MONEY Master the Game: 7 Simple Steps to Financial Freedom (46 page)

But don’t just take it from me. Listen to David Swensen, the rock star of institutional investing. Remember, he’s the guy who grew Yale’s portfolio from $1 billion to more than $23.9 billion by achieving a 13.9% average annual return across three decades of bear and bull markets. Nobody does it better. When I sat down with him in his office in New Haven, Connecticut, I asked, “What are the most important insights investors must have to achieve
financial freedom?”
He told me that there are only three tools for reducing your risk and increasing your potential for financial success:

1. Security selection—stock picking;

2. Market timing—short-term bets on the direction of the market; and

3. Asset allocation—your long-term strategy for diversified investing.

Before I could even ask about the first two, he made one thing perfectly clear: “Overwhelmingly, the most important of the three is asset allocation,” he said. “It actually explains more than a hundred percent of returns in the investment world.” Wait a second: How could it be
more
than 100%? Because those fees, taxes, and losses that come along with stock picking and market timing put a drag on your profits.

Asset allocation is more than diversification.
It means dividing up your money among different classes, or types, of investments (such as stocks, bonds, commodities, or real estate) and in specific proportions that you decide in advance, according to your goals or needs, risk tolerance, and stage of life.

Wow, that’s a mouthful, isn’t it?

Yet it’s the key to success or failure for the world’s best financial players, including every single one of the investors and traders I interviewed for this book. Paul Tudor Jones swears by it. Mary Callahan Erdoes, perhaps the most powerful woman on Wall Street, leads 22,000 financial professionals whose livelihoods depends on it. Ray Dalio, who founded the largest hedge fund in the world and is now worth $14 billion personally, lives it.

This chapter takes a complex subject and makes it simple enough for you to act on and positively affect your investment returns for the rest of your life, so give it your full commitment and focus! It doesn’t matter if you have only $1,000 that you’re going to save and invest or $1 million. The principles you’re about to learn are
critical
to start applying immediately. If you think you know them already, it’s time to take them to the next level.

Let’s talk about why asset allocation is so crucial to
your
investment plan, and how you can start making it work for you today.

Anyone who thinks there’s safety in numbers hasn’t looked at the stock market pages.

—IRENE PETER

How many times have you picked what looks like the fastest line at the grocery store, but it turns out to be the slowest? Or how often do you switch to the fast lane in a traffic jam and watch the cars in the slow lane whiz past you? You think you’re getting there faster, and then you’re wrong. And what about intimate relationships? In spite of how much you know about yourself and what you believe and value, have you ever chosen the “wrong” partner? We all know
that
decision can have an extraordinary impact on the quality of your life!

The same thing can happen with your investments. Except that when you make mistakes with your nest egg, if it’s too big a mistake, it’s all over. It can mean losing your home. Or still looking for work when you’re 70. Or having no money for your children’s education. That’s why this chapter is so important.

Asset allocation is the one key skill that can set you apart from 99% of all investors. And guess what? It won’t cost you a dime. David Swensen likes to quote Harry Markowitz, the Nobel Prize–winning father of modern portfolio theory, to whom I also reached out to interview for this book. He said famously, “Diversification is the only free lunch.” Why? Because spreading your money across different investments decreases your risk, increases your upside returns over time, and doesn’t cost you anything.

We’ve all heard the old adage “Don’t put all your eggs in one basket.” Well, asset allocation protects you from making that financial mistake. It sounds like such a basic rule, but how many people do you know who violate it?

I have a friend who got so excited about Apple that he put all his money in the company. For a while, it was the most successful stock in the world—until it dropped by 40% in a matter of weeks.
Ouch.
Then there’s another friend who was in her 30s when she quit her job as a television executive, sold her house in Los Angeles at the height of the real estate market boom, and used the money to open a rustic diner in Wyoming. She invested what was
left in high-risk stocks and junk bonds, thinking the interest would provide enough income to support her. And it did for a while. But the stock market crash of 2008 wiped out her entire savings. She had to fold up her teepee and go back to work as a freelancer for a fraction of what she used to make.

We’ve all heard horror stories from the economic meltdown. Maybe you know some baby boomers who had all their money tied up in real estate before the bottom fell out. Or a couple who were ready to retire with their 401(k) full and their target-date funds about to mature. They had the RV picked out, the boat in the driveway, the itinerary drawn up with visits to the grandkids marked out. Then the financial world unraveled. Their net worth was cut nearly in half, and their dream of retirement turned into 20 more years of work.

These stories are heartbreaking, and I want to make sure nothing like that ever happens to you. And the good news is, it never has to. That’s why I wrote this chapter: so that you’ll not only be protected but also can grow your nest egg faster.

What’s the simple and core investment lesson here?
What goes up will come down!
Ray Dalio told me point-blank that in your lifetime “it’s almost
certain that whatever you’re going to put your money in, there will come a day when you will lose fifty percent to seventy percent.” Yikes! That means any investment you pick is going to lose half to two-thirds or more of its value! And don’t most people typically favor one type of investment because they feel they “know” more about that area, or because it’s currently providing a “hot” return? Some people tend to put all their money in real estate, others in stocks, bonds, or commodities. If you don’t diversify enough, you stand to lose your shirt! Are you hearing me? No matter how well you plan, there will be a day of reckoning for every type of asset.
So, diversify or die. But if you diversify
well,
you’ll win!

By now I’m sure you’re crystal clear about the consequences of not diversifying! Now would you like to hear about the incredible impact of the
right
diversification? It’s almost like having a license to print money. I know that’s an exaggeration, but imagine what it would feel like if you knew you were making money while you sleep, and that your diversification gave you true peace of mind regardless of the economic climate.

Here’s a real example. How would you feel if, in that Defcon environment of 2008, when stock markets were losing more than $2 trillion, bonds were tanking, and real estate was falling through the floor, you could have had an asset allocation where your maximum loss was just 3.93%? This example is not a fantasy. This is the power of asset allocation that I’ve mentioned several times in this book, and I’m going to demonstrate it to you shortly. Better yet, what if in the last 30 years of your life (between 1984 and 2013), your asset allocation was so powerful that you lost money only four times, with an average loss of just 1.9%, and never more than 3.93%? Remember, everyone else during those three decades was riding the wild wave of inflation and deflation. In the last decade alone, we had two market drops of nearly 50%, yet you would have coasted through the storm without a single gut check and still averaged a compounded annual return of just under 10%. I’m not describing a hypothetical situation. What I’m describing to you is an actual portfolio, a specific asset allocation, designed by Ray Dalio. Soon I’ll show you the exact formula that has produced these mind-blowing results. But before you can use it,
you have to understand the core principles laid out in this chapter.

Rule 1: don’t lose money.

Rule 2: see Rule 1.

—WARREN BUFFETT’S RULES OF INVESTING

I can’t say it enough:
good people often fail because they do the right thing at the wrong time.
Buying a house—is it the right thing to do? Most experts would say yes. But in 2006, it was the wrong time!
So the question is: If we’re all going to be wrong some of the time, where do we put our money?
That’s where asset allocation comes in.

Here’s another way to think about it: when you’re trying to build a winning team in sports, you have to know the capabilities of each player. You have to know his strengths and weaknesses. You have to decide who you can count on in different situations. Now, say your portfolio is the team, and your investment choices are the players. Asset allocation helps you choose who starts and at which positions.
Ultimately, it’s the right mix at the right time that brings you victory.

Asset allocation offers you a set of guiding principles: a philosophy of investing to help you decide where to put Freedom Fund money or your nest egg and in what proportions.

Think of it as taking chunks of your money and putting them into two separate investment buckets with different levels of risk and reward. One of these first two buckets is a safe environment for your money, but it’s not going to grow very fast there. You might get bored with it, but it’s secure, so that when you need it, it’s there. The second bucket is sexier because it can give you the opportunity for much quicker growth, but it’s risky.
In fact, you have to be prepared to lose everything you put in here!

So how much goes in each bucket? It depends on how much time you’ve got to grow your investments and how much risk you’re willing to take. You’ve got to ask yourself, “How much risk can I
afford
to take at my stage in life?”
But remember, you’re not diversifying just to protect yourself. You want to enhance your results: to find the ideal blend of investments that will make you thrive, not just survive!

But, hey, if we’re willing to admit it, many people have more than enough stress in their daily lives without adding a ton of anxiety worrying about their investments day and night. A significant part of financial security or
even freedom is peace of mind, that feeling that you don’t have to think about money. The first bucket will give you certainty in your life, which, after all, is the first basic human need. And that’s why I call it the
Security/Peace of Mind Bucket.
It’s where you want to keep the part of your nest egg you can’t afford to lose—or even
imagine
losing without waking up in a cold sweat!
It’s a sanctuary of safe investments that you lock up tight—and then hide the key.

I don’t gamble, because winning a hundred dollars doesn’t give me great pleasure. But losing a hundred dollars pisses me off.

—ALEX TREBEK, host of
Jeopardy!

Taking a financial hit not only lightens our wallets but also can steal the joy from our lives. Remember that behavioral economics study with the monkeys and the apples? A monkey was happy if he was given an apple. But if he was given two apples, and then one was taken away, he freaked out—even though, in the end, he still had an apple. Humans are the same way. Research on human emotion shows that the majority of people around the world underestimate how badly they feel when they lose. The pleasure of our victories is dwarfed by the pain of our failures and our losses. So we all have to set up a Security/Peace of Mind Bucket to protect ourselves from taking the kind of hits that will not only set us back financially but also will make us miserable.

To familiarize you with the kind of investments that are considered a bit more secure, let’s look at eight basic types of assets (investment options or resources) that might belong in this Security Bucket. This is just a sampling. It’s not meant to be everything that would fit in this bucket. But as you read, you will notice a pattern: none of these types of investments tends to have extreme volatility—meaning that its value doesn’t tend to fluctuate much—especially compared with things you’ll see later in the Risk/Growth Bucket. (Although, as we’ve all experienced, there are short periods in history where virtually all investments have increased volatility. Later Ray Dalio will show us how to prepare for this as well!) But this quick list is designed to get you to think about your investments in the future, and give you a feel for what might go here.
Ask yourself, “Before I invest, is this putting me at risk? Is this something I’d be better off having in my Risk/Growth Bucket or in my Security Bucket?”