Financial Freedom: Asset Allocation
After I shifted my priorities to reflect my values, created and committed to a budget to reflect that new paradigm, and after I established my emergency savings account I had to determine how to invest that excess capital within the confines of my respective retirement accounts. I needed to determine (1) which asset classes I was going to invest in, (2) how I was going to invest in those asset classes and (3) what percentage of my excess capital I was going to devote to each asset class.
I needed something simple and yet effective – a strategy I could implement with ease and one that I could ultimately place on autopilot over the long term thereby giving me the peace of mind that my strategy was sound without the necessity of constant monitoring.
Best Long-Term Asset Class: Stocks
To make the determination as to which asset classes I was going to invest in, I had to first figure out which asset classes yielded the highest average annualized return over the long term. With a bit of research, it became clear that stocks provide the greatest opportunity for long-term capital appreciation by a wide margin. The following is a list of asset classes I looked into for potential investment – from the highest average annualized return over the long term to the lowest average annualized return over the long term (and here, as well as throughout the entirety of this post, I am referring to domestic or US based investments):
1) Stocks
2) Bonds
3) Real estate
4) Gold
From 1926-2023, the S&P 500 (a stock market index comprising the 500 largest publicly traded companies in the US) returned an average of 10.17% annually. This is a remarkable return on investment especially when you consider the fact that this average annualized return has been achieved despite the Great Depression, the Great Recession and numerous stock market crashes in between. In fact, if you had invested $100 in the S&P 500 in 1926 you would have had $1,278,430.98 by the end of 2023, assuming you reinvested all of your dividends. In that same time period, long-term US Treasury Bonds returned, on average, approximately 5% annually.
What about real estate? Jack Clark Francis, a finance and economics professor at Baruch College in New York City, and Yale’s Roger G. Ibbotson compared the annual returns of real estate from 1978 to 2004 to 15 different “paper” investments (stocks, bonds, commodities futures, mortgage securities, and real estate investment trusts). Housing had an average annualized return of 8.6%. Commercial property returned an average annualized gain of 9.5%. The S&P 500 returned an average annualized gain of 13.4%. This was the period before the housing bubble burst and yet stocks still trounced real estate as a long-term investment. Yale finance and economics professor Robert Shiller argues that real estate, on average, returns about 3% a year over the long term.
It has always puzzled me as to why so many are so enamored with real estate investing. I cannot tell you how many times I have heard people say that the best investment is real estate. Buy a second home and rent it out. The principal benefit of real estate investing for the average individual of course is the ready availability of leverage to maximize gains with little upfront cash. This is undeniably a tremendous benefit. But, have you ever been a landlord before? It’s a nightmare. And when a person seriously and soberly considers the following two options – (i) investing in an S&P 500 stock market index fund or (ii) buying a rental property – the optimal choice is, in my opinion, painfully obvious.
Would you prefer to own a rental property or the percentage equivalent of your local Costco? As a landlord you will be responsible for lease agreements, background checks, upkeep and repairs, insurance and all complaints and legal disputes involving tenants including evictions. As a passive owner of a small percentage of your local Costco you would be responsible for none of that. Rather, you would be effectively delegating the responsibility of the day-to-day running of the business, with all of its concomitant headaches, to some of the best businesspeople in the world.
What people generally fail to realize is that stock market investing is not about owning a piece of paper, rather it is about owning shares in an actual business. Purchasing stock in any given company is owning a piece of that company, albeit a microscopic ownership share on a percentage basis. Purchasing an S&P 500 stock market index fund allows you to make a passive investment in some of the greatest businesses in the world run by the smartest and most capable of managers and businesspeople.
When athletes and wealthy celebrities invest millions of dollars in their own restaurants or in their own business ventures, I often wonder if that investment is a reflection of hubris. Do they actually think they are better and more qualified at running a restaurant than the CEO of Darden – the company that owns Olive Garden, Ruth’s Chris Steak House and The Capital Grille? Do they sincerely believe they are better at business than the CEOs of Apple, Disney or NVIDIA? When I flirt with the idea of investing in my own real estate ventures or in purchasing a business that I intend to run, I keep those questions in mind.
Moreover, when considering the Forbes List of the wealthiest human beings on the planet for 2024, it becomes abundantly clear which is the best asset class for building generational wealth. The vast majority of the billionaires in the top 100 made their fortunes through businesses they started (with their sizable net worth now reflected in the value of the publicly traded stock they own in those companies) or through stock investments in various other companies (i.e. Warren Buffett). Only 3 out of the top 100 made their fortunes primarily through real estate investments with the highest net worth among the 3 coming in at #66 in the top 100.
What about gold? Gold and other commodities fluctuate greatly in price and therefore do not represent good buy and hold investments over the long term. Gold, for example, reached a peak of $850/ounce in 1980. Had an individual purchased gold in 1980 when it was at its peak and held that investment until 2023, this individual would have made approximately 2.16% annually for the next 43 years. If one was to calculate that return in light of inflation, this individual would have lost money over that lengthy period of time.
Investing in Stocks and Bonds through Mutual Funds
I made the determination that stocks and bonds represented the most effective means of capital appreciation, while also balancing my need for capital preservation, through a long-term buy and hold strategy. Mutual funds were my investment product of choice to invest broadly in these two asset classes. Mutual funds gave me immediate and expansive diversification without the necessity of a great deal of capital.
Percentage Allocation: Stocks and Bonds
Three approaches:
1) Conventional rule of thumb: Subtract your age from 100 and that is the percentage of your capital that should be invested in stocks. For example, if a person is 35 years of age then 65% of that person’s capital should be invested in stocks and 35% should be invested in bonds.
2) Benjamin Graham articulated a different approach. He argued that the average individual should have a 50/50 split between stocks and bonds.
3) Peter Lynch argued that an individual should invest as much of their capital into stocks as that person’s individual comfort and risk tolerance will allow.
Stocks can fluctuate a great deal in price over the short term, but the risk involved in equities is tempered in direct proportion to the length of the time horizon for investment. In other words, stocks are the best investment products for capital growth over the long term, but they entail a great deal of risk in the short term especially when a person does not properly diversify their stock portfolio.
Bonds, on the other hand, do not fluctuate to the extent that stocks can. If chosen correctly and conservatively (i.e. intermediate-term US Treasuries, highly rated corporate bonds, government agency issues etc.), bonds are very stable investment products, but with less upside potential over the long term. In life, no risk no reward. So too in the realm of investments. Risk is directly correlated with reward.
Investing is very much like mountain climbing insofar as the composition of one's investment portfolio in terms of the percentages devoted to stocks and bonds determines the height of the peak, the depths of the valleys, and the grade of the incline. The greater the percentage devoted to stocks the higher the peak an investor can expect to reach over the long term with the concomitant expectation that, at times, it will be a rough ride to the pinnacle and the depths of the valleys will test an investor's mettle. The greater the percentage devoted to bonds the lower the peak an investor can expect to reach over the long term with the relative comfort that comes with a smoother ride to a lower plateau.
For my portfolio, I decided to side with Peter Lynch and I initially started out by investing 100% of my capital into stocks. I was blessed with a very long time horizon with which to invest and my stomach for volatility was abnormally tolerant so I could endure the temporary and short-term fluctuations in stock prices knowing (assuming the past is prologue) that over the long term stock prices would go higher. As I age though I will invest in bonds at some point and the closer I get to retirement the larger a percentage of my assets I anticipate placing into the safety of bonds. As I age my risk tolerance for the fluctuations of stocks in the short term diminishes drastically. But, at the time I began my investment journey, I was better able to endure short term fluctuations, and I used those fluctuations to my advantage. I resolved to buy low and sell high - to treat every serious downturn as a Black Friday sale and every exuberant surge in stock prices as yellow snow - when every fiber of my being was telling me to do the exact opposite.
At the end of 1990, the Dow Jones Industrial Average was trading at around 2,600. At the end of 2023, the Dow Jones Industrial Average was trading at approximately 38,000. How does an investor not make money with this type of price trajectory? Here's how. Most investors panic when the stock market falls and sell their stock investments when the pain becomes unbearable and invariably that is the exact same time the stock market hits a bottom in preparation to rise to highs previously unseen. Likewise, most investors enthusiastically jump into the stock market when prices are hitting all-time highs, rising on the steam of irrational exuberance and unflinching greed, and invariably that is the exact same time the stock market hits a top in preparation to correct down to fair value. Buy low sell high.
Asset allocation is entirely a matter of personal preference. If an individual simply wants to follow the conventional rule of thumb there is nothing wrong with that and that is a perfectly sound strategy. If an individual wants to play it safer and simply split the difference and put 50% in both stocks and bonds that’s fine too. The important thing is to pick a strategy that you are most comfortable with and stick with it.
At year end, percentages will be askew because, depending on the year, stocks may outperform bonds or vice versa and subsequently the percentages devoted to each asset class will have changed. In order to correct the difference an individual should make future investments to adjust the percentages to coincide with their strategic plan for asset allocation.
So how often should I invest in those mutual funds of stocks and bonds according to my percentage allocation? Once a year in a lump sum? Every month in predetermined amounts?
Dollar Cost Averaging
Dollar cost averaging is investing a fixed amount of money at regular intervals regardless of the current market trends. The benefit being that a person utilizing this strategy will ultimately purchase more shares when the price is low and fewer shares when the price is high. The underlying premise of dollar cost averaging being that nobody knows the future direction of the market. If it was indeed possible to know to any reliable degree of certainty when the market is set to go higher and when the market is set to go lower, lump sum investing would be ideal. I would simply invest large sums of money when I know the market is set to go higher and avoid investing any capital when I know the market is set to go lower.
The truth is that most individuals are either not prescient or don’t care to be. Thus, for most individuals, dollar cost averaging is the simplest way to invest in the stock and bond markets over the long term.