My last blog addressed how people can accumulate capital through managing their expenses and consumption. Many other articles are aimed at increasing your income. So now what do we do with this money once we have it?
How do we make it start working for us to maximize its potential?
The Pyramid approach
First let me say, I am not a staunch advocate of the younger you are, the more risk you can take since you have more time to make it up if things don’t work out. Yes, that can appear to make sense, however anyone who has made money and lost it will tell you that while it teaches you valuable lessons; it’s no fun! This is coming from an ex-floor trader in the commodity pits that KNOWS risk. In hindsight, I would much rather take a structured approach from the beginning than throw “Hail Mary’s” for 20 years in my youth.
The pyramid investing model at least gives you a guideline so that you don’t build the portfolio from the top up.
The base of the pyramid should be wide and stable. It supports the whole structure’s stability and soundness, regardless of the weather. It is meant to be the largest part of your portfolio and the most conservative. Financially, this would include cash (remember that annoying thing called an emergency fund), bonds, and anything real estate related, (but not things bought on “spec”). Raw land investments are speculative; but let’s face it, as long as there are no environmental problems…you are probably ok. Your primary residence is definitely here. The kind of returns one would be expecting in this class are anything from 1-5% year. I know, kind of boring but it is what it is! The declines / risks would be the same. As you go up the pyramid, with higher tiers, the representative amounts of the portfolio get smaller, the risks get bigger, but so are the expected returns. This is where a younger person can play with the tiers, but don’t throw the baby out with the bath water! Keep that pyramid shape in place.
Equities, mutual funds, and other asset classes that might fluctuate in the economic market place are here. The annual returns should be at least the rate of inflation and up to around 12%. A word of caution – while we are promoting a diversified portfolio here, many people think that if you have 50 mutual funds that you are diversified. While different managers have different styles, most tend to invest in similar stocks. General Electric or other “blue chip” stocks are probably in all of them. The bottom line is dropping tides will probably drop all boats, or in other words, if the market crashes: most stocks will have some correlation and will drop. Finally; don’t kid yourself – anything over 12%, regardless of track record; you are assuming risk.
Upper Middle and Top
This would include “alternative investments”. This class, in my opinion, used to only include junk bonds, collectable art, speculative real estate, and maybe private equity; where Grace Century plays. Through screening and research, we believe that you can push some of the classes further down the spectrum. This is especially true with things like ETF’s, commodity funds, and gold. Technology has enabled the professional managers in these spaces to reduce risk, leverage, and fluctuations. This has enabled investors to reduce exposure and enable these classes to be included in portfolios that 30 years ago was reserved exclusively for high net worth Accredited Investors. The returns here are meant to be extraordinary and well above the lower tier of 12%. Since it is the smallest part of your pyramid, its loss will not affect the pyramid as a whole.
I have always said to keep your “powder dry”. The trick is to have the reserves available to take advantage of it, when they present themselves. No one action should make you or break you. There will always be another opportunity. Remember this when your hands are sweating and you are trying to make a decision. Analyze, research, and exercise due-diligence. If you do this, you can feel good about pulling the trigger with open eyes. Like the ancient Egyptians who built the great pyramids 1000’s of years ago, trust the design, and your pyramid will be there in the future too.