MONEY Master the Game: 7 Simple Steps to Financial Freedom (51 page)

Let’s start with the top four. The first is a broad domestic stock index, something like the Vanguard 500 Index or the Wilshire 5000 Total Market Index. Where would you put it? Does it come with risk? Absolutely. Have you got a guaranteed return? Absolutely not. Could you lose it all? Unlikely—but it could drop significantly—and it has at times! Over the long term, US stocks certainly have a great track record. Remember how they compare to owning your own personal real estate? Equities have done well over time, but they are one of the most volatile asset classes in the short run. In the last 86 years (through 2013), the S&P lost money 24 times. So stock index funds belong in which bucket? That’s right: Risk/Growth.

How about international stocks? David Swensen puts a lot of weight in foreign stocks because of the diversity they bring to the portfolio. If there’s a slump in America, business may be booming in Europe or Asia. But not everybody agrees with David. Foreign currencies aren’t as stable as good old US greenbacks, so there’s a “currency risk” in investing in foreign stocks. And Jack Bogle, the founder of Vanguard, with 64 years of success, says that owning American companies
is
global. “Tony, the reality is that among the big corporations in America, none are domestic,” he told me. “They’re all over the world: McDonald’s, IBM, Microsoft, General Motors. So you own an international portfolio anyway.” Where do foreign stocks belong? I think we can agree on the
Risk/Growth Bucket,
no?

Emerging markets? David Swensen likes to put some money into the volatile stocks of developing nations, like Brazil, Vietnam, South Africa, and Indonesia. You can get spectacular returns, but you can also lose everything.
Risk/Growth Bucket
? You bet!

How about REITs? David told me he likes “real estate investment trusts that own big central business district office buildings and big regional malls and industrial buildings. They generally throw off a high-income component.” So these index funds can generate great returns, but they rise and fall with the American commercial real estate market. Which bucket? You’ve got it:
Risk/Growth.

What about the last two on the list: long-term US Treasuries and TIPS? Do they offer lower returns in exchange for more safety? Spot on! So which bucket do they belong in? You’ve got it:
Security.

Congratulations! You’ve just assigned six major asset classes to their proper allocation buckets, which is something 99.9% of the people you pass on the street wouldn’t be able to do!
Pretty cool thing, isn’t it? But let’s dig
a little deeper here to understand why David chose this mix, and why it may or may not be right for you.

First let’s look at the Security Bucket. David said he chose only US Treasury bonds “because there’s a purity there in having the full faith and credit of the US government backing them.” But why did he pick this particular combination of bond funds? Half are traditional long-term Treasury bonds, and half are inflation-protected securities.

I said to David, “
You’re basically saying if I’m going to be secure, I’m going to protect myself against both inflation and deflation.”

“That’s absolutely right,” he said. “I can’t believe you saw that! A lot of people who put together bond indexes lump the two together. The Treasuries are for deflation, like we had in 2008. But if you buy regular Treasury bonds, and inflation takes off, you’re going to end up having losses in your portfolio. If you buy the TIPS, and inflation takes off, you’re going to be protected.”

I want you to notice that David Swensen, like all the best, doesn’t know which is going to happen: inflation or deflation. So he plans for both scenarios.
You might say as you look at this, “Well, yes, fifty percent for inflation and fifty percent for deflation. Doesn’t he just break even?” It’s not that simple, but your thinking is quality. He is using his Security Bucket investment as protection that if his equity investments or real estate go down, he’s lowering his downside by having something to offset some of those investment risks. So he’s certain to make some money in his Security Bucket. And he doesn’t lose his principal, so he’s practicing smart Security Bucket usage. He won’t lose money, but he’ll make some additional money if things inflate or deflate. A
very
smart approach.

But I was a bit surprised that only 30% of his asset allocation goes into the Security Bucket, while 70% of his assets go into the Risk/Growth Bucket! That seemed pretty aggressive to me for some investors, so I asked David how it would work for the average investor.

“That’s a good question, Tony,” he said.
“Equities are the core for portfolios that have a long time horizon.
I mean, if you look at recent long periods of time—ten, twenty, fifty, one hundred years—you see that the equity returns are superior to those that you get in fixed income.”

Historical data certainly back him up. Have a look at the visual below that traces the returns of stocks and bonds for periods of 100 and 200 years. It
shows that US stocks have historically outperformed bonds in compounded annual returns. In fact,
$1 invested in 1802 at 8.3% per annum would have grown to
$8.8 million
by the turn of the new millennium.

So David Swensen designed his ideal portfolio to be a wealth-generating machine that offers some stability through its tremendous diversity. And because it takes a long-term view of investing, it has the time to ride out periodic drops in the stock market.

I was curious to see how this asset allocation mix would have fared in the past: those volatile 17 years from April 1, 1997, when TIPS first became available, to March 31, 2014. It was during those years when the Standard & Poor’s index performed like a rodeo bull, yet it dropped 51%. So I had a team of financial experts test its performance against the index during those years. Guess what?
The Swensen portfolio outperformed the stock market with an annual return of 7.86%!
During the bear market of 2000 through 2002, when the S&P 500 dropped almost 50%, Swensen’s portfolio stayed relatively stable, with a total loss of only 4.572% over those three terrible years! Like other portfolios heavy in equities, Swensen’s took a hit in the
massive crash of 2008, but it still did better than the S&P 500 by more than 6%, (losing 31% as opposed to 37%) and then bounced back. (Note: see the end of this chapter for the specific methodology to calculate the returns. Past performance does not guarantee future results.)

So, ladies and gentleman, it’s safe to say that
David Swensen is one of those rare unicorns who can actually beat the stock market on a consistent basis—and in this portfolio, he does it with the power of asset allocation alone! And you have access to his best advice, right here, right now.
If that was all you got out of this chapter, I think you’d agree it’s been worth the time! However, the most important thing to understand is this: even though this portfolio might do better and be more stable than the general market, it is still an aggressive portfolio that takes a strong gut because few people can take a 35% loss of their lifetime savings and not buckle and sell. So is it right for you? If you’re a young person, you might be very interested in this kind of mix, because you’ve got more time to recover from any losses. If you’re getting ready to retire, this portfolio might be too risky for you.

But not to worry. I’m going to give you several other examples of portfolios in the coming pages, including that one particular allocation mix Ray Dalio shared with me that practically knocked me off my chair! It was so spectacular that I’ve devoted a whole chapter to it in the next section. But here’s a hint: its mix was much less aggressive than Swensen’s, but when we tested it over the same time frame, the Dalio portfolio
had a higher average annual return and significantly less volatility—it’s a smooth ride. It may be the Holy Grail of portfolio construction, one that gives you substantial growth with the lowest ratio of risk I’ve seen!

In any moment of decision, the best thing you can do is the right thing, the next best thing is the wrong thing, and the worst thing you can do is nothing.

—THEODORE ROOSEVELT

But for now, let’s get back to the big picture and look at how you’ll decide your own basic numbers: What percentage of your assets are you going to put at risk, and what percentage are you going to secure? Before you make the choice, you have to consider three factors:

• 
your stage in life,

• your risk tolerance, and

• your available liquidity.

First, how much time do you have ahead of you to build wealth and make mistakes with your investments along the way before you need to tap into them?
If you’re younger, once again, you can be much more aggressive because you’ll have longer to recover your losses. (Although nobody wants to get in the habit of losing!)

Your percentages also depend on
how much access to income
you have. If you earn a lot of money, you can afford to make more mistakes and still make up for it, right?

GAME SHOW TIME: WHAT ARE YOU WILLING TO RISK?

And when it comes to risk, everyone has radically different ideas about what’s tolerable.
Some of us are very security driven. Remember the 6 Human Needs? Certainty is the number one need. But some of us crave Uncertainty and Variety; we love to live on the edge. You have to know your personality before you dive in here. So let’s say you’re on a game show; which of the following would you take?

• $1,000 in cash

• A 50% chance at winning $5,000

• A 25% chance at winning $10,000

• A 5% chance at winning $100,000

Here’s another: you have just finished saving for a once-in-a-lifetime vacation. Three weeks before you plan to leave, you lose your job. Would you:

• cancel the vacation;

• take a much more modest vacation;

• go as scheduled, reasoning that you need the time to prepare for a job search; or

• extend your vacation, because this might be your last chance to go first class?

Rutgers University has developed a twenty-question, five-minute online quiz (
http://njaes.rutgers.edu/money/riskquiz
) that can help you identify where you fit on the risk-tolerance scale. But the real answer is in your gut.

For the past 30 years, I’ve been putting on my
Wealth Mastery seminars,
where I’ve worked with people from more than 100 countries to transform their financial lives by putting them in a total-immersion four-day wealth-mastery process. In it, I like to play a little game with them called “the money pass.” From the stage, I tell the audience to “trade money” with one another. That’s all I say. There’s usually a few moments of silent confusion, and then they start trading. Some people pull out a dollar, some take out a twenty, some people a hundred. You can guess what happens. People are moving around, they’re looking at one another, they decide how to exchange. Some negotiate, some give away all their money, and some take another person’s $100 bill and give them $1. You can imagine the astonished look on that individual’s face. After three or four minutes of this type of trading, I say, “Okay, grab a seat.” And I move on to the next subject.

Invariably, some guy will shout, “Hey! I want my hundred dollars back!”

I’ll say, “Who said it was your hundred?” And he says, “Well, we’re playing a game.” And I say, “Yeah. What made you think the game was over?” Usually I get a confused look as the person sits down, still frustrated over the lost $100. Eventually they get the insight: their perception of their risk tolerance and the reality are in different universes. This guy thinks he has a high tolerance for risk, but he can get pissed off over the loss of $100. It always amazes me. Imagine if you were to lose $10,000, $100,000, or $500,000. That’s what aggressive investors can lose in a relatively short period of time. People don’t know their true tolerance for risk until they’ve had a real-life experience taking a significant loss.

I’ve taken God-awful losses—multimillion-dollar hits at a stage in my life when I didn’t have that much to lose, when the losses equaled more than all that I owned. Those gut checks will wake you up! But the numbers don’t matter. You can get thrown by losing $100 or $1,000. The pain of losing far exceeds the joy of winning. And that’s why it’s great to have something like the All Seasons portfolio in your investment arsenal, because, through asset allocation alone, you can significantly reduce the risk of sizeable losses.

Just as science shows us that we’re hardwired to hate losing, it also shows
that humans are not good at assessing our potential to win. Sometimes after you’ve made a few successful investments, you start thinking, “Hey, I’m good at this; I can do anything!” It’s just human nature to think you can beat the system. It’s what psychologists call motivational bias. Most of us think we’re better than we really are at predicting patterns and luckier than we really are when there’s a jackpot at stake. What else can explain why so many people play the lottery?! A famous 1981 study at Stockholm University found that 93% of US drivers think their skills are above average. There’s even a name for this phenomenon: “the Lake Wobegon Effect,” referring to author Garrison Keillor’s mythical town where “all the children are above average.” Hey, who
doesn’t
think they’re above average! But when it comes to money, delusions that you’re better than everybody else can kill you.