Money gets you that control. It puts you in the driver’s seat. It gives you that ability to dictate how you want to spend your time, with whom you want to spend that time and for how long. Not only does it buy you options, it also buys you freedom.

And that path to freedom starts with savings first. You have to set money aside, whatever the amount, to get to a point that first takes care of emergencies. Like a car breaking down, an unexpected medical expense or in the worst-case situation, a job loss.

So a healthy savings pile is crucial to tide us through such emergencies. And the data shows that we as Americans are failing miserably at this first step towards stability. 

Now some of that is not our own doing. Circumstances prevent us from taking this first step because incomes have not kept up with the rise in the cost of living. And that is so unfortunate.

But with that aside, some of it is behavioral as well. Consumerism runs rampant in our society and Americans are the best at that. I mean worst at that. We are expected to spend because our global economy relies upon the fact that when no one consumes, Americans will pick up the slack.

That is sad and we need to reverse that because not only does it wreak havoc with our personal finances, it also destroys our world. Literally.

So we need to not heed that proclamation to spend but instead, save. I say start with setting aside at a minimum six months of living expenses in something that is highly liquid and accessible. Like a bank. And when an expense emergency strikes, you are ready with ammunition to blunt the impact.

Now liquidity and accessibility has a cost and that cost comes in the form of lower returns. Or interest rates to be more precise. You don’t earn as much on your money because it is designed to not earn as much. As of this writing, we are looking at less than one percent interest rates on bank savings accounts. And that is where this money should reside.

So that’s for the shorter-term goals. But we know we can’t keep stashing our cash in the bank for longer-range goals like say saving for retirement. We need rates of returns that are higher, much, much higher than what a bank account yields. 

And the only way that is possible is through the process of investing. And investing means risks but the longer one can remain invested, the lower the risks become. One of the easiest ways to invest and participate in our global economy is through the stock markets. Plural because there is not one stock market. There are many. And we need to participate in all of them.

Stocks as we know are ownership stakes in businesses and they have historically delivered a higher rate of return than what a bank account yields. They have to by design. In the long run of course.

But words are just words. Let’s look at the numbers to see why invest rather than just stash our savings in a bank account. We’ll start first with a single one thousand dollar set aside in these two different vehicles and compare the outcome.

Seven percent for stocks is just about right in the current interest rate environment. It could turn out to be conservative in the long run but as they say, better to be safe than sorry.

So we see the difference.

Now a single one thousand dollars of investment is not going to do much. So instead, say we save a thousand dollars each year. And this is what we get…

So much better. But say the amounts even with that are nowhere close to what you need to buy that freedom.

And you realize that pretty late, say when you turn 60.

So you try to accelerate the savings amount by doing 10x or $10,000 a year for the remaining years. What do we get?

So there is a difference but not as big as you would have expected. And that’s because your contributions did not have as many years to compound.

But what if you realized sooner and could do the same acceleration of saving $10,000 when you turned 40. And you did it for that same 5 years.

A big difference.

And those stock market returns are not going to come easy and this is how bad it could get every now and then.

At least, that’s how bad it has been historically. So expect that but keep on investing.

In parting, a few things:

• Emergency reserves are a must. Six months living expense is the right amount. And this money needs to be liquid and readily accessible.
• And we can’t rely on ‘safe’ investments to meet our long range goals. That money needs to be invested. But that also means small and big declines in the value of your portfolio every now and then. Be ready and willing to endure through those times.
• And Captain Obvious, the sooner we get our savings into investments, the faster we can buy our way to freedom. Not freedom from work but freedom from working on somebody else’s terms.

That’s all I have to say for now.

Thank you for reading.

Cover image credit – Karolina Grabowska, Pexels

Spending less than you earn and investing the difference is the first thing that comes to mind. But a bigger deal is time. Let me show you why.

Say I turn 25, start working (late start much) but have no clue about any of these things. So, I earn and spend. A few years go by and just like that, I turn 30.

And then I get to see the light of what I missed and how much harder it just got if my goal was to retire with a million bucks by the time I turn 65.

I know, I know, I am still a spring chicken and thinking about retirement is something only old people do. But remember, I am old. I just turned 30.

Though it’s not late yet but we all know that the more we put it off, the harder it gets. How much harder?

At 30, to get to a million dollars by 65, I need to set aside 701 dollars each month assuming my money grows at 6 percent rate of return each year. That is lower than what the stock markets have historically returned but I like to assume the worst and hope for the best.

But say I delay it to 35 and now I have to save 996 dollars to get to that same goal. At 40, it is 1,443 dollars and then it’s over. I mean it gets exponentially harder.

The word exponential is important because if you noticed the top end of the bars, they tend to curve up and curve up fast. That’s exponential growth. That’s compound interest. Nothing magical but then it is.

Here’s another take on the power of time and systematic investing. And all we are talking about is a mere 100 dollars one time or 100 dollars a month for 50 years. Yes, there is a difference but setting aside 100 dollars each month is a manageable sum for literally anyone.

The difference in final wealth though between a one-time investment of 100 dollars versus investing that amount every month for 50 years at that same 6 percent…

Not even in the same galaxy.

And all you had to do was set aside a cup of Starbucks worth of change each day.

Thank you for your time.

Cover image credit – Ron Lach, Pexels

And if you can convince the folks at the bank that you have a viable business at hand, the bank will lend you money. And lending means a periodic interest expense that you as a business owner will incur depending upon the terms you signed up for. Plus the money you borrowed to run and grow your business will have to be returned someday.

So your business must earn enough to not only cover all the expenses associated with building and selling your products but also enough to cover the interest expense plus eventually paying the loan off. And then whatever is left over are your profits.

What could you have done instead of borrowing that capital from the bank? You could have convinced the same folks at the bank to give you the money in return for a small piece of your business.

So now the folks who provided you with the much needed capital are partners in your business.

Plus there is no ongoing interest expense because the partners (investors) in your business now are in the same boat as you. And the money doesn’t have to be paid back…in theory. They are now part owners and they want you to succeed because if you succeed, they succeed.

Plus look at it from the bank’s point of view and their risk-reward situation. Their risk if you borrow the money is that your business fails and the bank not only loses the interest income but also the capital they lent.

But if your business turns out to be a startup that becomes the next Apple, they don’t get to participate in all that upside. All they are left with is collecting that measly interest income instead of the gusher of profits that would have flowed to them if they owned a stake in the next Apple. Or Amazon. Or Google.

Because with an equity stake in the business, they own a piece of that business and hence a piece of the profits made by that business.

So owners of businesses inherently make more than lenders because:

• As Naval Ravikant, the founder of AngelList says and I am paraphrasing here – when you are the owner of a business, you own the upside as well as the downside. But when you are a loaner to a business, you do own a guaranteed revenue stream (interest payments) but you also own the downside. So capped upside as a loaner with all the downside.
• Public businesses are run by some of the smartest folks around. We do occasionally hear stories about abuses here and there but in aggregate, these folks are running our businesses the best they could. And no business manager will borrow money at a cost (interest payments) that exceeds profits. So if you own a collection of them, you are bound to out earn a loaner.

The only advantage of being a loaner (lender) is that regardless of what happens to the profits in a business, the lender must get paid their ongoing interest and towards the end of the lending term, the entire loan amount (principal).

So there is a bit of a stability in the value of your investment being a loaner but that’s in the short-term. And that’s assuming the business survives.

As an owner, if business conditions deteriorate, profits decline and the value of that business declines. If that continues for long, the business could permanently shut down and the value of your ownership stake in that business will go to zero.

So stockholders (owners) suffer as well as the bondholders (loaners).

But that is if you own just one business.

The stock market and the bond market allow you to spread your money into hundreds of businesses and not all of these businesses will shutter.

If they did, the stocks will go to zero but so will the bonds. And you’ll have far worse things to worry about than worrying about money if that happens.

So if you are saving money towards goals that are more than a decade out, being an owner must pay out better than being a loaner.

But being an owner (stockholder) over a shorter-term means you are exposed to the full brunt of the volatility in business cycles and volatility as we know cuts both ways.

Thank you for reading.

Cover image credit – Jose Francisco Fernandez Saura, Pexels

That’s not quite market timing (it is panic selling) but it usually is the outcome of investing without a plan. Why are we investing, what are we investing for and what are we investing in is super-critical to know if we have a fighting chance to stick with our investments during eventual market declines.

Because without that, without that conviction, we’ll end up making decisions that are more emotions-driven than following a blueprint on what to do when such downturns occur.

And they will recur because volatility, I mean ups and downs in the prices of stocks, is inherent with the stock market but given enough time, stocks will and do recover to reach new highs.

As they did from the last time around when stock prices dropped big. That is again a feature of how the stock markets work. 

So to give you a primer on how difficult this market timing game is, take for example the year 2020 that started off just like any other year. And then came this little virus out of nowhere and the entire world stopped. I mean no school, no restaurants, no travel. The economy suddenly literally ground to a halt.

And we know what that means. A big stock market crash. And it happened. They say it was the fastest decline in the value of businesses by the extent the stock market dropped.

But then the market recovered and that too in a matter of weeks.

But had you sold at the bottom and many people did assuming things were going to get a lot worse, well, now you have a problem. 

And that always is the big danger. I’ll get to the why later but let’s run through some numbers on why it would have been a bad idea to even attempt to time the market.

So there were 253 total trading days in the year 2020. Had you stayed invested all through the year and though not ideal, if all you owned was a large company fund like the S&P 500, yes, you would have had to live through intense volatility but you did good. I mean you made 15.29 percent on your money.

But had you sold to buy back into the market at a later point and missed the single best day, your return for the entire year would have dropped by two-thirds.

So miss just one day and your return drops from 15.29 percent to 5.40 percent. That’s crazy.

And that usually is the most likely outcome if you were to attempt this market timing thingy since you’d always tend to get out at the worst possible days and the worst possible days are almost always followed by the best recovery days.

The best days are again lumped together and had you missed the best two days, you might just have been better off keeping your money safe in a savings account. Because missing just two of the best days turned a positive year into a negative one.

The plots below show all this in percent and dollar terms so don’t market time.

But why show missing only the best days? What would it look like if I were to miss the worst days of the year?

Fair question and you’d be right. You’d have quite a bit more money if you were able to somehow navigate out of the market before the worst possible days and were somehow able to get back in time to enjoy the recovery.

And the data that shows just that.

But we all know how hard that is. I mean the math is plain impossible. Let me show you why.

So there were 253 trading days in the entirety of the year. Your chance of missing the single worst day is of course 1/253 = 0.004 or 0.4 percent. Not only are your odds low but even if you timed it perfectly, it’s not like you made the kind of killing that would have changed your life.

Missing the two worst days brought you quite a bit more money but then your chance of successfully pulling that off is 1/253 x 1/252 = teensy tiny small. You might as well play the lottery.

And of course being able to time the market that lets you avoid all five of the worst days are out of the world remote.

So don’t market time.

And all this ignores tax consequences and all that time you’ll spend away from what you are good at, constantly watching the markets and the emotional heartaches that’ll bring you. Because trust me (my dad), this thing can be quite draining.

So again, don’t market time.

And the same plays out over longer timeframes.

Miss the 20 best days out of thousands over this 15-year stretch and you might just have parked your money under your mattress.

And here’s the biggest problem with market timing. Say you sell at the worst possible times thinking that things would get even more worse and they do, there is almost no chance you’d be willing to pull the trigger to get back into the game because then you’d wait for things to get even more worse.

So you wait and out of nowhere, the market turns and turn it does violently. That is what always happens. And now it goes past the point you sold at.

Now you are stuck, hoping and praying it (the stock market) falls again. And it never does. Because stocks as a collection are inherently designed to rise in the long run. They must. That’s the nature of the game.

So again, don’t market time. Don’t give up on the guaranteed returns that the global stock markets will deliver over time for that fake allure of being able to dance in and out of the markets.

And the best way to protect against caving to that lure of market timing is to follow a plan. Any plan, regardless of how sub-optimal it might appear to be is better than no plan. And then come hell or high water, stick to that plan.

I bet you’d come out a-okay.

Thank you for reading.

Cover image credit – Monstera, Pexels

But this apparently normal behavior somehow escapes the process of purchasing financial assets. And hence, an entire field of finance devoted to trying to understand why investors act the way they do while exhibiting perfectly rational behavior in other walks of life.

But I think investors behave the way they do because most fail to make a connection between buying say a box of Tide detergent versus buying shares in Procter & Gamble that makes that detergent.

And if we dig deep enough with anything we do or consume in our daily lives, there is always somewhere a connection between a product or a service and a business that delivers that product or a service. And that business, if publicly-traded, we can also own a piece of.

My younger daughter is all things LEGOs these days. I mean she spends hours building things like these…

And her gang is into it as well so we know she is not alone.

So then the discussion as usual leads to buying a piece of the LEGO making business. But she can’t because LEGO does not trade publicly.

But then that plastic that makes those LEGOs could be coming from a publicly-traded business. Or that oil that was dug up to make that plastic had to have a publicly-traded entity behind it. And so would the businesses that make those machines to injection mold these pieces or that steel that was used to make those machines or those semiconductor chips that control those machines and on and on.

So if she owned a diversified basket of global stocks, somewhere, somehow, she owns a piece of the supply chain that went into making those LEGO pieces. So she is all squared then.

Talk about supply chain, if you never came across this Milton Friedman video, well, you did now.

So the other day, I dug up some old notes and this one dates back to June 2nd of 2012. And that scribbling was all about yields – bond yields vs. earnings yield for a portfolio of global stocks. Earnings yield by the way is the inverse of price to earnings ratio.

So the 10-year Treasury bond yielded 1.5 percent at the time when global stocks were yielding 8.5 percent (price to earnings ratio of about 12). Global stocks here refers to the FTSE Global All Cap Index.

Stocks were a bargain then. How sweet of a bargain? The last time the spread was as wide was all the way back in 1962.

And yet investors were dumping stocks left and right, for some reason or the other and at the time, that reason appeared to be the Eurozone debt crisis. In just the April of that year (2012), U.S. investors sold a net total of 20 billion dollars worth of stocks. In May, they withdrew 26 billion dollars from the stock market.

All in all since 2007, investors withdrew some 530 billion dollars out of stocks and stock-type investments.

And where did most of that money go? Into the apparent safety of bank savings account and into bonds.

But that at the time could be considered as a reasonable behavior. Not right, not logical but reasonable. Investors were terrified of the slightest of turbulence. The trauma of the Great Recession was fresh in everyone’s mind.

And hence the equity risk premium. Stocks are risky because profits are not guaranteed. But if there was no risk, the earnings yield for stocks would collapse to meet that of bonds.

But earnings or profits for businesses can and do fall. And that causes the value of these businesses and hence the stock prices to fall. So the risk.

But in hindsight, that was THE time to plow everything you had into the markets.

And what was predicted at the time to be a great time to invest was indeed a great time to invest. I mean if you were anywhere close to the stock markets this past decade, you made money.

So where are we now? The bond yields are about the same but the earnings yield for stocks have basically cratered. That is, the equity risk premium got reduced.

And most of that reduction in the equity risk premium happened because of the expansion in multiples. I mean you were paying 12 times earnings for a portfolio of global stocks in 2012. Now you are paying 17 times that.

But then it sort of makes sense. Besides that small hiccup at the onset of COVID, we have basically forgotten what risk is. The Great Recession is a distant memory. The Dot-com crash of the early 2000s is like it never happened.

And hence the complacency.

What do I personally wish? I wish for a renormalization of interest rates. That’s assuming we know what “normal” is in the interest rate world. Maybe we are in a new era and maybe we never go back to the way things were but I think we must considering all the craziness that is out there in the markets these days.

I want things to reset a bit. I want the bond yields to grow and the equity risk premium to expand back up. So technically a double hit on the price of stocks.

Painful yes, in the short run but ideal for most of us in the long run. We rather take the medicine now than having to surgically remove a tumor later. Bubbles are painful when they deflate.

So if you are a millennial or a Gen Xer, you should get down on your knees and pray for a decade of flat returns. That’ll allow you to pump as much powder as possible into the markets while the bond yields normalize and the equity risk premium reflates.

None of it says that you sell your stocks. Because no one knows the future and you don’t want to get into the game of predicting the future. But if you’ve got a reasonable plan and a decent portfolio that fits that plan, you can tweak and make adjustments to that portfolio where and when necessary but you must stick to that plan.

That of course requires conviction and conviction only comes with knowing what you own is what you should own but once that’s done, all you can and all you should do is throw as much savings as possible into that plan and wait.

Thank you for reading.

Cover image credit – Tran Long, Pexels

And then there are the minimalists and there is a spectrum amongst them. The hard core ones are the planet-first kind who do everything they can to conserve and preserve. Think living off the land and off-grid.

And then there are the pseudo-minimalists who are the mindful consumerists. They do everything within reason to conserve and preserve but prefer not to take it to extremes even if they could afford to.

But wherever you are on that minimalist spectrum, that conservation and preservation mindset by default leads to wealth accumulation.

But ask any 6th-grader who between the two – the uber-consumerist or the minimalist – they think is wealthy and by default, they’d pick the uber-consumerist.

That’s how we are wired. What shows is what counts.

But it’s the minimalist likely swimming in cash while the uber-consumerist is one paycheck away from disaster. That’s the classic rich vs. wealthy debate. People who look rich might not be wealthy and people who appear run-of-the-mill own real wealth.

And you’d think the rich and the wealthy are the same and though there are similarities, there are big differences.

Rich is a state which is more current or transitory. Lottery winners, newly discovered celebrities, star athletes, folks working in high-paying professions such as medicine and law are the rich. They have quite a bit of money flowing in with most of it derived from a single source.

And the rate of outflow sometimes equals or exceeds the rate of inflow. The rich as a state can happen instantly and then it disappears.

Wealth on the other hand is more permanent. It comes through ownership of income-producing assets – enough assets that allows for a life full of choices.

And the income that these assets produce grows with time to a point where it surpasses income needed to support one’s daily existence.

So whether you work or not or if the skills you possess are in demand or not, your standard of living remains unaltered. If the same thing were to happen to a merely rich person, he would quickly become poor.

Wealth buys freedom. Enough wealth that the income it throws surpasses the income you need to live comfortably. Enough wealth that you can stop doing anything remotely resembling work and instead do something that you always wanted to do but couldn’t. You want to work for a non-profit that hardly pays anything, you have the freedom to do that. That business you always had an itch to start, you can do that. Or if all you wanted is to sit back and retire, you can do that too. All of that without impacting your quality of life. That’s critical mass.

And the only path that I know of that is guaranteed to get you there is a slow-boring one because it’s the most tried and true one. There is a reason why we come across many “get rich quick” schemes but never any “get wealthy quick” ones.

Yet behaviorally, the slow-boring path is the hardest to adhere to.

Charles Kinderberger, economic historian and an author of many investment classics, once said that there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.

And there will always be folks getting richer than you on some of the dumbest things you could have ‘invested’ your money in. Don’t let that take you off the rails away from a well-crafted plan.

And sure, you can strike it rich a million ways but holding on to wealth without a process, without a plan is tough. Because there are a million ways to lose it all.

I am not saying you have to hoard wealth to a point that you forget to live in the now and defer everything to that proverbial future. Because as they say, you can’t go snow-boarding in your nineties.

All I am saying is that there must be a balance between consumption now versus consumption later. That’s consumption smoothing where we tweak and optimize our spending to design a life that has a base level of happiness with occasional spurts of exoticism blended in. Because of course, YOLO.

And forget worrying about what we’ll leave behind for our heirs to inherit. That’s going to be dissipated anyways. I mean we can try but it’s going to be tough because of the human condition and hence the saying ‘shirtsleeves to shirtsleeves in three generations’.

And it makes so much sense. Say you are in the minimalist camp, your kids will absorb all those experiences and maybe implement some or most of them into their own lives. But then that minimalist mindset automatically means wealth accumulation which then gets passed down to your kids. Or at least that’s what most people do.

But then your kids someday have their own kids and now the setup is completely different. Their kids never get to see the struggle. They never experience frugality and choices being made. Life is easy. There is no drive and hence slowly but surely, wealth gets frittered away and the cycle repeats.

So is it any wonder that 70% of wealthy families lose their wealth by the second generation and a stunning 90% by the third¹.

Of course that does not mean you don’t try but many a times, it would be an exercise in futility and it’s good to have that perspective.

So coming back to you, the timeframe to reach critical mass is different for different people. And it’ll come down to two things – your burn rate and your investment returns. Investment returns beyond what’s statistically likely based on the risk-return characteristic of your portfolio are not in your control and neither should you base your financial plan on.

Burn rate is in your control and of course the lower the burn, the sooner you’ll reach critical mass. And one big side benefit of a lower burn rate is that now you are used to living on way less than you could since you’ve designed your life around that. I mean you were able to get to that base level of life satisfaction that your burn buys. And that should be the goal.

So increase the earn, reduce the burn and take the difference and deploy it into a plan that is tailored for you. Do that for some time and critical mass would be within reach far sooner than you realize.

That’s all I have to say. Thank you for reading.

Cover image credit – Joel Santos, Pexels

¹ Chris Taylor. “70% of Rich Families Lose Their Wealth by the Second Generation”, Reuters. June 17, 2015.

Or does it?

First, because it is market-cap weighted, the biggest companies occupy too much of your portfolio if this is all you own. Nothing wrong with that but just to give you some perspective, these were the companies that occupied its top 5 slots in the year 2000: General Electric, Exxon Mobil, Pfizer, Citigroup and Cisco Systems.

Things change so diversify.

Second, S&P 500 is a large cap index. It owns the biggest 500 public-traded U.S. businesses. So when you own just this, you own only one flavor of the market.

Third, tech businesses have come to occupy too big of a share of the index lately. And many of the tech businesses trade at valuations far richer than the overall market, some justifiably so, many not so.

And the reason the market affords a much higher multiple to these growth-oriented names is because of the historically low interest rate environment we find ourselves in. And low interest rates means equally low discount rates.

But then they are also more sensitive to changes in interest rates so if and when rates rise, the value of these growth-aligned businesses will decline, oftentimes precipitously.

And if what you own in your portfolio is skewed towards these names, your portfolio will suffer. It will eventually recover but that recovery could take much longer than your patience can handle. The decade of the 2000 is a perfect example. If a portfolio of S&P 500 is all you owned, you had less money at the end of that decade than at the start. We often forget but then we have the data.

But enough with the ramble and on to some number crunching. We’ll run through some test portfolios that are exclusively invested in one type of stocks and compare that to the one that’s globally-diversified across size and value spectrum yet still 100 percent invested in stocks.

The first is an S&P 500 only portfolio. Of course, this is past performance and future performance can and will differ but one thing I can almost reliably say is that if you expect an S&P 500 only portfolio to do over the next decade what it did over the last, it’s not going to happen. It could if business profits suddenly explode to the upside due to some breakaway technological advancements but these things don’t happen that often and hence.

So this below is the best and worst-case rolling returns of an S&P 500 only portfolio over these past many decades.

And just to give you some perspective on all the things that transpired during this timeframe:

• The 1987 stock market crash.
• The Savings & Loans crisis of the late 1990s.
• Gulf War I.
• Real estate recession of the early to mid-1990s.
• The Asian financial crisis 1997-1998.
• Dot-com boom and then a bust 1995-2003.
• 9/11.
• Gulf War II.
• The housing market crash and the ensuing global financial crisis of 2008.
• The European debt crisis 2012.
• And of course the pandemic.

And embedded in between these major events are the many micro booms and bursts that happen from time to time. They will always happen because it’s systemic. It’s the nature of the markets.

This below by the way is the exact annualized performance of an S&P 500 only portfolio over these last two decades…

What stands out is how most of the gains are back-loaded. That’s because S&P 500 sucked wind the entire decade of the 2000s. All the gains are packed in the decade that just ended.

So the best time to have loaded up on large-cap U.S. stocks was in 2010, exactly the time of maximum despair for a large-cap only portfolio.

But then there are businesses that are not in the S&P 500 that are smaller in size that can be found in say the Russell 2000 index. Smaller businesses are usually risker, both in terms of price volatility and in terms of their ability to survive.

The best and worst-case rolling returns for a small-size companies only portfolio over these last many decades…

And the actual annualized return for these businesses going back 20 years…

The shocker is not that small companies earned more over time. That’s expected. Not guaranteed but expected.

The real shocker is that they made you more money with less risk than their large cap brethren (compare the 10 and 20-year rolling portfolio returns for the S&P 500 only portfolio vs. the Russell 2000).

Now spreading our wings a bit more and looking beyond our borders with international stocks with a great barometer for that being the EFA index, EFA as in the Europe, Far-East and Australasia.

The same rolling returns for an EFA-only portfolio of stocks…

And the exact annualized returns for that EFA-only portfolio over the past two decades…

So not that hot compared to say the S&P 500 or the Russell 2000 but that’s expected. International stocks have treaded water for quite some time but that’s the nature of the game. They will shine again at some point, no one knows when yet no big deal.

But now we’ll mix and match all these and bring in emerging markets, value stocks, mid-size companies etc. that exposes a portfolio to all available factors and possible outcomes. The exact portfolio is not as relevant because there are tilts and tweaks you can apply based on where you find a better bang for your buck at any given moment but assuming a portfolio that’s designed keeping first principles in mind, you won’t go wrong. And of course assuming a portfolio that you will stick with, come hell or high water.

The rolling returns first…

And the exact annualized return for that global all-stock portfolio over the last two decades…

A few condensed takeaways…

• First things first, this is diversification within a category of investments (stocks) so it’s not what a true diversified portfolio can and maybe should look like.
• Small-caps (Russell 2000) did better than their large-cap brethren (S&P 500) not only from the performance perspective but also from the perspective of delivering better risk-adjusted returns. That’s with comparing the 10 and 20-year rolling returns as well as the exact annualized performance over the last 20 years. Not what you would have expected considering the hype around S&P 500 this past many years but that’s expected considering how recency bias plays tricks on us. But then we got the data.
• International stocks sucked in this timeframe and that is and should be expected from any asset category from time to time. They say that you only know when you are truly diversified is when you always own one or two segments in a portfolio that are treading water at a given time. If everything does good or bad at the same time, you have a problem. That is to say that your portfolio should own a lot of uncorrelated investments though these days with correlation of literally everything with respect to everything else approaching one (perfectly correlated), it’s not that easy but that’s our world today.
• And when you sprinkle the ‘right’ type of investments in the ‘right’ proportion, though individually they might suck, the blended portfolio almost always overcomes that individual performance disadvantage over the very long-term. For the statistically inclined, that’s because when the variance of one investment is added to the variance of the other, the resulting combined variance of a portfolio is always lower. And hence that shows up in better portfolio outcomes, not only with what you make in returns over time but making those returns with a reduced portfolio volatility. So a win-win all around.

That’s all I have to say.

Thank you for reading.

Cover image credit – Chris F., Pexels

So first a snapshot of the many goals you might have to plan for…

And with life after work (retirement) being the most expensive amongst them, we will use that as a use case to lay out the construct since the same process can be replicated for other life goals.

But before anything, a thing or two about perpetuities. Back in the day in 1751, the British government issued something called Consolidated Annuities or Consols that paid a fixed 3% rate of return each year (cash flows) and had no maturity date (cash flows go on forever).

The modern day equivalent of a Consol is a perpetuity as in the cash flows continuing forever.

And quite elegantly…

The present value (the price today if you were to buy it) of a perpetuity = C/r

C is the cash flow you receive each year if you were to buy this perpetuity and r is the interest rate or the rate of return.

Most long duration assets are perpetuities. Stocks, especially of the growth kind, in theory are the ultimate perpetuities because the present value of the cash flows that they’ll generate that’ll flow to you in the form of dividends twenty, thirty, fifty years down the road is very close to zero. And hence their valuation today can be condensed to a very simple perpetuity type model shown above.

So that was some necessary sidetrack but not to dwell on it much, the most important takeaway is the estimation of the present value of a perpetuity.

Back to planning for retirement, this is what the accumulation and the distribution phases look like for that goal.

Though two different rates of returns are assumed for the two life phases, there is not and there should be not a clear demarcation between the two. Those rates of returns should change gradually, abruptly or none at all depending upon individual circumstances and market conditions but let’s assume these two distinct phases exist for you for now.

And we’ll start with the ‘in retirement’ phase first to help us quantify the $ value of the goal and then work backwards.

The first thing you’ll need to know are your income needs in retirement. I know it’s not easy to know that yet when you are like 25 but you should have some idea about the amount of money it takes to afford you a good life today. You then inflation adjust that to the year you retire and through retirement.

So during retirement, you’ll know the cash flow you’ll need and you have an estimate of the rate of return that the portfolio you’ll own is expected to deliver (r2 in this case).

Hence,

The $ value of the goal at retirement = The present value of a growing perpetuity that you buy right when you retire – The value of a growing perpetuity that you’ll buy at 100, discounted to the year you retire

Growing perpetuity is another flavor of a perpetuity where you assume growing cash flows (inflation-adjusted income need in retirement) instead of the constant cash flows we assumed in the original perpetuity equation.

So now that we know the $ value of the goal, we tackle the first phase of planning for retirement. And these are your accumulation years where you need to set aside a fixed amount of money each year to reach that goal.

We start with first discounting the $ value of the goal and bringing it to the present (at 25 in the plot above) using the assumed rate of return (portfolio growth rate = r1). Any savings (earmarked for retirement) that you already have now needs to be subtracted from the present value of the goal to calculate the gap you have to fill over the years to reach your goal.

That is…

The Gap = Present value of the goal – Savings you already have, earmarked for retirement

With this gap in savings required known, you can then reverse calculate the amount you need to set aside each year using the same perpetuity logic.

That is…

The Gap = The present value of a perpetuity you buy at 25 – The value of the perpetuity you buy at 65, discounted to the present (at 25)

You know the gap, you know the years to retirement and you know the portfolio growth rate during accumulation years and with that, you can back calculate the amount you need to save each year to fill that gap.

There is a lot that I skipped over to give a brief overview but for those interested in diving into the nitty-gritty of how this is done, a video tutorial is in the wings that I’ll release when ready.

Thank you for reading.

Cover image credit – Pixabay

This and the Capital Asset Pricing Model that Dr. Sharpe subsequently developed led to him winning the Nobel Prize in economics in 1990.

The Sharpe ratio…

In English, it is the excess return of a risky investment over and above the return that a safe investment yields per unit of risk (volatility) of that risky investment. This is another way of stating that what counts is not just returns but risk-adjusted returns.

The risk-free rate of course is not constant. Many use T-bills (Treasury bonds with a maturity of less than a year) as the benchmark for the risk-free rate but that’s not always right. Stocks as we know are long-duration assets (perpetuities in theory) so if you own an all-stock portfolio, you need to match that with a comparable duration asset like say a long-term bond with a 10-year or a 30-year maturity for instance.

And if you add shorter duration bonds to that all-stock portfolio, the duration of the risk-free asset and hence its return to calculate the Sharpe ratio needs to be adjusted accordingly to match duration for duration.

But in today’s never seen before interest rate world, the risk-free rate of return difference between long and short maturity bonds is not going to make or break things. In fact, you are free to ignore duration entirely and use a flat 1 percent rate of return in lieu for the risk-free rate.

So that was a bit of a technicality but what Sharpe ratio tells us is that you better get compensated for the risks you take in your portfolio. And the higher the Sharpe ratio for a portfolio, the better designed a portfolio you have. Within reasons.

Because you can play games using leverage etc. to prop up the Sharpe ratio of a portfolio but we know the thing with leverage. When things blow up, they blow up spectacularly.

But Sharpe ratio or anything to do with long-range portfolio construction and prediction does not work with individual stocks. Or individual bonds. Or a single piece of real-estate. Or your entire angel investment portfolio.

It only works with broad-based asset classes that you can derive meaningful statistics from to build a portfolio around which then forms the core part of your financial plan (more on that later).

So someone just starting out in his career could have owned an all-stock portfolio that is globally allocated, across size and value factors. Of course an all-stock portfolio means being exposed to the full brunt of the volatility of stocks but that’s expected.

And this is what you would have had to endure over the years. We are going to run through three different portfolios with this one being the one with a lower Sharpe ratio than the other two. A lower Sharpe ratio isn’t necessarily bad but if you are comparing two likewise portfolios, you’d want to the pick one with a higher Sharpe ratio as long as you understand what’s in that portfolio.

The exact mix of this all-stock portfolio is irrelevant because you can always implement your own tweaks based on which corner of the market you think offers a better value but this is what you should expect. Or at least this is what you did get going back in time.

Now these are rolling returns which means that say for the 3-year bar in the plot above, you’ll start out in 1987 and end in 1990, then move to 1988 and end in 1991, then to 1989 and end in 1992 and so on. That way, you are not picking and choosing timeframes.

So what stands out is there was a year when this portfolio declined in value by 41 percent but then there was also a year where the portfolio gained an equivalent amount. But there was never a 5-year period where this portfolio lost you money. So that’s the perk of remaining invested for the long-term.

And depending upon how lucky or unlucky you were, the difference in returns between different 20-year periods is huge. I mean there was a 20-year band in the same 1987-2020 time-period where you did almost 12x your money (+1072 percent) in one versus just 4x your money (+323 percent) in the other.

And that worst 20-year band most likely corresponds to the last 20 years that ended in 2020 as can be seen with the exact annualized returns that you were able to achieve with this all-stock portfolio.

But this 20-year band saw a lot. Starting out of the gate was the Dot-com crash followed by the housing market crash of 2008 and then of course the pandemic. Not saying that the next 20 years can’t be worse but just saying.

So if you endured through this, you should be able to endure through anything the market throws at you except for world-ending calamity. But then, your portfolio would be the least of your worries and hence.

Now someone mid-career who had amassed a reasonable amount of money towards retirement could start to temper down on the volatility by allocating say 20 percent towards bonds. Bonds are less volatile and don’t generally yield more than stocks but the lower volatility of bonds and their inclusion in a portfolio shows up in the increase in Sharpe ratio of that portfolio. Again, not necessarily good or bad but a metric you can use to compare across similarly constructed portfolios.

And the best and worst-case returns below.

The annualized returns for the same portfolio going back in time.

Not that much different from an all-stock portfolio but that was for the last 20-years where stocks were literally cut in half twice in one decade.

Now someone nearing retirement could have increased the allocation to bonds to say 40 percent. The Sharpe ratio for this portfolio as expected goes up so if you are comparing two portfolios with a similar stock/bond mix, you’d know which one’s more efficient.

And the best and worst case performance data below…

…as well as what this portfolio did going back 20 years.

Again, the anomaly with the last 20 years shows up with stocks not doing as well as they did historically and with bonds absolutely crushing it. This is unlikely to be repeated for a portfolio with 40 percent allocation to bonds over the next 20 years though.

So what kind of portfolio should you own? But before that, a bit on what I do with my (our family’s) money.

We use a core and explore approach to how we deploy our savings. The core is the can’t miss, can’t fail segment of our money that must be there when we need it and hence is invested accordingly. That makes up about 90 percent of all the money we have though that percent allocation is higher now for reasons I’ll elaborate on more below. And it’s invested in an all-stock portfolio like the one shown above for three reasons:

• 4 percent is what is typically used as a safe withdrawal rate from a portfolio to live on during retirement though that might need some adjustments considering the interest rate environment we find ourselves in. But a 4 percent withdrawal rate means your portfolio cannot afford a lot of volatility and hence bonds become an important component of that portfolio. But if say a 2 percent withdrawal rate is plenty to live on during retirement then there’s no need to add bonds as dividend income alone can fulfil your income needs and that is where we expect to find ourselves at.
• There is unlikely to be a repeat of bond market performance of the last 40 years over the next 40. So if you don’t need bonds, you should not need bonds. Yes, the right kind of bonds can and do make the ride smoother but if you don’t care about the ups and downs, you don’t need bonds either.
• And though an all-stock portfolio will have an inferior Sharpe ratio than a portfolio with a decent allocation to bonds, that in and off itself is not necessarily bad. Because there is no guarantee that adding bonds will enhance the volatility reduction benefits bonds provided in the past. So though Sharpe ratios are important to compare two similar portfolios, that is where that comparison stops. Just because a portfolio’s Sharpe ratio is lower does not automatically imply inferiority.

I also do a bit of exploring with our money and that’s where the tiny explore portion of our money is invested. We haven’t done much to this in the last many years due to the valuation environment we find ourselves in but we will at some point again when wonderful businesses could be had at reasonable valuations when this current cycle turns. And turn it will.

But of course there is no need to do the explore if you are not meeting your plan goals. And it also comes down to whether you enjoy doing all the work needed to explore because work it does take.

Plus since statistical calculations can’t be done with the explore segment of my portfolio, Sharpe ratios and things like that goes out the window. This is an attempt to eke out a bit more than what the core-only portfolio can deliver but of course there are no guarantees.

The explore portion of our money is currently invested in a bunch of businesses that are small, cash flow rich with predictable business models. At least, businesses that I can do some modeling and projections on. Businesses like Raven Industries that make precision agriculture products and engineered films. It’s been in the news lately as it is getting acquired in an all cash deal.

Other companies that were acquired since the time I first built this portfolio almost a decade back…

• Pall Corp., a maker of water filtration systems was acquired by Danaher Corp. August 28, 2015 was the last trading day for the stock.
• Mead Johnson Nutrition Co., maker of infant formula such as Enfamil brand, was acquired by Reckitt Benckiser Group. June 14, 2017 was the last trading day for the stock.
• Clarcor, a maker of filters for automotive and heavy industrial applications was acquired by Parker-Hannifin. February 27, 2017 was the last trading day for the stock.
• Kaydon Corp., a maker of industrial bearings and shock absorber systems was acquired by SKF. October 15, 2013 was the last trading day for the stock.
• Bio-Reference Labs, a provider of clinical laboratory testing services for the detection, diagnosis, evaluation, monitoring, and treatment of diseases in the United States was acquired by Opko Health. August 19, 2015 was the last trading day for the stock.
• Sigma-Aldrich, a company that develops, manufactures, purchases and distributes a range of biochemical and organic chemical products, kits and services that are used in scientific research was acquired by Merck. November 17, 2015 was the last trading day for the stock.

Then there are business like International Flavors and Fragrances. And W.W. Grainger. And Copart. And C.H. Robinson Worldwide and a few others that we’ll continue to own for a long time.

Hope this helps.

Thank you for reading.

Cover image credit – RF Studio, Pexels

Venture capital as a funding model didn’t exist back then. And back then is 1960s. You needed capital to start your business? You’d rely on the faith and generosity of friends and families or you’d go down to your local bank to pitch them on the promise that was your startup.

And banks were and still are in the business of lending. They lend instead of taking a stake in your business. So a completely different business model.

And conservativeness is the name of the game. Return of capital is more important to them than a return on capital. An excerpt from that book is indicative of those times.

“Here I’d built this dynamic company, from nothing, and by all measures it was a beast – sales doubling every year, like clockwork – and this was the thanks I got? Two bankers treating me like deadbeat?”

Phil Knight in Shoe Dog

So imagine where we would be if we had to rely on capital from banks to fund our bleeding edge businesses of today.

But then we also have the landscape of today. Apoorva Dutt wrote a piece that is based off of excerpts from Dan Lyons book titled Lab Rats which talks about how Silicon Valley’s business model of moving fast and breaking things is making life miserable for the rest of us. This was in 2018 and things have just gotten crazier since then. Some choicest excerpts from her piece about Dan Lyon’s book…

“Silicon Valley has no fountain of youth. Unicorns do not possess any secret management wisdom. Most startups are terribly managed, half-assed outfits run by buffoons and bozos and frat boys, and funded by amoral investors who are only hoping to flip the company into the public markets and make a quick buck. They have no operations expertise, no special insight into organizational behavior. All they have is a not-very-innovative business model: they sell dollar bills for 75 cents and take credit for how fast they’re growing.”

Apoorva Dutt, Tech in Asia

“The vast majority of these new companies are losing money. Traditionally, to get rich in business you had to build a company that turned a profit, and then the profits were shared with investors. The new VCs have invented a form of alchemy in which they make a fortune for themselves while skipping the step about building a profitable company. I call it, Grow fast, lose money, go public, cash out. You pump millions (or billions) into a startup, so that it grows rapidly. You generate hype, flog the shares to mom-and-pop investors in an IPO, and scoot away with the loot. In 2017, I made a list of 60 tech companies that had gone public since 2011. Fifty of them had never made a profit. Some new companies lose incredible amounts of money.”

Apoorva Dutt, Tech in Asia

That’s harsh but there is also truth in that. And we can see some of that play out lately with many of the newly listed companies with their values down 50 percent and more. And they are still nowhere from being reasonably priced.

Venture capital as an ecosystem is not designed to work with a lot of capital. In fact you make things worse for startups who are doing things right and playing by the books on their plans to grow a business with profits as the end goal. And that must be the end goal for the system to flourish.

Because you can always throw junk in the public markets and the public might lap it up. To a point. It’s that same fool me once, shame on you, fool me twice, shame on me endgame.

And we don’t want that endgame.

Of course, few businesses start out of the gate being profitable. But there must be a point beyond which profitability becomes imperative. We cannot have billion dollar businesses perpetually losing money.

Mihir Desai, professor of finance at Harvard Business School and an author of one of my favorite books, The Wisdom of Finance, wrote a piece in New York Times right before Uber was about to go public and why you should root for that IPO to fail. That’s cruel but hear him out.

“This cycle – in which unsustainable start-ups make ever-larger promises to bloated venture capitalists, who promise more than they can deliver to flush sovereign wealth funds, who are too eager to believe them – distorts the allocation of capital and talent. The rush to invest, no matter the underlying economics, diverts entrepreneurial energy toward unviable business models.”

Mihir Desai, New York Times

Of course that’s nothing to do with Uber but that’s what we get when so much capital is chasing returns wherever it can find in this ultra-low interest rate environment with pension funds, endowments and even John Q public piling in.

Now that I’d depressed you enough, there’s still a decent justification for you to still participate in this ecosystem because not many avenues exist that can add sparkle to your portfolio with returns beyond what you already have access to. Plus all that thing about backing entrepreneurs and helping turn their dreams into a viable product or a service.

So how do you decide how much can you afford to invest in this space?

I’d start with my 10 percent rule. That’s your play money and venturing into venture capital is equivalent to that. Very high risk with a potential to knock it out of the park.

For those that are into statistics, traditional stock and bond investing have returns that are more normally distributed. Venture capital returns follow a power-law distribution.

And data shows that you’ll need a minimum of 50 investments to even have a shot at this.

So assuming you deploy $10,000 in each one of them, that’s $500,000 right there.

But you can’t just invest once and be done with it. You need to invest at the minimum in a follow-on round to make sure you don’t get diluted out of your initial stake.

So that’s another $10,000 for each of those 50 bets.

So you need to carve out a million dollars from your portfolio to play this game. And since this can’t exceed 10 percent of all the money you have means you can only afford to play this game if your net worth is in the 10 million dollar range.

So that’s the hard math.

The way around it is to invest in a pool with other like-minded investors. That way, you can get exposure to this asset class even with a lot less.

To me, investing in this sphere if opportunity presents itself is to be an enabler of this ecosystem. Not that it needs any of mine or yours help in the current environment.

But if there is a chance to strike it big, there is also a chance it all flames out. That’s the nature of this game and you must play the game to find out.

Thank you for reading.

Cover image credit – Startup Stock Photos, Pexels