Diversification is an example of a risk management tool … I take exception with it because the financial services industry promotes diversification as an ‘end’ rather than as the simple ‘means to an end’ that it really is …

Andee talks about a way to turn the concept of ‘risk v return’ on it’s head! Here’s his comment:

On the question of diversification, do you think it has something to do with risk?

I was thinking about the old phrase of Risk and Return. i.e. the higher the risk the greater the return. This has been used in the past to steer people away from high return. How about taking the opposite view which is; If you can manage the risk better than anyone else then you deserve to get the high return.

However, there’s only a limited number of risks that you can manage well and this often leads to LESS diversification and sticking to your knitting.

One of our clients said to me that he knew everything that could go wrong in his business and therefore wanted to pull money out and diversify. My question of him was this: Why would you take money out of something where you know the risk and can manage it and put the money into something different where you don’t understand the risk and therefore can’t manage it!!

If you can manage the risk better than anyone else, do you then deserve to get the high return?

Not sure about ‘deserve’, but I agree: you have to pick the return that you NEED to get then manage the risks accordingly.

If you have no particular goal in mind … other than: work until you reach retirement age, then see what you have in your 401k and live accordingly … then, you probably need to at least diversify (a low-cost Index Fund should do the trick – I wouldn’t even bother rebalancing into bonds etc.) and WAIT (at least 20 years-to-40-years) …

… but, if you do have a Number – a financial goal that is clearly set in your mind, to be achieved by a certain date –  then you have to take Andee’s tack:

1. Choose your Number and Date

2. Compare that to your current Net Worth

3. Calculate your required Annual Compound Growth Rate (i.e. to take you from 2. to 1.)

4. Choose your required investment vehicle (i.e. to achieve 3. or better)

5. Mitigate the risks

Mitigating your risks means learning all there is to know about the investment vehicle/s that you chose (4.); also, choose the ‘least risky’ investment vehicle that can get you there, rather than choosing a ‘more risky’ investment that could have helped you ‘overshoot’ your Number.

What if there is no investment that you feel comfortable with that CAN get you to your Number?

Simple:

a) Lower your Number by a few million, or

b) Extend your Date by a few years, or

c) Do a mixture of both …

… in other words: opt out of your dreams!

Well, we’ve reached a Milestone …

7Million7Years.com is officially ONE YEAR OLD … now, that’s a lot of posts! I hope that some have been useful?

To celebrate, I am running my first ever competition:

It’s easy, all you need to do is write your most pressing, interesting, or “I’m just plain curious” personal finance question in the Comments section below …

… I will choose at least one winner (maybe more, if I am blown away by the responses) and eventually publish answers to all of the rest.

The winner/s will receive a personal finance book of my choice (I may choose a book that I think will be relevant to their question, or one of my favorites … who knows?!).

So, don’t waste another moment: write your question in the Comments below (make sure that you signed in with your e-mail address, so that I can let you know if you’ve won … no need to include it with your answer, though).

My ‘problem’ is that I seem to see everything as through a pair of glasses that somebody has stepped on – cracking the thick glass lenses, but not quite breaking them; case in point – Rick says:

Consider two cases in the first you rebalance in the second you don’t:

Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
37.5K 37.5K 75K After rebalancing
75K 37.5K 112.5K Right after market recovery
56.25K 56.25K 112.5K After rebalancing

No Rebalancing:

Stocks Bonds Total Comment
50K 50K 100K Initial conditions
25K 50K 75K right after market crash
50K 50K 100K Right after market recovery

Note rebalancing earned an extra $12.5K over doing nothing, it doesn’t compare to perfect market timing but there was no crystal ball required! Jeff pointed out rebalancing maintains the risk level. Was it less risky to hold half stocks half bonds? Yes, in the 50% market crash there was only 25K in losses rather than a 50K loss.

What if the order was different?

Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
62.5K 62.5K 125K Rebalance
31.25K 62.5K 93.75K Market drops 50%
46.9K 46.9K 125K Rebalance

No Rebalancing:
Stocks Bonds Total Comment
50K 50K 100K Initial conditions
75K 50K 125K Market rises 50%
37.5K 50K 87.5K Market drops 50%

Again rebalancing helps prevent losses over doing nothing. If you are invested in more than one asset class you should rebalance. We all know that there is no such thing as a free lunch though… What is the down side?

By allocating 50% bonds 50% stocks you only get half the superior stock returns if the market is steadily going up. Rebalancing reduces risk at the cost of returns in the good years. The good years actually do outnumber the bad, even though it doesn’t seem like it right now! If you can withstand the risk you should keep a large percentage in stocks. I’m young enough that I don’t have a large % of bonds- and it sucks to take the full losses. However, I’m willing to risk it now for the full gains and I’m glad I get to buy shares at a steep discount now. As I get older I will be increasing the % of bonds that I hold and will be rebalancing.

I ‘read’ the numbers, but I ‘see’ something totally different … something that Rick sees too, because he covers it in his closing comments:

The problem with ‘numbers’ is that they don’t reflect real life.

The market changes: it doesn’t reverse then recover with all ‘vital signs’ the same as they were before!

So, you are in constant ‘motion’ as bonds go up one day, stocks down the next (with sub-moves within the markets such that overseas funds are up and US funds down), and so on ….

Before we do any of this, we need to revisit our objective … why are we doing all of this in the first place?

You see, the key ‘number’ is in fact your Number and if moving half your net worth into Bonds to ‘avoid risk’ stops you from achieving your Number, why do it at all?

A simpler solution is to be 100% invested in stocks (or a suitable alternative) and hold for the long-term.

Warren Buffett is … George Soros is … I am [AJC: Well, almost 100% in real-estate with cash on the sidelines waiting for the next ‘deals’ to come along … although, I will also put some in stocks and ventures ‘for fun’].

Why?

When studies like the Dalbar Study show 11.9% 20 year returns, and others show absolutely NO 30 year periods EVER with less than an 8% compounded return in the stock market, why would you do anything else?

Of course, if your expertise is in real-estate, buying businesses, or Egyptian artifacts, I am sure that similar studies can show their benefits over 15 – 30 years, as well …

… the key is to find something that produces income that:

1. Tends to rise with inflation, and

2. You can leverage (borrow) to buy into

That way, if inflation is > 0% (as it surely will over 20 to 30 years), your return increases disproportionately (in YOUR favor, assuming that your income from the investment eventually covers your mortgage and other holding costs).

A closing note:

If rebalancing is the right thing to do, why is Warren Buffett – who was previously invested 100% in bonds – for the first time in 40+ years of investing, moving his entire personal net worth into the stock market right now?

The answer, of course, is simple: he sees that American Business is extremely undervalued right now … and, is happy to ‘rebalance’ his portfolio 100% away from bonds and 100% to stocks.

This is not really rebalancing at all: this is putting your money where the best value (hence, best long-term returns) are to be found.

What do you do if, like ALL of the original 100+ serious applicants for my ‘grand experiment‘, your Number is in the millions?

That means that saving anything less than 50% of your salary over anything less than 20 years is unlikely to get you there?

As I mentioned in a previous post: in the world of money, the ‘momentum’ that we build up comes from the power of compounding; just take a look at how $1,000 compounds over 30 years (@ 10% p.a.represented by the blue part of the graph, below) … more importantly, look at what happens if we start just 10 years later (represented by the red part of the graph):

… we can get to the same end point, but only by increasing our annual compound growth rate by  a hefty 55% (i.e. to 15.5% p.a.).

That difference in compound growth rates could literally ‘force’ you out of nice, safe, easy Index Funds into making scary, difficult investments in individual stocks.

Or, if your Number / Date combination is much Larger / Sooner, it may even ‘force’ you into investing in real-estate, small businesses/franchises, or even into starting your own high-growth businesses!

Which is fine for some …

So, you could just ‘go for it’ anyway … as I’ve said before massive passion drives massive action, which produces massive results …. maybe.

But, what if you’re the more rational (sane?) type? How do you come up with a more reasonable target?

I see two ways – and, I have posts for you to read on both of these … just follow the links, below:

1. Reduce your Number: http://7m7y.com/2008/11/14/my-mountains-too-steep-part-1/

2. Extend your Date: http://7m7y.com/2008/11/15/my-mountains-too-steep-part-2/

Seems obvious and easy, right?

Well, the ‘cost’ is in delaying and/or reducing your expectations for how you really want to live your Life … so, you want to consider ALL of your options, VERY carefully … fortunately, the financial-self-discovery process itself is not difficult ….

Food for thought?

This kind of follows on from the Cash Cascade, which was a recent post about paying off debt:

Part of the decision-making process around paying down debt revolves around what you would choose to invest that money in, instead …

… and, that depends – at least in part – on your appetite for risk.

A while ago, I discussed the difference between what I call ‘technical risk’ and ‘absolute risk’ and Jeff (our resident ‘risk manager’) asks:

Ultimately, I just want to figure out how to calculate (take into consideration) the additional risk–or variance in outcome–that leveraging adds to an investment, so can make educated investment decisions.

It’s easy, Jeff: just attribute a risk % to each investment category based upon your perception of the various factors and multiply the expected return by that factor.

Or, you can try using the Standard deviation, and model thus:

r(V) = {V^2} – {V}^2 where curly braces represent average values. For compound returns:
r(V) = {N1^2}*{N2^2}*…*{Nn^2} – {N1}^2*{N2}^2*…*{Nn}^2

Now we can again use the definition {Ni^2} = v(Ni) + {Ni}^2 to get

r(V) = (r(N1) + {N1}^2)(v(N2) + {Nn}^2)…(v(Ni) + {Ni}^2) – {N1}^2*{N2}^2*…*{Nn}^2

Or, you can simply do what I suggest which is work backwards:

1. Decide WHY you need the money

2. Decide WHEN you need the money

3. Decide HOW MUCH money you need

4. Calculate the required Compound Growth Rate to go from where you are today to where you want to be

5. Decide if you can ‘stomach’ the inherent risks involved in the investment methods required to achieve that required compound growth rate …

… if not, then go back to 1. and downgrade your expectations for happiness.

Source: http://www.joedelagarza.com/

I call this the How To Go Broke By Having Too Much House Rule … used (in good times) by banks and (in ANY times) by real-estate agents to keep as much of YOUR money in THEIR pockets as possible.

Under this ‘rule’ the bank becomes the ‘senior partner’ in your life: it’s usually Uncle Sam and your spouse who fight over that particular position 😉

So, how much house CAN you afford?

Well, to get started, you may have no choice but to follow our friendly Realtor, Joe del Graza’s ‘rule’ …

… you simply may have little personal net worth and not much income, and as I said in this early post, owning your own home (for some) may be the only way you will ever get ahead financially.

But, if you already own a house and are wondering if you can really afford to keep it – or even upgrade (why not, bigger houses are relatively cheaper in the current market?), then how do you decide how much house you can afford?

Simple: apply two ‘rules’:

1. The 20% Equity Rule, together with

2. The 25% Income Rule.

The 20% (Equity) Rule

This says that for a family earning $100,000 a year, with a total net worth of $100,000 that you can have up to 20% of your Net Worth tied up in the house. With a total Net Worth of only $100k that’s $20,000 … this probably won’t touch the sides of the deposit that you have on your current house, let alone moving into a bigger one?!

The 25% (Income) Rule

There’s some debate as to whether this should be based on your gross or net income … in other words is tax just another household expense or is it something that you just ignore and go straight to your ‘after tax number? Well, we’ll deal with that issue in another post … here, we will work off net (i.e. after-tax) income.

This says that you take home roughly $70k a year ($100k less 30% taxes) of which you can spend 25% – or one quarter – on mortgage payments: $17,500 a year.

A bit of trial and error with an online mortgage calculator shows that $17,500 a year (or $1,458 / month)  “buys” you $250,000 of mortgage.

Add your 20% (Equity) Rule sum of $20,000 and you can ‘afford’ $270,000 of ‘house’ (ignoring closing costs).

That leads to some obvious issues in practice:

1. Usually one rule or the other will limit how much house you can afford; in this case it’s the equity rule: you will simply not have enough deposit unless you buy ‘no money down’ which is impossible in the current market and inadviseable in most markets.

2. So, for your first home, ignore the 20% (Equity) Rule first, then compromise on the 25% (Income) Rule – if you HAVE to – to get yourself into your first house … but, use these ‘rules’ together to govern any future upgrades, renovations, etc.

3. It’s easy to see why you MUST fix your mortgage rate – preferably for 30 years: your salary is unlikely to double even if variable mortgage rates double.

Remember: your house is usually your biggest expense / liability … the 7 million 7 years blog is here to tell you how to use that to help make you rich 🙂