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The perfect portfolio for loss-proof investing

June 25, 2009 09:37 IST

Over the past thirty years, I have developed an asset allocation system for middle class investors, i.e. people who work or have had to work for a living. It is called Functional Asset Allocation.

The asset allocation models prevalent now in the financial planning arena were developed by insurance, mutual fund, or other vendors. While based on modern portfolio theory, they were designed for large pensions and foundations. As such, they are virtually useless for real people for two reasons:

  • They do not take into account real estate (including personal residences) as a distinct asset category; and
  • While touting "tax efficiency", they do not take into account the most essential tax feature of individual investments which is 'asset location'. Asset location refers to the distinct types of accounts which hold investments such as qualified pensions, 401ks, Roth IRAs, etc. (in the Indian context, provident fund, etc.).

Functional asset allocation recognises that there are three basic asset allocation categories. These asset categories are functionally different:

  • Interest earning investments, i.e. bonds, bank deposits and cash);
  • Real estate, which includes personal housing, income producing real estate, and non-performing real estate (e.g. vacant land); and
  • Equity investments, i.e. stocks and shares.

The first asset category is interest earning investments. These include cash and bonds and their function in a portfolio is capital preservation. These investments protect the investor in times of deflation.

If properly structured, cash and bond assets protect the investor with an invincible shield in times of deflation. To be most effective for capital preservation, bonds should be both absolutely safe and non-callable (such as US Treasuries), plus they should be held to maturity rather than traded.

The second asset category is real estate. The function of real estate is to provide the investor personal enjoyment as well as an invincible shield in times of inflation, because real estate is the most inflation sensitive asset category.

While real estate investments generally are advantageous in inflationary times, there is often considerable regional variation and it is difficult to achieve geographic diversification in these inefficient markets.

The third category used in the 'functional asset allocation' system is equity investments, or stock. The function of equities in a portfolio is to provide capital appreciation so that clients can most effectively accumulate wealth during periods of prosperity.

While volatile in the short-term, a twenty-year plus investment horizon stock easily outperforms other securities. Over the past seventy years, US stocks have increased an average of 11 per cent annually versus 6 per cent for interest earning investments.

Over a typical twenty-year horizon, $10,000 invested in diversified stocks would be worth over $90,000 compared to $33,000, if invested in bonds and cash. Thus, the equity category is where money can be expected to make the most money over the long- term and provide growth in the portfolio.

Elements of the perfect portfolio

In the interest earning category, liquidity of about three months living expenses is fine if a client also has at least 20 per cent of their outstanding mortgages in emergency liquidity. Emergency liquidity are investments which don't fluctuate in value but where withdrawal triggers a taxable event.

While emergency liquidity could even be cash value of life insurance, I recommend US Savings Bonds for emergency liquidity. For example, "Mary and Jack Johnson" assume a joint income of $100,000 and a home valued at $250,000 with a $200,000 mortgage. They should have at least $25,000 in cash equivalents and another $40,000 in US Savings Bonds or other tax sheltered liquid investments. Emergency liquidity provides two years of house payments, if needed, and so is an essential element of the loss-proof investing.

For long-term capital preservation, which is a function of the interest earning category, I recommend a bond ladder with US Stripped Treasuries (these are treasury securities that pay out no interest, but are sold at a discount from their face value and at maturity can be cashed in at face value).

If the Johnsons want to retire at the age of sixty or sixty-five, we would start the bond ladder at that year and go out fifteen years. Assuming their living costs are $100,000 a year to live, and their pensions and Social Security would bring in $40,000, then they will need $60,000 more cash flow. In that case, we'd build a ladder with Treasury strips that has a $60,000 rung starting the year the client retires.

For example, it might start in 2008 and extend out fifteen years to 2023 with a $60,000 rung coming due each year. This would use up about $600,000 of their investments. This shield of invincibility assures clients will be able to maintain their current lifestyle for a fifteen-year investment horizon through pension payments, Social Security benefits, and the cash flow the bond ladder generates - all of which are US Government guaranteed.

For the real estate category, I generally recommend that investors buy a home that is 200-250 per cent of their annual income and that they trade up once their income increases to within 25 per cent of the value of their home.

For the Johnsons, a $250,000 home is appropriate for their $100,000 per year income level. They are fully leveraged at 80 per cent (a $200,000 mortgage), so their home protects them against inflation since home values rise generally at a higher rate than inflation. When there's a period of deflation, mortgaging at a lower rate could save 10 per cent per month in expenses.

Leveraging real estate is recognized as an effective strategy to get a multiplier on the investment. While often overlooked, leveraging real estate is advantageous as the most effective way to hedge against the lack of geographic diversification.

If the Johnsons have a 6 per cent mortgage for fifteen to thirty years, assuming they are in a 30-35 per cent tax bracket (including state taxes), their after tax cost of the funds is about 4 per cent. A well-balanced portfolio should be easily able to provide a return of more than 4 per cent over a fifteen to thirty year period.

If interest rates in-crease, their mortgage is locked in at 6 per cent while their investments earn higher yields, so they are ahead in inflationary periods since interest rates follow inflation. If interest rates drop, they can simply remortgage and reduce their living expenses.

For equities, I recommend 50 per cent in large cap and use non-qualified money - in other words, after tax money. We often use the Cambridge Index Strategy, which I designed.

Fifty large cap stocks are purchased in December (stocks in the Dow plus the top ten stocks in the Nasdaq and in the S&P). There are no trades until the end of the following calendar year.

In October, all losses are realised to harvest the capital losses short-term. These funds are reinvested for the next thirty-five to forty-five days in index funds.

In December, all the stocks with more than a 10 per cent gain are used for gifting to a charitable foundation, which avoids tax on the long-term gains and a charitable tax deduction on the full market value. Some clients prefer to give these winners to their children to sell (at an advantageous tax rate) to pay for college, or simply keep them in their permanent portfolio.

Investors are advised generally to have 25 per cent in small caps and 25 per cent in internationals that are managed by separate account managers.

Equities, in general, have been overemphasized by the financial industry, so that inflation and deflationary dangers have been ignored. By following the guidelines outlined above, you will have a loss-proof investment portfolio which also offers decent returns in all kinds of economic conditions.


(Excerpt fromĀ TheĀ Invincible Investor: 10 Top Financial Planners Reveal the Secrets of Loss-Proof Investing (www.visionbooksindia.com/details.asp?isbn=8170947456) Published by Vision Books.

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