MONEY Master the Game: 7 Simple Steps to Financial Freedom (50 page)

So what investments would you put in here?

Here’s a sampling of seven main asset classes to consider:

1. 
Equities.
Another word for stocks, or ownership shares of individual companies or vehicles for owning many of them at once, like mutual funds, indexes, and
exchange-traded funds
(ETFs).

Exchange-traded funds (ETFs) have been called the “It” girl of the stock market, ballooning in popularity by more than 2,000% from 2001 to 2014, and holding more than $2 trillion in investments. But what exactly are they? ETFs are built like mutual funds or index funds, because they contain a diversified collection of assets, but you can trade them just like individual stocks. Most of them follow a theme (small-cap stocks, municipal bonds, gold) and/or trace an index. But with an index or mutual fund, you have to wait until the end of the trading day to buy or sell; ETFs can be traded all day long. Experts say that if you like the idea of an index fund, but you want to buy when you see the price is low and sell when the price is high during a trading session, an ETF might be for you. But that’s trading, not investing, and trying to time a market brings very intense and special risks.

But there’s another difference: when you buy shares of an ETF, you are not buying the actual stocks, bonds, commodities, or whatever else is bundled in the fund—you are buying shares in an
investment fund
that owns those assets.
That company
promises
that you’ll receive the same financial outcome as if you’d owned them yourself. But don’t worry, it sounds more complicated than it is.

A lot of people like ETFs because they give you a tremendous amount of diversity at a low cost. In fact, many ETFs have lower fees than even comparable traditional index funds, and sometimes lower minimum investment requirements. And because they don’t engage in a lot of the kind of trading that produces capital gains, they can be tax efficient (although there is a move toward more actively managed ETFs coming to the market, which makes them less tax efficient).

Should you invest in ETFs?
Jack Bogle, founder of Vanguard (which, incidentally, offers many ETF funds), told me he sees nothing wrong with
owning broad-spectrum index ETFs, but he warns that some are too specialized for individual investors. “You can not only bet on the market,” he told me, “but on countries, on industry sectors. And you may be right and you may be wrong.” David Swensen wonders why individual investors should bother with ETFs at all. “I’m a big believer in buying and holding for the long run,” he told me. “The main reason you’d go into an ETF is to trade. And so I’m not a big fan.”

2. 
High-Yield Bonds.
You might also know these as junk bonds, and there’s a reason they call them junk. These are bonds with the lowest safety ratings, and you get a high-yield coupon (higher rate of return than a more secure bond) only because you’re taking a big risk. For a refresher, go back and read the bond briefing at the end of the last chapter.

3. 
Real Estate.
We all know real estate can have tremendous returns. You probably already know a lot about this category, but there are many ways to invest in property. You can invest in a home that you rent out for an income. You can buy property, fix it up, and then flip it in the short term. You can invest in first trust deeds. You can buy commercial real estate or an apartment. One of my favorites that I mentioned to you already is investing in senior housing, where you get both the income and the potential growth in appreciation as well. Or you can buy REITs: real estate investment trusts. These are trusts that own big chunks of commercial real estate (or mortgages) and sell shares to small investors, like mutual funds. REITs trade like stocks, and you can also buy shares of a REIT index fund, which gives you a diversity of many different REITs.

For growth, the Nobel economist Robert Shiller told me that you’re better off investing in REITs than owning your own home (which belongs in the Security Bucket, anyway). “Buying an apartment REIT sounds to me like maybe a better investment than buying your own house,” he said, “because there seems to be a tilt toward renting now.” That could change, of course. And, as with any investment, you’ve got to pause and think, “What am I betting on?” You’re betting that the price of property is going to go up over time. But there’s no guarantee, so that’s why it’s in the Risk/Growth Bucket. If it goes up, it could have a nice rate of return; if it doesn’t, you get nothing—or you could lose it all. When you buy your own home, you’re betting that the price of your home will go up. When you’re buying real estate that has income associated with it (a rental unit, an apartment building,
commercial real estate, an REIT, or an index that holds these), Shiller points out you have two ways to win. You make income along the way and if the property increases in value, you also have the opportunity to make money when you sell on the appreciation.

4. 
Commodities.
This category includes gold, silver, oil, coffee, cotton, and so on. Over the years, gold has been considered the ultimate safe haven for many people, a staple of their Security Bucket, and conventional wisdom said it would only go up in value during uncertain times. Then its price dropped more than 25% in 2013! Why would you invest in gold? You could keep a small amount in your portfolio that says, “In case paper money disappears, then this is a little portion of my security.” You know, if all hell breaks loose, and the government collapses under a zombie invasion, at least you’ve got some gold (or silver) coins to buy yourself a houseboat and head to sea. (On second thought, can zombies swim?) Otherwise gold probably belongs in your Risk/Growth Bucket. You’d invest in it as protection against inflation or as part of a balanced portfolio, as we will learn later on, but you have to accept the risk. So don’t kid yourself: if you buy gold, you’re betting it will go up in price. Unlike many other investments, there’s no income from this investment like you might get in stocks from dividends or from income-producing real estate or bonds. So gold could be a good risk or a bad one, but it goes in your Risk/Growth Bucket for sure. This is not an attack on gold. In fact, in the right economic season, gold is a superstar performer! That’s why in chapter 5.1, “Invincible, Unsinkable, Unconquerable: The All Seasons Strategy,” you’ll see why it can be invaluable to have a small portion of gold in your portfolio.

5. 
Currencies.
Got a yen to buy some yen? Since all currency is just “paper,” currency investing is pure speculation. There are people who make a fortune in it and even more who lose a fortune. Currency trading is not for the faint of heart.

6. 
Collectibles.
Art, wine, coins, automobiles, and antiques, to name a few. Once again, this asset class requires very special knowledge or a lot of time on eBay.

7. 
Structured Notes.
What are these doing in
both
buckets? Because there are different types of structured notes. Some have 100% principal protection, and those can go in your Security Bucket, as long as the issuing bank is financially solid. Then there are other kinds of notes that give you higher potential
returns, but only partial protection if the index drops. Say you buy a note with 25% protection. That means if the stock market drops up to 25%, you don’t lose a dime. If it goes down 35%, you lose 10%. But for taking more risk, you get more upside: sometimes as much as 150% of the index to which it’s tied. In other words, if the market went up 10%, you’d receive a 15% return. So there’s potential for greater gains, but there’s definitely increased risk. Remember once again, structured notes should be purchased through an RIA, who will work to strip out all excess fees and deliver them to you in the form of an even greater return.

Safety doesn’t happen by accident.

—FLORIDA HIGHWAY SIGN

We’ve now covered a sample of some of the investment vehicles/assets that you might find in a diversified Risk/Growth Bucket. You may be wondering why I haven’t included some of the more daring investment vehicles of our time: call and put options,
credit-default obligations
(CDOs), and a whole host of exotic financial instruments available to traders these days. If you build up a lot of wealth, you may want to have your fiduciary look into some of these vehicles.
But just realize that if you’re playing this game, you’re most likely no longer just an investor, you’ve become a speculator as well.
It’s what’s called
momentum trading,
and you have to realize you can lose everything
and more
if you play the game wrong. And because the mantra of this book is that the road to financial freedom is through saving and
investing
for compounded growth, I’ll leave a discussion of these momentum assets for another day.

IT’S TIME TO GET IN THE GAME

Okay, now you know the players that belong in your allocation buckets, and you know the key to building a winning team:
diversify, diversify, diversify!
But there’s more. You not only have to diversify
between
your Security and your Risk/Growth Buckets, but
within
them as well. As Burton Malkiel shared with me, you should
“diversify across securities, across asset classes, across markets—and across time.”
That’s how you truly get a portfolio for all seasons! For example, he says you want to invest not only in both stocks
and bonds but also in different
types
of stocks and bonds, many of them from different markets in different parts of the world. (We’ll talk about diversifying across time in chapter 4.4, “Timing Is Everything?”)

And, most experts agree, the ultimate diversification tool for individual investors is the low-fee index fund, which gives you the broadest exposure to the largest numbers of securities for the lowest cost. “The best way to diversify is to
own the index,
because you don’t have to pay all these fees,” David Swensen told me. “And you get tax efficiency.” Meaning that if you’re investing outside of your IRA- or 401(k)-type account, you don’t get taxed for all that constant buying and selling that goes on in most mutual funds.

HAVE SOME FUN!

Of course,
if you have your money machine in full gear, and you have the desire, there’s nothing wrong with setting aside a tiny percent of your Risk/Growth Bucket to pick some stocks and do some day trading. “Index your important money, then go have fun,” Burton Malkiel told me. “It’s better than going to the racetrack.” But, he said, limit yourself to 5% or less of your total assets or portfolio.

Is all of this giving you an idea of what kind of portfolio mix would be best for you? Before you decide, just remember that we all have a tendency to pile up on the investments that we think will give us our greatest victories. And everybody gets victories. You know why? Different environments reward different investments. So let’s say real estate is hot. You’ve invested in real estate, so now you’re a genius. Stock market is hot? If you have stocks, you’re a genius. Bonds are doing great? If you have bonds, once again you’re an investment master. Or maybe you just landed in the right place at the right time, right? So you don’t want to get overconfident. That’s why asset allocation is so important. What do all the smartest people in the world say? “I’m going to be wrong.” So they design their asset allocation ideally to make money in the long term even if they’re wrong in the short term.

LET’S TEST YOUR KNOWLEDGE

In the coming pages, I’ll be showing you the portfolios, or the asset allocations, designed by some of the greatest investors of all time. Let’s start with a sample from someone you’ve been hearing from throughout this book:
David Swensen, Yale’s $23.9 billion–plus man,
a true master of asset allocation. Would you be interested in seeing his personal portfolio recommendations? Me too! So when we sat down together in his office at Yale, I asked him the key question:
“If you couldn’t leave any money to your kids, only a portfolio and a set of investment principles, what would they be?”

He showed me the asset allocation that he recommends for individual investors—one he thinks will hold up against the test of time. He also recommends this portfolio for all institutions other than Yale, Stanford, Harvard, and Princeton. Why? Because these four institutions employ an army of full-time top analysts.

When I saw his list, I was amazed by how elegant and simple it was. I’ve shown you 15 types of assets to choose from; he uses only six categories, all in index funds. I was also surprised by how much weight he gave to one particular bucket. Can you guess which one? Let’s activate some of what we’ve learned thus far about the division between the Security and Risk/Growth Buckets.

Have a look at the box below and jot down where each asset class belongs. Check which ones you think belong in the Security Bucket, where you put things that are going to give you modest returns in exchange for lower risk; and then check which belong in the Risk/Growth Bucket, where there’s greater upside potential but also greater downside.