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Monday, July 12, 2010
The other day, a millionaire asked me to construct a retirement portfolio for her…
Unfortunately, I don't have the right government certifications for this type of work, so I had to refuse the job. But it got me thinking…
Most financial planners would have recommended some ratio of stocks to bonds. The rule of thumb is, you subtract your age from 100. That's the percentage you put in stocks. The rest you put in bonds. My friend is in her fifties. A conventional financial planner would probably have her put 45% of her money in stocks and 55% in bonds. I'm 35. They'd have me put 65% in stocks and 35% in bonds.
I can't stand this advice. For starters, it's based on the flawed economic theories they teach at business school. These theories suggest the best returns come from buying and holding a diversified basket of stocks.
Buy and hold worked last century when the Fed was able to reinflate the economy every time it looked like a recession was coming, fostering an almost unbroken 70-year bull market. Now we're paying for that party with a long, drawn-out bear market. Not only is buy and hold broken… it's about the worst possible strategy you could choose in this environment. If you bought the S&P 500 on January 1, 2000, for example, you'd have lost 27% of your money already…
Your basket of bonds won't generate any worthwhile returns, either. The Fed has declared war on your savings by putting interest rates at zero, so corporate and municipal bond rates are near all-time lows while credit risk is higher than ever.
But the thing I hate most about this advice is it suggests you should hand over 100% your wealth and savings to the Wall Street machine. It suggests you aren't capable of managing it yourself.
What strategy would I have suggested she use instead? The "barbell" strategy is my favorite.
In the barbell strategy, the two "bells" generate the returns, while the "bar" keeps most of your money safe. With this strategy, 20% of your investments generate 80% of your return… and the rest gets invested in the safest place you can find, probably cash.
Famous financial author and hedge-fund manager Nassim Taleb's hedge fund uses this strategy. He keeps 95% of his hedge fund's money in Treasury bills and invests 5% of his fund in high-risk option strategies. If the Treasuries generate 1% and the options generate 100%, the total performance of the portfolio is just under 6%.
So what barbell strategy would I recommend for you?
First, build your "bar."
Your bar should be composed of extremely safe investments held outside the financial system. Own a modest house, without any debt. This is your personal property. Keep a stash of gold and silver bullion. Keep six months worth of expenses in cash. Open an account with Treasury Direct and buy a large chunk of short-term government bills direct from the Treasury. Consider buying short-term debt of other governments, too. You're avoiding Wall Street this way… and keeping your money absolutely safe.
Don't trust your bank, broker, or mutual fund manager to keep your cash safe. If the system fails, they'll all fail together, no matter how strong they are individually.
The "bar" won't pay you any significant income, but it will keep the bulk of your wealth 100% safe. The "bells" generate the income…
One bell runs strategies that profit from a declining stock market… like short selling, covered-call strategies, and short-term technical trading.
The other bell invests in unique, safe, high-income opportunities, like the kind I've been writing about in DailyWealth. These ideas could be stocks, bonds, or preferred stocks. The key is, these investments must be able to generate income safely in an environment of falling stocks. You should own a basket of these stocks to diversify risk… and always use stop losses as a final backstop.
Let's say you invest 70% of your wealth into the "bar," which pays 1% a year; 5% into trading, which generates 50% a year; and 25% into bear market income, which generates 10% a year.
Take a $100,000 hypothetical portfolio… $70,000 in the "bar" at 1% equals $700, $5,000 in one "bell" at 50% equals $2,500, and $25,000 in the other "bell" at 10% equals $2,500. That's a total of $5,700 from a $100,000 portfolio.
This portfolio will generate a total 5.7% a year… while keeping the bulk of your assets absolutely safe and sound.
This is a fantastic return in an environment where everyone else is losing money… and the stock, commodity, and real estate markets are falling.
You'll have to build your own barbell strategy… with the right balance between trading, income, and defense. These numbers are just for demonstration, but in general, with more working years ahead of you, you can keep your "bar" shorter and make your "bells" heavier.
Good investing,
Tom
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