Over the last few months, many of my Thoughts On Money have revolved around the importance of marrying one’s financial plan and investment management. That is to say, that the financial plan should be the driving force behind how an investment portfolio is designed.
Now, I am not talking about a “financial plan,” as in, a 100+ page bound printout that makes its way from your advisor’s office to being a dust-collecting–paperweight at your home. I mean, the actual planning of finances – the living document, the dialogue, the collaboration around how to best plan all of your money decisions.
Often this is not the case, though; these two practices – financial planning and portfolio construction – are held in isolation and not seen as a collaborative exercise.
This is a problem.
This results in investors and many advisors trying to develop alternate (sub-optimal) methods for how to best design a portfolio. Some will conclude with a one-size-fits-all age-based solution, and some will try to navigate these waters with a risk-survey-only driven process. Today, I want to teach you about a process I call Expense Based Planning (EBP).
First, A Quick History Lesson
First, the academics did investors a great disservice.
Finance professors and financial analysts alike needed a way to quantify risk. These gurus of finance settled on standard deviation as the metric, and volatility, the fluctuating price of a security, became the textbook definition of risk.
Yet, there was one glaring issue; investors already had their own understanding of risk – it was car racing and gambling. These “risks” didn’t only deal with high levels of uncertainty, but the potential outcomes could result in big losses financially or physically. Hence, when one hears the word risk roll off their financial professional tongue, it elicits some understandable fear and concern.
Academics and investors continue to struggle with reconciling this misinterpretation of what one means when they use the term “risk.”
Next, the business of finances did investors an even greater disservice.
Once this definition and understanding of risk permeated the finance industry as a whole, the business brains behind the industry sought to determine each investor’s “risk tolerance efficiently.” I highlight “efficiently” because the goal of so many businesses is to (1) create something that can scale and (2) protect the business from litigation. And thus, the infamous risk survey was born. These risk questionnaires (or surveys) became a form of CYA and efficiently determined an investor’s self-reported comfortability with volatility.
The finance industry and investors continue to struggle with reconciling how just one simple survey is sufficient for constructing a portfolio of one’s entire life savings.
A Conversation Vs. A Conclusion
Let’s pause here…
Does this mean that I am against a risk questionnaire? Absolutely not. I use them regularly and religiously. Here’s the difference though I use risk questionnaires as kindling, they are intended to spark the fire of a greater conversation about one’s experiences and attitudes around investing and volatility.
The risk survey is not the finish line, and it is not the conclusion. The risk survey is the starting line; it is what sparks the dialogue.
As the business-of-finance seeks to further its quest for efficiency, we see the spread of Robo-solutions in which the risk questionnaire becomes the sole resource for designing the portfolio. This I object to.
A Better Solution
So, how do we go about marrying our financial plan to the design and management of our investment portfolio? Expense Based Planning (EBP).
In order to understand EBP, we first need to understand two key concepts – expenses and safety nets.
David Bahnsen said something to me many years ago that has always stuck with me. He said, “I have met people with ten million dollars that are poor and people with one million dollars that are wealthy.” David inferred that it wasn’t the balance sheet in isolation that determined wealth, but rather the balance sheet concerning one’s expenses. A retiree with ten million dollars that is spending a million dollars a year has a lifestyle that is not sustainable based on their resources.
Expenses are the nucleus of financial planning.
If it has always been your dream to be in the circus, perhaps you might want to take a stab at the trapeze. If you’ve ever watched this act, you know it is both graceful and terrifying. It is safe to assume that the trapeze artists you‘ve watched are not first-timers. Thousands of hours of practice are what it takes to build up this expertise, and these hours of practice are done with a safety net to ensure survival as one hones one’s craft. The artist will fall in practice, and they will be thankful that there was a net to catch them.
In the same vein, when an architect is designing a building, they create a design that will pass all the needed codes and regulations. This includes fire safety, which means multiple exits and escapes plans in case of a fire. The architect doesn’t intend for their creation to one day burn down, but it is required and prudent to have these multiple exit plans in place in case of a tragic event occurring.
The hope is that no buildings burn down and that no one falls from the trapeze, but we will still install the safety nets and map out the fire exits. Financial planning is the same. We will create a plan that will provide sustainable and sufficient income, and we will also build in safety nets if things don’t go according to plan.
This concept around safety nets should redefine for you what being a “conservative investor” really means. This term should have less to do with the type of assets you own and more to do with the number of safety nets and protections you build around your plan and portfolio.
Employing an EBP Strategy
Here’s the big difference between EBP and other portfolio design methods. An age-based method uses just your age to determine what your asset allocation should be. A risk-survey-only method uses your opinion about your own comfortability with “risk” to determine what your asset allocation should be based on the survey deeming you conservative, moderate, or aggressive. EBP starts with the most important part of your financial plan – your expenses – to begin the design process, and the entire design revolves around your expenses.
Here is the first step in EBP. How much do you spend every month? Every year? This might seem like a daunting question, or perhaps your immediate response is that your spending patterns are not consistent. If so, I challenge you – take a look at your credit card statements or withdrawals from your checking account and notate what you spent over the last few months or the last few years. What you will typically find, adjusting for the every-so-often large one-off expenses, is that your lifestyle (your expenses) is fairly consistent. You have a rhyme or rhythm or cadence to your spending, and you need to be aware of what that is. This first step will be the heavy lifting, and you should take your time, as accuracy is helpful.
Once you’ve determined expenses, you can then begin to design your portfolio. Remember, EBP hinges on safety nets and expenses. The intent of an EBP portfolio is to (1) create sufficient income to cover expenses and (2) create multiple safety nets to account for the uncertainties of life.
SAFETY NET #1: You will want to have an emergency account that contains cash reserves. This is not intended to be proxied with other securities like bonds or indexed annuities, or other yield-bearing securities. Cash is king for Safety Net #1 because it is accessible, and the value is stable. The amount of cash should be a multiple of your expenses. This is the key to EBP; everything relates back to expenses. For some investors, perhaps they have a secure and stable profession and prefer to keep 4 months of expenses here, or maybe a retiree might want to have a year or more. The length of time expenses should measure this allocation’s size would be covered and determined by one’s preference.
SAFETY NET #2: Here, an investor will travel one-notch up the risk spectrum. At The Bahnsen Group, we’d call this asset “Boring Bond,” which is intended to be a category of government bonds, investment-grade corporate bonds, and U.S. agency mortgage-backed securities. Again, an investor will want to relate the size of this allocation to their expenses. The goal of Safety Net #1 and Safety Net #2 is to cover a minimum of 3-5 years of expenses typically. These allocations will not be a great hedge against inflation. Still, they will provide a resource if the more volatile allocations in one’s portfolio have extended recovery periods or if a surprise expense occurs at an unfavorable time for markets.
SAFETY NET #3: This safety net will not be an allocation but rather another access point to resources should a dire emergency arise (keep reading, I’ll explain). Remember, this is safety net number three, so it would be rare that this resource would ever be needed but having access can be comforting. This additional access point would be something like a line of credit. To obtain the most favorable rate, it would be best if this line of credit was collateralized with equity – this could be in the form of a Home Equity Line of Credit or a Portfolio Line of Credit.
SAFETY NET #4: Portfolio income. The ideal financial plan would have an investment portfolio that is producing enough income (e.g., dividends and interest) to cover one’s expenses. These would be the surplus expenses that were not being covered by other income sources like employment income, social security, rental income, pension, etc.
Pulling It All Together
Once an advisor and client get through formulating the resources for these four safety nets, the portfolio’s allocation design begins to take shape. For some balance sheets, there will be a surplus. This often means that the size of one’s balance sheet greatly dwarfs their expenses. For this investor, their portfolio design can venture into less income-centric investments that the long-term growth prospects may be more favorable and where an investor may be able to accept some level of illiquidity to seek these higher return premiums.
Again, the entire process revolves around the investor’s current and future spending. As I mentioned earlier, this process also redefines what it means to be a conservative investor because this definition leans more on the volume and strength of your safety nets, as opposed to the traditional definition that was determined by the type of assets you own.
I’ll leave you with this tidbit to ponder as well. If one investor was to go through these three processes – an age-based method, risk-survey-only method, and EBP method – would it yield a different portfolio design? I believe most of the time that it would. I also know that portfolio design has a BIG impact on long-term outcomes. For these reasons, coming from an individual that has worked on hundreds, maybe thousands of financial plans, I believe an expense-centric design process (EBP) method is superior.
A Conversation Starter…
I introduced today’s topic not as a playbook for how you might execute an EBP strategy on your own but rather as a thought-provoking discussion you might have with your financial professional. That you might measure your current portfolio design by your expenses and shift your paradigm for how you view your own portfolio. I don’t believe there is a bullet-proof strategy-in-a-box. I believe great portfolios and great plans come out of great conversations, and I hope that this concept I introduced will spark some great dialogue for you. If you have questions or want more clarity on this, please do reach out. I’d welcome a discussion. You can reach me at firstname.lastname@example.org.
I hope you enjoyed the article today, and I will be back next week with more of my Thoughts On Money.