We’ve been proponents of Dollar cost averaging for over 5-years (long-time followers of the blog will know this) and now we’re going to switch gears and suggest it is better to manage your own book. We’ve seen too many companies get bid up due to participation in specific ETFs/funds etc. that don’t deserve a propped up multiple. If we look across investment funds we also see two more alarming trends: 1) small time retail investors are now blind purchasing passive funds and 2) the increase to passive now has projections for making up 51% of the market by 2021-2024. When the masses start to flood into a specific type of investment and more than half of the companies are seeing bids due to blind purchases… we all know how that will end. Before we begin, we note that none of this information should be considered as legal or professional financial advice.
Before You Manage Your Own Book…
Trust No One: While we’ve long recommended simply purchasing the S&P 500 index (you would have made a good amount of money by the way!) the first rule is to trust no one’s opinion but your own. Taking advice from a single person/entity forces you into a position of reliance… What happens if that person/entity no longer exists? You get burned. Do not give someone that type of power. All decisions will be made by yourself and you will do extensive research before investing a cent into any project/stock/bond etc.
Keep Yourself Honest: If you decide to manage your own book, when you make the transition it is critical to purchase a small amount of comparable indexes. Wait… We said you shouldn’t buy indexes right? Well, the point is to keep your performance honest. If you can’t beat the index you’re bench-marked to… then you’re simply wasting your valuable time. As an example, owning nothing but micro-cap stocks and comparing yourself to the S&P 500 is not a fair comparison. In a more positive example, if you own a large number of mid-cap stocks and consistently beat the mid-cap S&P index, you’re outperforming. By purchasing a small amount of comparable indexes when you begin to manage your own money, you’ll see the actual results.
Ask If IT Is Worth the Time: The last thing you’ll have to do is ask yourself how much time it will take to manage your own money. If your net worth is under $1M… It does not make sense to manage your own money. You’re better off owning a basket of products across multiple asset classes: Real estate, stocks, bonds, etc. If you’re north of $1M and have some specific knowledge you can apply? Then you’re going to be a *candidate* for money management. As a basic example take a person with $2M to invest. If he can return an additional 5% that’s $100K. Take the $100K (above market return) and divide by the amount of time spent managing the book. If it’s less than how much you could make in your own business then run with it. If not… Go back to square one and do basic broad stoke investments across asset classes.
Managing Your Money and Asset Classes
There are millions of ways to break down asset classes. Most people will simply say “stocks” is an asset class (we stated this above as well). But. The reality is each stock has a different profile. There are micro-caps, small-caps, mid-caps, large-caps, dividend paying stocks, REITs…. And much much more. So we’ll start with the most important step first (as usual) financial independence cash flow.
Step 1) Cash flow to Cover Costs: If you can wake up every single day knowing you’ll never have to worry about food, drinks, shelter and healthcare… You’re a solid candidate for managing your own money now or in the future. Your asset classes here will typically consist of 1) dividend paying stocks, 2) real estate, 3) bonds and 4) some small amount of boring CDs. If you’ve gotten to this point in under 10 years or so, then your goal is simple *don’t lose the money*. This chunk should not be managed, it’s just there to give you peace of mind. Even if you do a poor job with money management… You’re still never forced to work for a living.
Step 2) Decide on Your Strategy: We have always found humor in Entrepreneurs stating that managing your own money is not a good idea. Entrepreneurs quite literally went all in on one “stock” (their own company) but some of them believe that good companies/investments cannot be found? It doesn’t add up. That said, you’re going to need a specific strategy to build up your portfolio in the future. If you’re going to go down this route you’ll need a specific comparable index. Since we don’t know your strategy we’ll go ahead and provide some examples:
Real Estate Example: Real estate is one of the most common ways to get rich. If you live in a specific city, say Chicago, then you’ll have to compare your returns to the Chicago housing market. If the market continues to go up at ~6-8% a year and your returns are closer to 15%… You’re in the right business and have the necessary skills. We also have a theory on real estate…. It is a common way to get rich because you’re essentially combining a regular scalable business with investing. You’re essentially a niche portfolio manager since you’re dealing with both investment returns and an active side if you build an actual RE business.
Sector Fund: Another way to try and create excess returns is through a sector focus. If you have this type of knowledge in say retail products, then you’re going to compare yourself to a retail focused index fund. If you were to focus on oil and gas, then you’d have to compare yourself to the overall O&G basket of stocks. Beating a dead horse, but as you can see, just because a “stock is up” doesn’t mean it was a good investment relative to the comparable group. Our guess is most people will fall into this category. They successfully started a business in category A,B or C and can then identify business structure changes that will impact the Companies in the space.
Caps and Risk: This is largely a macroeconomic strategy. Business cycles are not only sector specific but “cap and risk” specific. Largely speaking you’ll see small caps get hit harder in recessions and outpace mid-caps and large-caps during expansions (as we have seen thus far). The best part about this strategy (if you believe you have an edge) is the S&P is likely the best comparable metric for you. Since the S&P is a good general benchmark for the “market” (US specific) you’ll need to outperform this benchmark by weighting your exposure to small, mid and large caps over a multi-year time frame.
Step 3) Annual Benchmark: Under no circumstances should you under-perform the benchmark. If you have a real edge you should be outperforming the benchmark every single year. If you want to be more flexible with this then you should outperform the market 8/10 years and (of course) the total returns need to more than offset your “bad years”. Our annual outperformance benchmark is certainly hard to accomplish, however, unless you have more than $100M, you’re not going to run into “size issues” where purchasing any stock will actually move the value. If you have $10M or less and manage your own investments, a single move into any security, bond, etc. should be liquid at all times.
Step 4) Always Have Cash: In addition to all the ideas listed above you’ll need liquid cash in your investing account at all times. If you know a certain sector well or you believe a certain cap will outperform, you need the flexibility to buy when no one else will. We realize this is typically a large hurdle given that you’ll have a separate portfolio that will always cover your living expenses (never touched) And you’ll need cash on top of this for “one time events” where there is a large opportunity that can’t be missed. (In the past we’ve stated it takes about ~$50K to start a new consumer product and we think that same number is fair for a cash balance in case there is a nice investment opportunity).
Step 5) Do Not Actively Manage Everything: As usual, if you’re already set for life you can ignore this last paragraph. That said, it always feels great to see your net worth go up every single year. Therefore, if you’re going to actively manage your money in the future, we would recommend taking at least 20-30% of your future earned income (likely a business or career) and investing it into a wide variety of assets (stocks, bonds, real estate, etc.). This is a hedge against a one year blow up and all but guarantees you’ll see an increase in your net-worth every single year.
An Example: Instead of doing a conclusion for the five steps we’ll use an example instead with an affiliate marketer. Assuming the affiliate marketer gets to ~$1M we’d put this cash aside and invest in a variety of items to generate about $5K a month in income. This will cover all of his living expenses in the future and all the money he makes in the future can now be invested without any concerns. Since he’s good at what he does, we’ll say he makes $500K a year to keep it simple. This leads to about $400K net income since he’ll live in a state tax free location and will always have business deductions.
Now year one, we’d take $100K and put that into an index he’s going to benchmark. Let’s say he wants to trade internet stocks and media (he’s an affiliate marketer and better know the space very well), then that’s the set of stocks he’ll compare himself to. After that he’ll take $100K and throw it into various investments (similar to the $1M portfolio) and the remaining $200K is his to start actively managing. While year 1 only has $200K in actively managed money, year two should have $300K+ every single year (assuming his business is stable or up) since the original $100K into the indexes is simply for bench marking purposes.
Year Logs: In year one… He’ll have $1.1M in diversified funds, $200K in actively managed and $100K in the correct benchmark. In Year two…. He’ll have $1.2M in diversified funds, $500K in actively managed funds and $100K in the correct bench mark… Then in Year three he should have $1.3M in diversified funds, $800K in actively managed and $100K in the correct benchmark. This does not include investment gains. As you can see, by year 4 or so, if you’re outperforming the market your actively managed money should be well north of your diversified funds and you’ll have proof of your market outperformance (keeping yourself rational at all times).
Risk On…. For some reason people believe that risk is bad. The reality (as you all know) is that risk can also lead to large scale rewards. We never understood the point of slowly building up a larger amount of money once you’re rich. If you don’t have to work for a living and have ~$10K in all but guaranteed money coming in per month… Is an extra $5K per month really going to move the needle? Of course not. At the same time we have also seen our fair share of “disasters” where someone accumulates $5M into a single stock and then loses it all (should have sold off ~$2M to avoid working and let the rest of the $3M ride if he was truly convinced that the Company would succeed). That said, here are some ideas for the risk loving readers we have.
Crypto Currencies: You all knew this part was coming eventually, since we do accept BTC as a form of payment for Efficiency… This is a perfect example of a high risk investment. From what we’ve seen the crypto currency “universe” has a wide range of investors from small scale retail to very big investors (VCs, billionaires and more). The one thing you’ll find in common? The rich guys don’t spend a lot of time talking about the prices. They simply focus on following the changes and evolution of the technology. They don’t trade, they build a position and talk about the technology. They also accept it as currency, no questions asked, since it’s not a big deal. (this should be a good hint at how you should think about it as well)
Leverage: Levering up excess money can spike your net-worth pretty quickly. In the affiliate marketer example, if he had conviction that a trend was taking place in 2017, he’d lever up the $200K and buy into the stocks that he believes would benefit. This would then give him a 2x return (assuming a doubling of buying power to keep it simple) and severely outperform the market over the full year. While the most common example of leverage is used in Real Estate (which has been covered in the past), this can also be done with securities.
Mini Private Equity: If you’ve read our entire book, you’ll see a clear hint at another way to generate large returns (with a different type of risk) being small scale buyouts. Scour the internet for poorly run websites/businesses and see if they will bite on a bid. Follow the rules listed in the book in terms of “what to look for” to see if a website is being run appropriately or not. Now you’ll be able to enter a new purchase at say 3x net income and exit that purchase at 4x net income with a much higher net income number… As usual we’ll drop a hint… What if someone did this with a low interest rate loan with cash acquired by using another asset class as collateral?
Parting Thoughts: To cap this all off let’s look at what the “index king” is saying about passive investing. Jack Bogle the founder of Vanguard stated at the Berkshire Hathaway annual meeting “If everybody indexed the only word you could use is chaos, catastrophe”. Now remember what we said above, by 2021-2024 there is a good chance that passive will make up over 51% of the market (Bogle believes 75% passive is safe – we disagree). We have also stated numerous times “Chaos is just another word Opportunity”. We’re looking forward to a future where people continue to blindly invest in index funds. It’ll just mean more money and opportunity for the smart people in the room.
