What Are You Actually Invested In For Retirement?

The other day I was thinking about how these days, everyone recommends a certain fund to invest in or a particular group of funds. There are ETFs and Index fund recommendations everywhere. What the heck is in Vanguard’s “Wellington Fund” anyway? What about international funds? Or biotechnology? I thought it might be good to take a peek inside my own family’s retirement account allocation in order to better understand what we’re actually invested in.

The growth of the mutual fund industry and now the index fund and ETF industry have done a lot of good for investor – no doubt. There’s a lot more built in diversification than there used to be. However, fund names often blur the lines and act as a psychological barrier between what an investor thinks she and owns and what she actually owns.

Also, even with investors like me who invest strictly in just a couple funds in retirement accounts, say an S&P 500 index, methodologies are changing all the time. The S&P 500 now allows for things like mortgage REITS (mREITS) which would never have been allowed in days past.

You’ve got to look at turnover too. The people you’ve entrusted to manage your retirement money through your 401(k) at work or your IRA often change out different securities within the funds you hold. Companies and grow and companies shrink, so relative weightings change over time as well.

All this is to say; you should know what you’re investing in. It’s such a simple thing to check up on but a lot of people don’t take the time to do it nonetheless. Simply taking a fund description’s word at “heavily diversified index” is a good start, but it’s not exactly due diligence. Take a look at the prospectus for each fund you invest in. I decided to take the time and check out my own family’s allocation, and it looks something like this:


You’ll notice the biggest position is in company stock. I know a fair amount about how my company makes money, what a lot of the risks are, and what past performance has been like, so I feel comfortable with this being the largest position here.

From there on you’ll see the usual suspects: Apple, ExxonMobil, Google, Chevron, Wal-Mart, Microsoft, etc. These are the big American companies that everyone knows about. Given diversity across industries and the relatively small piece of the pie that they each make up here, I’m cool with that.

I remember when I first looked at an S&P 500 prospectus and looked over the top holdings. Apple is over 3% even though it’s just one of the 500 components?! Yep. If there’s a huge change in technology and iPhones become irrelevant tomorrow, the impact to my portfolio is going to be greater than say, if Facebook went under (1% shown above).

This is just one example. Every stock mutual fund and stock index fund is made up of hundreds of components of individual stocks. Every bond fund is made up of bonds. Most “balanced” funds tend to be made up of a combination of both.

The financial media over at least the past decade or so has really pushed investments in mutual funds, index funds, and ETFs. When people say “never ever buy individual stocks, they’re too risky!” and then go ahead and buy stock mutual funds, I just shake my head. Sure, there’s a lot of diversification from owning index funds. I own index funds. But for an investor who has sizable assets it could make sense to invest in a collection of individual securities, but that’s already been explained by somebody else.

The problem is, people don’t know what they own. At the very least, take a quick look at the top 10 holdings in each of your funds. Did anything surprise you? Are you comfortable with how your managers are allocating your funds? Don’t be shy about seeking fundamental information about what you actually own – behind all the fund names.

Income Based Talmud Asset Allocation

Income TalmudSeveral months ago I read an article on one of my favorite blogs about an approach to asset allocation based on the Talmud, the ancient Jewish religious text.  It essentially espouses the use of three different asset classes: businesses (stocks), real estate, and reserves (cash or cash equivalents).  Directly from the text, it reads: “One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.” (Baba Metzia, 42a)  I was mulling the idea around in my head for a while and thought it might be nice to further refine those allocations based on an income-based approach.

I think a good way to allocate our assets in the long term might be split evenly between dividend-paying stocks, rental real estate (actual real estate – not REITs), and cash.  I like this allocation model because it is diversified yet retains some amount of focus on asset classes that appeal to me.  It also gets my attention because it helps provide the three key metrics that define financial health and fortitude: net worth, predictable streams of income (profit), and liquidity.  These metrics apply both to the financial health of a business of a family’s personal finances.

Capital Appreciation Increases Net Worth

Net worth is the foundation of wealth, really.  If you have a stream of income but now assets – say you are reliant on a paycheck from a job – your income stream can stop at any time.  You may get let go for one reason or another, or you may just quit and leave.  Think about, however, if you had $500,000 in assets and no liabilities when you quit your job, giving you a $500,000 net worth.  Then at the very least you could sell your assets over time, piece-by-piece and live off of the gains.  A Talmud-like portfolio, or any portfolio that you build with assets that grow over time would insure you have an ever-increasing net worth.  The capital-appreciation of dividend growth stocks and rental real estate would accomplish this.

Dividends and Rents Provide Income

This is not the whole picture though.  I’m of the belief that true wealth also consists of the income your investments provide.  If you build up a million dollar nest egg, but it generates no income, then sooner or later you are going to eat through your savings.  This is often how financial planners talk these days when advising an individual or a couple on saving for retirement.  “If you can build a $1,000,000 portfolio, you can sell it off year by year and it will last you two decades if you keep your expenses below $50,000/year!”  No, no, no.  I don’t want to be like that.  I’d much rather have my income increase each year, by at least the rate of inflation.  That’s what preserves my purchasing power.  Dividend growth stocks and rental real estate do this.  They can provide ever increasing streams of cash whether I am able to add to the investments or not, so that I can feed the family even as prices for goods and services increase.

Cash Provides Liquidity

A third, but often-overlooked part of financial success and portfolio management is liquidity.  Small businesses fail everyday because they don’t have the reserves necessary to deal with everyday situations.  This can happen in big businesses too.  Look at Wachovia – an otherwise successful bank disappeared nearly overnight because it couldn’t meet short-term financial obligations (significant losses in its loan portfolios).  If it had a few extra billion dollars in cash reserves, who knows?  It might have been able to weather the storm.  The cash portion of the Talmud portfolio is there to help in situations like that.  If I’m flooded with emergencies one day, I don’t want to feel pressure to liquidate investments to stay above water.

Another key reason for keeping a decent amount of the portfolio in cash is to take advantage of prime opportunities.  If another 2008 happens (really not if, more like when), I want to be able to scoop up shares of the best businesses in the world at bargain prices.  Having liquidity allows you more options and ways to make money when there’s blood in the streets and everyone is panicking.

Overall, I Think There’s a Good Case for An Income-Based Talmud Asset Allocation

Talmud_setAre there weaknesses to this model?  Of course.  By tying up a full third of investments in cash, there is less money being put to work in higher-returning investments.  Also, by focusing on income-producing stocks rather than pure growth stocks, you are missing out on making a hundred times your investment in a short time frame by finding the next Microsoft or Apple.

I’ll take my chances with these considerations in mind, though.  The more I explore and think about the idea, the more I like the Talmud’s approach to asset allocation.  It provides capital preservations (liquidity), growth (a rising net worth), and income.  As for semi-annual or annual rebalancing to keep things in order – I would shy away from selling assets explicitly for this purpose.  I wouldn’t want to generate unnecessary taxes from capital gains.  Instead, I would gradually build up whatever position needs a boost to match the 1:1:1 ratio of asset classes.  Overall, I think this method would provide solid growth, income, and liquidity for the future.