In this article, I will discuss what I call the first guiding principle for managing wealth:
Make your balance sheet, cash flow, and portfolio your friend
There is a critical distinction between possessing a high net worth and having a strong balance sheet, cash flow, and portfolio. Problems in these three areas can give rise to huge frustrations and mistakes. The predicament of a gentleman I’ll call “Harry” illustrates this point.
In terms of net worth, Harry was in an excellent position, with total assets valued at somewhere north of $60 million. I would have thought it safe to assume that his balance sheet, cash flow, and portfolio were spectacular, but that was not the case. A very high percentage of his assets was locked up in a private company he owned, or in his homes and other personal property. In fact, when I first met him, his liquid and semi-liquid assets were not sufficient to sustain his rate of spending for much longer. Though he had a $3 million portfolio, he was beginning to tap it at an unsustainable rate. Harry was wealthy and he felt wealthy, but he was heading toward an inevitable cash crunch.
Part of Harry’s problem was that he needed to be more cost conscious. A lot of his cash flow problems came down to over-paying for various goods and services. His mortgage payments were much higher than they needed to be. He was bleeding cash in the form of high brokerage fees. He was paying far too much for financial advice and services that were focusing on the 85% Trap and missing the Essential 15%.
Oil crisis in Russia. Bad debts in China. Impeachment proceedings in Brazil. Emerging markets have plenty of issues to navigate, but a closer look shows that much of these concerns are already baked into the stock prices, perhaps overly so.
Emerging markets present attractive long-term growth opportunities generally not seen in developed markets: Younger demographics, a growing consumer base with rising wages and debt-free balance sheets, and government policies that are opening up countries to outside investors.
But emerging market stocks have lagged their developed market counterparts badly in recent years. Since October 2010, emerging markets have declined 6.0% annually while U.S. large cap stocks (as measured by the S&P 500 Index) have gained 10.0% per year. The last time emerging markets lagged this much was when the U.S. went through the 1990s tech boom:
When building an efficient portfolio, most market practitioners would agree to an allocation to bonds. This allocation reduces the overall volatility of the portfolio and adds a layer of safety. The two main components affecting fixed income returns are: 1). interest rates and 2). the credit quality of issuers. With the recent increase of interest rates and the Fed’s plan to incrementally increase rates over the next few years, we feel investments in credit, especially high yield, offers better return potential to investors.
High yield bonds tend to deliver the potential to improve a portfolio’s overall risk/return given the historically low correlation with other core asset classes. Due to their location on the credit spectrum, high yield bonds offer enhanced yields compared to high quality bonds and can potentially increase the overall yield of a portfolio significantly. Although this has not been the case as of late, historically speaking, high yield bonds have provided better downside protection than equities while delivering equity like returns with significantly less volatility and drawdowns.
Turn on any media outlet and there’s plenty to worry about. Will China’s slowing economy lead to a global recession? Has the Federal Reserve waited too long to raise rates? Are energy stocks in a long term bear market? Will Donald Trump really become our next president?!
But what is real “risk” for individual investors? In general, risk is uncertainty of the future. Technically speaking, risk for investors the standard deviation of returns. Most investors understand key tenets of portfolio management, such as the power of diversification in reducing the risk of future portfolio returns. (We discuss such topics in detail in our white paper.)
But with all of this attention focused on the markets and the portfolio, we fear many investors are missing the forest through the trees. What about the uncertainty associated with retirement? How long should you plan for? What about the risk that your portfolio won’t get you there?