years or more.

The effect of such an event is the havoc it can do to your savings and investments. Yes savings too, as we don’t know which banks or financial institutions will go under the water, and whether government stimulus can rescue them.

It may be a rare event so far, or some rescued in 2008 but we cannot guarantee with every black swan event. Just in Feb 2020 (when it was still normal business), a very large private bank in India went bust taking with it hundreds of thousands of dollars worth of deposits of very normal people. Ironically the bank was named “Yes” bank.

Similarly by end of March 2020, the stock and mutual fund portfolios are down 20%-50% depending on how much risky the portfolio was to begin with.

The only respite from all of this is to maintain a good asset allocation as each investment avenue has its own risks. Some of the typical risks are:

Cash – Banks going down and Government struggling to insure the deposits.
Stocks – Markets tumbling for an extended period of time due to economic fears.
Bonds – Risk of default as even good companies’ bonds can turn into junk debt very quickly. Lot of mutual funds in India were invested into Yes Bank bonds. Long term bonds can also run into interest rate risk.
Real Estate – Somewhat resilient but affected by vacancy, interest rates, unemployment.

If your finances are severely affected by this storm, how do you achieve a good asset allocation once the clouds are gone and the sun is shining again on the stock market?

KISS – Keep it simple, stupid

Its not overly complicated although some financial experts make it so. Let’s say I want to hold 25% each of the 4 asset classes and distribute my assets accordingly.

Here is a step by step method on how to achieve this. It is better done in an Excel sheet as the calculations can be automated and even graphs can be plotted, although equal allocation is easy to visualize anyway.

List down all your assets into one column which comprises your Net worth including your home and any other property you own.
Now in a second column, list the value corresponding to the asset. Be conservative, do not add any speculative value.
- For your home, just take the equity value that you have.
- For stocks or mutual funds, take the present value.
- For any bond investment, take the invested value or the expected maturity value (if the term is not too long).
Now add 4 columns for the asset classes.
The chart should start to look like this. Here is a simple example of a $100,000 Net worth.

Now based on the asset class for each, fill the right side columns in the right proportions. For example the mutual funds may consist of equity funds, bond funds and REIT funds in equal proportions. For each mutual fund, a look at the fund report will reveal the proportions of these asset classes that it invests in.
Fundrise is just an example of a private REIT that is considered real estate asset class but in paper form. It is only for illustration and I am not an affiliate of the investment fund.
Once you allocate the numbers to the 4 asset classes and add up each column, it will become visible how your asset allocation is skewed.

A visual inspection of the numbers reveals that this portfolio is heavily skewed towards Real Estate due to the largest investment in the Home. This is true for most people, as their largest investment is their home.
A more vivid depiction of this can be drawn using the Excel chart.

How to balance it? There is no ideal asset allocation as it depends entirely on the person’s situation, age, risk appetite, goals and many other factors. It is only after this simple analysis that one should approach a financial coach or investment adviser.
For example, if the person (who’s portfolio we have just analyzed) is not happy with the Real Estate skew, he can allocate future investments more towards Equity or Bonds (or even Cash), than buying more real estate or paying down his mortgage aggressively.
Being overweight in Home Equity can mean house poor and the person will find it difficult to raise funds or access cash in times of emergency or other life goals.

Conclusion

The beauty of this asset allocation method is that in a simple exercise which takes less than 10 mins and one sheet of Excel, you can look at your entire financial picture.

It gives you a quick overview of your Net worth.
It gives you the current asset allocation you have.
It tells you where your financial situation is vulnerable to market, liquidity or economic risks.
It tells you what action you need to take (whether to sell some or boost up another) regarding the various asset classes.
It directs how your future investments should be structured.

The value of this exercise is immense and a good asset allocation can let you sleep in peace when the entire world is savaged by another Black Swan event.

photo of building during daytime — Photo by Matthew DeVries on Pexels.com

Personal finance

The Power of Financial Scribble

Posted on February 23, 2020 by The Tortoise

A picture is worth a thousand lines of a spreadsheet.

Managing your personal finances can be scary at times when you visit a financial coach or financial planner.

Any good financial planner worth your money will present data in a nice spreadsheet or make you fill a template form which has 30-40 questions about your current situation and your goals.

After filling out the form or trying to decipher the complicated spreadsheet and charts, you wonder if you have made any progress in your financial planning. The concept of simplicity gets ignored in the data and jargon.

Personal financial planning has to start with your goals, what you have today and where you want to reach. It is not about numbers on a spreadsheet, but more about what is your current life situation and where you want to go in next 3, 5, 7 or 10 years.

How do your write your goals in a spreadsheet or a predefined questionnaire? The answer is you simply can’t. These tools are built for data collection and analysis and not for top down planning.

The solution lies in a much traditional tool, pen and paper – even better pencil, eraser and paper. I find it extremely refreshing to write or draw my goals, current situation and how I want to go where I want to go.

It is what I call the Financial Planning Scribble.

Financial scribble

It is a lot of fun and creativity as you design your own symbols to represent personal finance as possessions,liabilities, plans and road map.

Lets say you are assessing your Net worth (your assets – your liabilities). Your assets may contain real estate, cash, stocks, bonds, gold. Now think of a symbol for each along with a space to write the present value of the asset.

For example, for each real estate you can draw a house (remember the 3-D cube with triangle for the roof) and write the value in between the figure. Similarly use an envelope symbol for your cash (even though it is not hard cash but balance in your checking account). Your vacation fund can be a picture of your favorite spot (beach or mountain) and so on…

Go creative with your assets… you have built them with sweat, sacrifice and planning. They deserve to be given a life and make you happy about them.

Photo by Andrea Piacquadio on Pexels.com

The second part of Net worth are the liabilities, or in other words, what you owe. You should not feel good about these unless you have a plan for strategic leverage, like building your rental real estate portfolio with debt or student loan to finance a good education.

Your liabilities can be depicted as something that may scare you and force you to act to reduce them. Again go creative here as per the kind of debt. High interest credit card debt is a demon with blood in its mouth, as that is what it is doing to your life and finances.

The idea is to depict your personal situation today as accurately and vividly as possible. This is not always apparent in a numerical spreadsheet. The demons should scare you and the vacation fund or investments should make savings feel worthwhile.

The difference between the two (assets and liabilities) is your Net worth. See if the residual picture (your bright side covering the dark) is positive or not. You can find a symbol for the net worth, positive or negative.

Once you get to the habit of scribbling and sketching, you will find it so useful and refreshing that you can extend it to beyond Net worth.

Your investments and asset allocation can also be depicted through sketches and you can even draw your plan and ongoing monthly investments.

Conclusion

The idea of financial scribble is not to get too complicated and lose interest in tracking finances. Finance can be fun once you depict it in your own way, not in a financial planner’s jargon and spreadsheets.

Financial scribble helped me internalize my personal situation and plans, in a clear and concise way that anytime I can draw it on a piece of paper and use it to make bigger decisions. A very rough scribble (you can be definitely be more artistic) from one of my recent planning sessions is shown below.

Investing, Personal finance, Savings

Afraid of investing? Not so simple either

Posted on November 27, 2019 by The Tortoise

There are two aspects of investing that are often in war with each other. Fear and Simplicity.

This post is going to look at these two traits of investors.

While Fear is a natural human reaction to market gyrations and an impediment to investments, lack of simplicity on the other hand is another destructive feature of investor behavior.

Fear

For any investor starting on the journey of personal finance and investment, fear is the first thing that comes to play. Following are very common symptoms and questions.

What if the stock market goes into a downward spiral?
What if the real estate that I buy goes down in value or the rental property is trashed?
Even with perceptibly safe investments like bank CDs and money market, the bank can run into liquidity issues or simply go out of business.

It is this kind of fear, especially the one regarding stock market that keep investors waiting on the sidelines for months and years. And then when the stock market is up, they become euphoric and participate in the bubble, only to confirm their worst fears when the market tanks.

On the other hand, as an investor matures and gets the thrill of investing in the stock market, real estate, he becomes bolder and starts investing in all sorts of esoteric investments like lending products, life insurance cash value and derivatives, futures, options.

While it is good to constantly look for opportunities to make your investments work, one of the fundamental rules of good investment is : “Invest only in what you understand.”

This has become a cliche since the time Warren Buffet revealed that he has followed this principle throughout his investment career. However very few investors have the discipline to keep their portfolios that simple to understand.

Sometimes it is also done in the pretext of diversification. But there are enough easy to understand investment avenues that give instant diversification.

In this post, I wish to provide some solutions on how to deal with these two conflicting behaviors, which are destructive to wealth building.

Solutions

Confront the fear – know thyself and create a plan
Disciplined investing – Time is more important than timing
Correct Diversification – Choose products with built-in diversification
Asset allocation ratios – How to diversify across asset classes
Unconventional investments – Tear down the cover
Load than buy new – Grow vertically, not horizontally

Confront the fear – Create a plan

The best way to address the fear of the stock market and other investing factors is to have a plan.

A plan consists of a hierarchical set of investments that cushion the risk. The plan has to be highly customized to the individual but here are some generic guidelines.

Have an emergency fund – Keep a stash of money in low risk bank accounts (with FDIC guarantee) that can act as ready money available in a bad economy and job loss, unexpected expenses etc. Typically the stock market takes about 12-18 months to recover when it tanks, so some people can be ultra-conservative (specially if one is planning to retire early) and keep cash to tide over expenses for these 12-18 months.
From your monthly budget for investments, allocate a small portion (10%) to play-it-safe, for example to grow the emergency fund or some kind of fixed income investment.
Invest in well diversified index funds first before any other investment. These are low cost and perform well over a long period of time. The S&P 500 index is known to return about 9-10% over multiple decades of time period.
Assign a time value to each investment account and invest accordingly. For example, 401-k accounts are for long term, brokerage account can be for medium term and CDs for very short term. That way, there will not be any pressure to withdraw or sell when the market or economy tanks.
Go slow and do it right with real estate investment. This is the biggest investment we make in our lives and for most people, it is emotional and hence not done with right investment mindset.

Disciplined investing – Time in the market is more important than timing

There are times when we read about a particular investment or hear about it on the news channel, and want to jump in right away. For example, this year 2019, REITs performed exceptionally well and the Internet is full of articles on how to invest in REITs.

But next year it may not be the same. Does it mean I do not invest in REITs? I do invest but in a defined proportion and in the account that is shielded from distribution tax.

Similarly chasing the highest performing stock or mutual fund will result in only speculation, not investment.

Keep your investment in a monthly mode once chosen, by setting up automatic investment plan.
If you are well diversified, you do not need to worry about which asset class is over-performing. That is the purpose of diversification, isn’t it?
Time in the market is more important than timing the market. This simply says keep investing in the same asset month after month without worrying about Mr. Market.

Correct Diversification – Choose products with built-in diversification

Mutual funds, ETFs, REIT Index funds are all products with built-in diversification.

Yet there are portfolios that I have seen which are over diversified. For example, holding more than 4-5 mutual funds with overlapping portfolios does not make sense.

Here are few models of simple diversification:

Total US Stock Market Index Fund
Total International Stock Market Index Fund
Total US/World Bond Index Fund
Global REIT Index Fund

I personally have the following combination – 6 funds at present but I am always looking to consolidate with less. May be the last two can be combined with a Total World Stock Index Fund.

S&P 500 Index Fund
Small Cap Index Fund
Global REIT Index Fund
US Bond Index Fund
International Index Fund
Emerging Markets Index Fund

Asset allocation ratios – How to diversify across asset classes

While the above Mutual Funds or ETFs give instant diversification, they are still victims of the volatility of the trading market.

The stock market instruments can move higher or lower depending on the overall sentiments in the economy. However due to automatic investing and reducing the risk in a hierarchical manner, it should be okay to digest this volatility.

Although the mutual funds provide in-built diversification in stocks, bonds – there can be other investment outside the stock market that will diversify at the asset category level.

The following asset classes can be added to a portfolio to spread the risk evenly.

Cash and cash equivalents like CDs, money market.
Stock mutual funds and ETFs.
Real Estate Investment Trusts or REIT Index Funds.
Private REIT like Fundrise.
Real Estate buy-and-hold as rental properties, own homes.
Commodities like gold, silver.

Unconventional investments – Tear down the cover to reveal the costs

There are ambiguous investments where the returns are packaged in a way to show it as an attractive investment. Some of these are wrapped around insurance products, while others are mere speculative in nature.

Sometimes these are also packaged as guaranteed return products like annuities, fixed income insurance products etc. While there is nothing wrong in guaranteed return products, these need to be analyzed to see what return they are actually producing.

The concept of IRR (Internal Rate of Return) and NPV (Net Present Value) provide powerful tools to calculate the real return that can be compared to more traditional instruments like treasury bonds, stocks and mutual funds.

Recently I was offered a product in India where I have to pay X amount per year as premium for 12 years, and then I will get a guaranteed return of 2X per year for next 12 years. It sounds interesting as it guarantees a cash flow in future and produces a absolute double return of the original investment.

But when you put it through the IRR formula for 12 + 12 years, you will see the return is close to 5%. 5% guaranteed return can still be good, if I am okay to leave the money invested for so long. These products typically have very little liquidity. Hence I would have been stuck in the contract for next 12-24 years for a return of 5%. Why not invest simply in stock mutual funds, which should produce more than 5% and with much better liquidity if kept out of IRA accounts?

Similarly I have been offered Guaranteed NAV plans (NAV – net asset value), where it is market linked but the company is guaranteeing a limited upside. The problem is not that we cannot take advantage of such instruments, but we need to understand that thoroughly.

One question to ask always: How is the company making money out of this? If you probe with this mindset, you will see things that were designed to be overlooked by the investor. For mutual funds, I know the answer is very transparent – through the Gross Expense Ratio in most cases.

Load than churn- Grow vertically, not horizontally

Anyone who has done day trading knows the extremes of churning. However individual portfolios are also susceptible to churning by high-beta fund managers, or the investor himself as he loses patience to hold on to a particular investment.

With 3-4 mutual funds in the portfolio, it takes a lot of patience and courage to stick to them when your investment brain is screaming – Do Something, its been a year!!

The best way to get around this very humane behavior, is to divert your attention to saving and investing more, rather than changing your investment vehicles.

If you have to do something, take a look at your monthly budget, analyze your spending and see if you can LOAD up the existing investments rather than CHURN them.

Conclusion

The above steps address both the fear in the minds of investors and also gives them a simple formula to allocate their investments with complete understanding.

My investments are diversified in the following manner, and are stacked in decreasing amount of risk.

Cash in the bank, money markets.
Stock Mutual Funds – passively managed.
Stock Mutual funds – actively managed.
Public REIT Index funds
Private REIT – Fundrise
Real Estate holdings
Unit Linked Insurance Plans (well understood ones)

This is as much diversified as it can be.

#1 and #2 provides enough cushion.
#2, #3 and #4 are volatile and longer term, but liquid.
#5, #6 and #7 are the only non-liquid investments, and I am careful to maintain the ratio of such investments to less than 50% of overall net worth. Only real estate can skew this ratio, since this is a high value and often appreciating asset.

Put your best foot forward with diversified shoes, but ones that you feel comfortable in.

Photo by Ingo Joseph on Pexels.com

Investing, Personal finance

Know yourself and your investments

Posted on August 5, 2019 by The Tortoise

I am back after a long hiatus, as I enjoyed a fabulous vacation in India. These are times when I can introspect and know myself better and deeper. Nothing to do with the spirituality of India, but just an opportunity to separate my mind from the daily rat race, and consider what is really important.

Like everything else, personal finance is also very personal. You got to know yourself thoroughly to understand how to restructure your finances, savings and investments to fit and serve your own unique needs. It cannot be driven by advertised claims from pundits, or hyped up investment professionals.

There are several occasions when I made the mistake of trying out something which did not fit my personality or immediate goals. It was just giving in to the popular notion of what I should be doing, without thinking twice about it.

Once I was nominated or elected for a post in the HoA (Homeowners Association). While the work or responsibility was not very complex, but the surrounding politics and conflicts required a lot of different people handling skills. I utterly failed in this endeavor and quickly realized that it is not for me. I have better things to do and spend my time on.

Similarly as I read more on Real Estate Investing and the numerous strategies, I wonder is it possible for everyone to jump in and spend so much time or build such skills to be successful? Or is it better to stick to your own vocation and invest passively, thereby spend your valuable time doing what you can do best. This will also increase your income and put you through a better path to success. This is of course provided you like your job and not desperate to get out of the 9-5 routine.

Some of the investment avenues that people jump into without much education or risk analysis.

Direct stock investment
Real Estate investment
Life Insurance coupled as investment
Crypto-currency
Exotic Art and collectibles

If you are like me, who likes to keep things simple outside his area of expertise – here is a no-nonsense investment plan.

Try as hard as you can to stay out of debt. Create a budget to track your income and expenses and live within your means. See the post: Budget – Grow the tree upside-down
Maintain an emergency fund and create a cash cushion. See the post: One essential comfort zone
Invest in simple Index Funds and create a goal based portfolio. See the post: Investing in the High Five portfolio
Keep emotions under check and have a realistic plan. See the post: Emotional Investing
Last but not the least, Get Started. See the post: Shun that perfection
Use the following tools to get started. See the post: The Starter Kit

Finally invest in what you understand fully and comfortable in dealing with.

Rest everything can be ignored and continue a stress-free financial journey.