Stop Treating your Assets like Separate Pots of Gold
There’s an old parable about five blind men who come across an elephant for the first time. They sense something immense but they understand little. One takes the elephant by the tail and exclaims to the other three, “An elephant is like a rope! Long and thin.” Another places his hands on the elephant’s side and argues, “No! The elephant is like a wall! Immense and flat.” The third grabs the elephant by leg and yells, “Ignorant dolt! The elephant is like a tree! Tall and sturdy.” The fourth grabs the elephant by the trunk and screams, “Idiots! It’s like a snake! Coiled and ready to strike!” The fifth man grabs the elephant by the ear and bellows, “You are all FOOLS! The elephant is like a piece of parchment! Flat and smooth!” The elephant, who was amused up to this point, is now a little pissed off and decides to trample all five of them into a smooth paste. The lesson: if you’re going to mess with an elephant you should understand the entire thing.
Investing is a bit like the elephant, we shouldn’t try to break our investments down into discrete little chunks to be considered one by one. We need to look at the entire elephant and understand what we’re dealing with. But I often encounter people acting like the blind men and the elephant far too often. Someone is saving up for a house and so they have a ‘down payment fund’, or a ‘new car fund’, or an ’emergency fund’, or a ‘home repair fund’, or a separate fund dedicated to ‘kid’s college’. This is something I touched on in my post about why I hate emergency funds; I talked about how my wife and I view our portfolio as one holistic unit, and how under any conceivable circumstance we would always treat it as such. But given the prevalence of the alternative way of thinking the concept deserves some elaboration.
Determine your Risk Tolerance
At any given point in your life, you have one level of risk that you are willing and able to accept. You either can or cannot tolerate market fluctuations using current income and reduced spending.
Financial planners like to talk about risk, and everyone has a certain tolerance for it. You might be the type of person who balks at the crazy ups and downs of the stock market, or you might be the type who loves base jumping and chasing penny stocks. To each their own. But everyone has a certain level of risk that they are willing to accept. A certain amount of up and down in their portfolio that they can stomach.
But even more importantly, depending on where you are in life and what upcoming decisions and outlays you have, there is a certain level of risk that you CAN allow in your life. The young high skilled couple in their early thirties can handle more risk that the elderly blue-collar workers about to retire. A family about to send three kids off to college may need to have a more stable portfolio than a 20-year-old software engineer.
But the bottom line is that you can always distil your comfort and ability to withstand risk down to one variable. You’re either at a point where you’re willing and able to accept it, or you are not. Either you can adjust for market fluctuations through current income and reduced spending or you are not able to make those adjustments in the short term. There is not some magic middle ground where half of your assets are able to accept risk and the other half are not. Or your ‘car fund’ is not able to accept risk right now, but your ‘retirement fund’ is. There is no time when the ‘college fund’ can adjust using current income, but your rental property cannot. It’s all one, it’s all mixed. And you should treat it as such.
Maximize your Net Worth
The purpose of investing is to maximize your total net worth and the returns over time. Do this and every other ‘goal’ will come along for the ride.
When we invest we are not trying to locally optimize for one particular element of our life. We’re trying to maximize everything. If your risk tolerance is one singular element, your goal is also the same across everything. Maximize the entire number over time. The point of the above is that if you choose the best portfolio you can while taking into account the level of risk you are able to accept, any other ancillary goals will take care of themselves and in the fastest way possible. If your net worth is higher you’ll be able to afford the down payment or the college tuition. If it’s lower you will not be able to do so. Take those outlays into account when considering your appetite for risk at any one point, but ultimately keep the goal in mind – maximizing one number.
Treat Everything as one Portfolio
Everything you own is a single portfolio. Allocate it as such.
Repeat after me – everything I own is one portfolio. From your house to your IRA, to your 529 plan, to your rental properties, to your Lending Club account, to the cars sitting in your driveway. Conceptually, this seems like it should be obvious, but many people miss this basic fact. The Grizzlies net worth is spread across multiple accounts, multiple investments, but ultimately we have only one asset allocation. Our net worth will move in conjunction with what we have in these disparate accounts, and we base our total allocation on our current appetite for and ability to handle risk. That is currently high and as a result, we have a fairly aggressive allocation focused on stocks. If it were lower we would adjust to a more conservative one focused on bonds and real-estate.
If tomorrow we decided that we want to save up for a downpayment on a new house or to purchase a car why would we change this fundamental view of our risk tolerance? The answer is that we would not. We would keep and maintain the same asset allocation, confident in the fact that it is the best mix of assets for our current level of tolerance for and ability to handle risk.
Use Special Accounts to Minimize Taxes
Utilize special accounts to minimize taxes and penalties over time. That is their one and only purpose.
If our portfolio is all one big pot of money then why are we maintaining all of these separate accounts? One reason and one reason only – minimizing taxes, fees, and other idiosyncratic risks like lawsuits. A retirement account is only a retirement account because we have labeled it as such. It really is just a special legal entity that carries a certain set of tax advantages and rules. No more, no less. Similarly, a 529 plan is an education plan because we call it that. It is also only a special legal entity that gives you certain tax benefits and restrictions, some of which focus on education. A couple posts back I talked about how to save for your children’s education and recommended the use of a 529 plan. The 529 plan provides a very useful explanation of the full principal in action.
We view our daughter’s 529 plan as part of our broader asset allocation and treat it as such. We fund it because we know that for a given level of college education that we want to provide, the 529 plan is the most tax efficient and student aid efficient way to do so. Our overall risk tolerance as a family is very aggressive right now and our daughter’s 529 plan is also aggressive. As we approach her college years our overall risk tolerance may change and we may feel the need to incorporate more stable assets into our portfolio. If this is the case, one very tax efficient location to hold bond funds is in a tax-advantaged 529 plan. As a result, we may shift some of the 529 Plan to less risky assets. But it will be a shift that takes place in the broader context of our entire portfolio. If we have decided on a 30% allocation to bonds and real-estate, we will only hold 30% in bonds and real-estate. Some of that 30% may be in Baby Bear’s 529 plan. But we will not consider her 529 plan as a separate pot of money dedicated solely to one purpose.
You have a given amount of liquid assets at any point. Balance this amount to your cash needs.
One important aspect to keep in mind across all of this is liquidity. I laid out a couple posts back how to access retirement accounts early, and one of the important points about the entire process is ensuring you have enough liquid and accessible assets to cover living expenses over any given time frame. The concept of one single portfolio applies here as well. For any given point in your life – whether you are about to retire, thinking of buying a house, or funding your kid’s education – you will have a certain need for liquidity. Once again you should think of your entire portfolio of assets holistically to decide how and where it is best to provide that liquidity from. If you have enough in taxable accounts you do not need to worry about drawing down retirement accounts. If you have sufficient resources in Roth contributions you do not need to keep an emergency fund. There is no need to establish separate pots of liquidity for specific purposes. Just treat it all as one and utilize it all in the most tax-efficient way possible.
Advanced topic – Treat Your Family’s Assets as One Portfolio
Invest like you would for your great-grandchildren
I will caveat what I’m about to say first. Utilizing this depends entirely on how comfortable you are with intergenerational transfers of wealth. There are some people who are against leaving fortunes to their kids, some people have no problem with it.
But if you are comfortable with the concept, there is a second order of this entire principal. You should view your entire family’s portfolio as one central pool of resources with one level of risk tolerance. A level of risk tolerance that is usually MUCH higher than what any one individual or generation would take on. This also means a much higher return than any one individual would be capable of.
My dad is a senior mustachian if I have ever seen one. He is one of the most frugal individuals I have ever met, and he’s been practicing it for at least the last 30 years. I’ve calculated out his annual budget at less than $7k per year. This is while he continued to work a normal well-paying job for most of that time. I don’t know exactly how much he has at this point, but it is substantial. He’s never given my sister and me anything because he wanted us to make it on our own, but he plans to leave it in a trust for both of us and our children eventually. He’s now 65 years old and the conventional wisdom would be that since he is now in retirement he should shift much of his assets to less risky areas. This would be silly. There is no conceivable world in which the stock market will plunge so much that he could not support his lifestyle. At this point, he’s either investing for a charity or for his grandchildren and is allocating his investments accordingly. If you want to take this entire thread to its logical conclusion that is what your family should do as well.