Mar

Portfolio Balancing

By Emily

When you read through financial books, many of them talk about the idea of balancing your portfolio. We always hear about diversification… but what does that mean for you? Is it diversification just within the stock market? What about investing in real estate, or a business that you’ve created?

The goal with this discussion is to help you think through and decide what asset categories you’re going to invest in, and how much money you should hold in each area.

Most people mention diversification in the context of stocks… own some growth stocks and some value stocks; hold stocks from small, medium and large companies; own stocks domestically and internationally. Also – don’t forget the bonds and the cash reserves!

However, I’d like to stretch you a little bit to think about diversifying your investments outside the stock market (gasp!) My husband and I hold about 25% of our investable asset portfolio in stocks. The rest is invested in private businesses, promissory notes and real estate.

Whether these “alternative” investment classes are right for you is really a question of your knowledge and expertise in these areas. I would NOT encourage you to blindly jump into investments in any of these areas without great knowledge, insight and relationships in the field. They can be a little riskier if you’re not well-versed in the industry.

On the other hand, many millionaires have done VERY well by investing and re-investing in their own businesses, those of friends, and leveraging what they know – in terms of industry knowledge and relationships, to invest “outside the box” for greater returns. According to Brian Tracy’s book, Getting Rich Your Own Way, 74% of millionaires have built their wealth through building their own business or investing in real estate.

How Much Do You Have To Work With?

Before you start talking about how much of your portfolio you want to put into foreign oil futures (For me: NONE! – I don’t know a thing about commodities), it’s important to assess your pool of investable assets.

For example, let’s say your balance sheet looks like this:

You own a house with $50,000 equity
You’ve paid off 2 cars worth $20,000 combined
You have $100K in your retirement accounts and
You have $150,000 in the stock market in non-retirement accounts.
There’s $10,000 in your checking…

Cha-Ching! That’s $330,000 – NICE! But, what do you do with it?

For me, I would first take a look at my “investable assets” to assess the pool of funds I really have available to invest with.

From my total net worth of $330,000, I would subtract the equity in my house and my cars, leaving me with about $260K. I would also subtract the cash in my checking account – that’s working capital to pay my bills, and not money I would want to invest. (Now we’re looking at about $250K to invest.)

I might also consider increasing this $10,000 cash reserve fund to whatever 3-5 months of expenses are in my household so I have a good-sized amount on hand and don’t have to liquidate stocks or other invested assets if I hit a rough patch, like losing my job.

Let’s say you do that and save up a total of $25,000 for your reserve account before you start putting more money into your investments. Now we feel more comfortable and aren’t as nervous about finding high-yield investments that will make a great rate of return, even if they go up and down a bit over time.

So, we’ve got a total pool of about $250,000 in investable assets to work with – how do we want to handle that?

What About the Money In My Retirement Accounts – Should That Be Handled Differently?

I would say for the purposes of your portfolio balancing, not to worry too much about how the assets are divided between retirement and non-retirement accounts. Assuming that you’re not going to access these funds til you retire anyway, it won’t make much of a difference.

However, if you’re investing in anything that’s tax-advantaged (like municipal bonds) then you wouldn’t want to put those in your retirement account, or you won’t be taking advantage of the tax savings they provide. Also, if you’re investing in something leveraged – like real estate with a mortgage, or buying stocks on margin – through your IRAs, you’ll want to research UBIT – Unrelated Business Income Tax – which is a tax your IRA will have to pay on the leveraged portion of your earnings.

Third, if you’re investing for something other than retirement, such as a child’s college education, you might want to structure your portfolio allocation differently for those assets – knowing that they will need to be liquidated and placed into use sooner than the retirement funds in your general portfolio.

Anyhoo, let’s set aside those complications.

Sample Investment Allocations

In the Charles Schwaub book I was reading at the library a few months ago, they suggested the most aggressive stock allocation to be something like a portfolio of 20% foreign stock and 80% large cap American stock.

Personally, with my stock portfolio, we’re working toward a balance of 10-20% foreign stock, 40-45% Small/Medium Cap American stock, and 40-45% Large Cap American Stock. I don’t have any bonds because their long term growth rate is much lower than that of stocks, and I don’t feel the urge to reduce my rate of return long term in exchange for shorter term portfolio stability. You may feel differently.

This gives me a well-balanced, growth-oriented stock portfolio. However, due to its lack of bonds, it may be less stable than some investors would be comfortable with. Since I’m only in my 20′s and don’t anticipate taking any money out of my stock portfolio for a good 40 years or more, I am not concerned with the volatility as much as with the long-term growth. I would be happy to see a long-range growth rate of 10-12% in my stock portfolio.

Outside of stocks, I have diversified my asset classes into real estate. Some people do very well entering the real estate market via REITS, but I don’t hold any of those since I am holding a number of individual properties. The bulk of my investable assets – 70% are in equity in real estate – and I don’t feel I need the extra exposure to the real estate market that REITS would provide.

A good real estate portfolio should yield a 20-30% rate of return on your equity, which is much stronger than the 11% rate of return I expect from my stock portfolio. However, real estate does have the disadvantage of being less liquid. Also, since many real estate portfolios are highly leveraged (including mine) they have more risk associated with them in the event of a down turn in the market. Your stock portfolio can never have a negative balance, but it is not uncommon for inexperienced real estate investors to get upside down on their properties if they bought with 100% financing and experience a down-turn in the real estate cycle.

Even though I love real estate, it can be dangerous if you don’t know what you’re doing. Aiming for 20% liquidity in each of your holdings will help mitigate your risk when things head south. The more volatile the real estate market, the more liquidity you may need to feel secure. (That means you wouldn’t want to have a mortgage on the property greater than 80% of the property’s value.)

Fun with Your Money!

My husband and I debate about what the best asset allocation is for our portfolio. At one point, he was leaning toward creating a 50-50 mix of stocks and real estate. There’s nothing wrong with that – it’s a personal decision based on your needs for liquidity, stability, and rate of return.

As a real estate professional, I get a lot of real estate opportunities across my desk and feel I know more about them and can analyze them better than I could the average stock fund. However, there’s also something nice about knowing that if I ever needed to “cash out” I could turn my stock holdings into cash in very short order, whereas with real estate, liquidating at a decent price can take MONTHS. In the case of commercial real estate, it can take over a year to liquidate, depending on how much you’re willing to drop the price and the market dynamics in the area you’re holding the property.

All in all, I think the lessons are these:

Determine your Investable Assets (don’t include all your balance sheet assets, like house and car – just the money you have to invest with).
Decide on an appropriate asset allocation given your holding period, risk tolerance, desired rate of return, areas of expertise, and tax consequences. Consult with a good financial book or stock broker to talk about diversification.
Rather than selling off massive parts of your portfolio to adjust the balance in your holdings, consider re-balancing by just buying into the new funds or investments where you’d like to increase your holdings. The ratios will even out over time.
Consider the redundancy of your holdings. I don’t own any REITs because I own real estate directly, and feel that REITs would be increasing my exposure to real estate markets, which is not my current objective. If you owned real estate in a foreign country, or a lot of foreign currency, that might affect your willingness to increase your exposure to that market’s economy by buying additional stock there.
Have clear investment goals and an asset mix in mind, and track your portfolio and its performance occasionally so you can determine if your portfolio is performing well and meeting your objectives.

Feel free to talk to me about this by commenting below. I love discussing this topic!

Emily

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