I met with a client today to talk about planning. He runs a successful business and is in the process of expanding it, and at home he has a young child with his wife.
The time to plan is something most people put off. They are either afraid to discuss finances with someone, or don't like the idea of having to follow a path with THEIR hard earned money. I sympathize with these fears. It can be scary to disclose that you have not saved anything or have large debts. It can also be uncomfortable to realize you curtail spending on some "creature comforts." But this is something I take very seriously, and I never judge clients based on past mistakes or events.
A lot of the time, a person can be thrust into a situation that is not their fault. And it can feel as if there is never a good time to meet with a financial planner. But sometimes we have to do things to plan ahead. A team or army or business never flies blindly, without goals and steps to meet those goals. Likewise, a person and their family should not go through life without some sort of plan.
If we weigh: the slight discomfort and time it takes to meet a planner versus the satisfaction of knowing why we are saving and that we are on the right path, the choice can become clearer. Imagine the satisfaction in knowing that little by little, debt is being paid off while we also save for retirement and a child's education. The assurance of knowing you are working towards a goal is the key to advancing in life.
That brings me back to my client today. Even though it was tempting for him to hold off planning and saving so that he could pay for business expenses and family comforts, the truth is he can do both. And most people can do both, as long as they accept that the amounts may start out small. Imagine agreeing to set aside $50 per week to begin saving. Starting small is better than not starting at all. That first financial plan can lead to greater benefits down the line. It can also provide peace of mind.
Whether the plan suggests a ROTH IRA and term life insurance, a 529 plan for a child, or a Simple IRA with employee group benefits, the willingness to sit down for the planning session is the most important thing. My client today saw that. Do you?
Diversification. You've undoubtedly heard the word. You probably even know what it means, and in what context it gets used most often. Yes, diversification is used most commonly when speaking about investment strategies.
So in the previous post, we discussed a rough approximation of how you can get to $10 Million in savings. The ways we can drive revenue to put into our savings account will be discussed in future posts, and mainly focuses around developing passive income strategies. But it is also important that we know how we will be deploying that passive income in our savings vehicles.
That is where the concept of diversification comes in. As much as we'd like to find one stock that will go up 10,000% in the next 20 years, there is almost an infinitesimally small likelihood we will be able to do that. Unforeseen events and competitors make that unlikely. It's more likely that something bad will happen to the stock over that time span, and we will lose a chunk of our investment. That is why we diversify. It is a much better idea to spread our risk over various stocks and asset classes, and simply count on the benefits of capitalism, economic growth, and interest rates to help us in the right direction. So spreading money across many stocks can help prevent the fallout if one stock fails. But what about market-wide, or sector-wide declines, like the '00 Internet Bubble/Crash, the '14-'15 Oil Crash and the '09 Housing/Financial Crisis? How do we mitigate their affects? The same way we do for an individual stock. We diversify across different sectors and different asset classes.
What does that mean? It means that you don't put all your money in one stock, and you generally don't put all your savings in only one type of stocks. You spread it between big and small stocks, growth and value stocks, US and international stocks, bonds, REITS, commodities, cash, etc.
What does this diversifying do in a nutshell? It lowers the correlation within your investment portfolio. That means that one component does not act like another. If one sector like Retail stocks goes down, another like Utilities, may do better. If stocks as a whole under-perform, bonds may be more likely to outperform. If stocks go down, real estate may keep going up. These aren't certainties of course, but we seek to hold assets that react differently to different situations.
There are long run benefits to this as well. We don't just do it to protect our money. It acts to increase returns in the long run. For example, ETF.com wrote an article on correlation and has an illuminating quote:
"The most dramatic impact in the portfolio comes when adding commodities as the seventh asset class. This multi-asset portfolio was comprised of large U.S. equities, small U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities—each asset class having a portfolio weighting of 14.3 percent. The seven-asset portfolio had the highest return (11.25 percent), the lowest standard deviation of return (8.67 percent), the lowest aggregate correlation (.128), the smallest maximum one-year drawdown (-10.2 percent) and a zero frequency of a 10 percent loss (as measured by IRR) over one-, two- and three-year periods. (The -10.2 percent maximum portfolio drawdown is, by necessity, calculated differently than IRR).
... The key point here is that highly diversified portfolios with low aggregate correlation tend to avoid losses, which essentially negates the need for a high recovery probability. In sum, the probability of recovery from a 10 percent loss within three years is slightly lower in the more diversified portfolios, but the frequency of 10 percent or higher losses is nearly eliminated."
So there you can see the benefits of lowering correlation by diversifying among asset classes, sectors, and definitely beyond individual stocks. We minimize huge losses, and therefore don't have to do as well to recover.
Did you notice something else? Just by diversifying between these asset classes, we have almost achieved one of our goals of 11.5% annual returns (see our second blog post). This is the number that we needed to achieve to reach our $10 million dollar goal!
So there you have it. A diversified portfolio is essential to reaching our goal, so is there any other reason not to do it? Tune in next week for further discussion on Asset Class Allocation.
The title of this blog is kind of audacious. $10 Million? Really? I know for some people it seems way off. But the whole concept of this blog is to develop a path for someone that is 30 years old, and without much in the way of assets, to find a way to $10 million dollars by age 65.
I chose $10 million because thanks to inflation, $1 million probably won't be enough to live well in 35 years. I also think it is still an achievable number for most middle class individuals. Working backwards, we can arrive at weekly savings goals, and annual returns on our saved money/assets.
With that said, let's begin calculating what it will take. Assume we can begin saving $100 every week. (This amount might seem like a stretch, but the whole point of this blog down the road is to evaluate ways to bring in this money).
We begin saving $100 per week, and every year thereafter, we increase that weekly amount by $50. So in year 2 we save $150 per week. In year 3 we save $200. In year 4 we save $250. And so on and so on. You may be asking how we will afford to raise this amount every year, but the answer will be through passive income streams. We will spend many many blog posts discussing these. If you work along with the blog and add a passive income source every 6 months, you will be able to increase this weekly savings number every year.
So $100 per week the first week, and then increasing $50 a week every year after. You need to make annual returns of 11.5% to have $10,456,620 at age 65. I think many financial "gurus" overestimate projected annual returns on stocks going forward. People forget that: 1) the U.S. benefited from the destruction of Europe's industrial capacity during WW2, leaving us the only game in town; 2) the fall of the Soviet Union in the early 1990's left us as the lone super power for 2 decades; and 3) the Federal Reserve has been manipulating the economy through monetary policy since the 1980s. Our stock returns since WW2 may very well be higher than we should expect going forward.
So for that reason, lets assume stocks only average 8-10% going forward. Just to show you the power of compounding interest, can you guess what our savings total comes to if our annual returns only average 9%, rather than 11.5%? $6.6 million... So a 2.5% difference in annual returns can mean the difference of almost $4 million dollars ($10.456,620 - $6,630,007 = $3,826,613) when we hit age 65.
So how are we going to try and reach 11.5%? Patience grasshopper. There are ways to try and increase equity returns. We will discuss these strategies going forward. For now just know that we need to start thinking of ways to save $100 per week from our income.
Until next time. Good night and good luck.
I am a Chicago-area financial adviser to young doctors & business owners.