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Should I change my asset allocation strategy?

I am approaching 50 years old, single, and have about $2,000,000 in total assets ($1,000,000 in a 401(k), $500,000 in cash, and $500,000 in stocks). I don't own a home but plan on buying one within the next couple of years. My monthly expenses are about $10,000 but if needed I could cut down to about $7,000. I have no debt. I am employed in a good position. Given all of this information, how well-positioned am I for the future? Should I be doing anything different with my asset allocation strategy?

Financial Planning, 401(k), Asset Allocation, Real Estate
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July 2018

You are well positioned regarding the amount you have amassed so congratulations on that part. But without knowing more about what strategy you employ I cannot really give you sage advice. I can give you some ideas that will generate questions for you to address.  Most important, how will you protect these assets from a major correction or bear market? How will you respond emotionally if you lose 25% to 30% with your current allocation? Mike Tyson once said, "Everyone has a plan until they get punched in the face."

First, you say you are "employed in a good position" so I am assuming that you are not cannibilizing the $2Mn in order to meet the $10k monthly expenses.  Also, are you saving or adding to the $2Mn nest egg?  I really need a better picture of your current cash flow situation to come up with the assumed growth of your portfolio.

But let's just start with the nest egg portfolio & ignore the rest for a moment. I do think that with 25% in cash, you have a "cash drag" on your total overall portfolio.  Believe me, I am not saying you need to be fully invested at all times and I am not a set it and forget "pie chart" advisor. Things change and so should your portfolio on an ongoing basis. Our shop is a fee based only, active management firm, and cash is absolutely an asset class.  In fact, you dial up or dial down risk using cash depending upon the current market environment. Sometimes we will have 10%, sometimes 15%, and if the markets begin to break down we will have 40% or possibly more, or even use hedging techniques. Currently we have 10%. But if you have a static 25% at all times, especially in this low interest environment, that puts quite a drag on your overall investments making the hurdle rate for invested assets even higher. 

You also didn't mention how the IRA is invested - stocks, bonds, commodities, cash etc...??  The IRA itself is just a type of account or receptacle for the investments.  In this rising interest rate environment, bonds are much riskier than they were just a year ago.  And virtually all bond sectors have lost money or just breaking even this year.  This is why I would need a better picture to give you sound advice because I don't know how 50% is invested, but I do want to give you some broad strategies to think about.  

We have a sell discipline for every position in our portfolio to prevent us from losing big in a major market correction.  Regular market fluctuations and pullbacks are ok, healthy, and normal, but if certain levels are hit, then selling begets selling and risks increase & accelerate quickly.  I can always get back in when the markets stabilize & selling subsides.  The two main risks you have to manage are drawdown risk and whipsaw risk. If you minimize your drawdown risk (tight stops) then you increase whipsaw risk and overtrading occurs.  If you minimize whipsaw risk (wider stops) then you have more drawdown. So these two risks are not positively correlated until you hit your maximum drawdown & are both are in defensive mode.  I am not trying to get too technical, just want you to be aware that there may be a better way.  And it is less emotional.  

The main problem is that in this low rate environment, there isn't "safe money" currently that pays enough to keep up with inflation, and bonds are risky with the prospects of rising rates.  So how do you participate and yet sleep at night knowing you have a maximum drawdown you are willing to endure and levels on each position.  This way you can participate and have more of your idle cash working if the markets are acting pretty well.  When it gets ugly, it is usually pretty obvious but most still don't take action as the see the deterioration.

Regarding buying a home, depending upon where you live, you may want to wait till rates rise & prices come down.  Some markets have already topped & reversed and a few are still strong.  So it is location location location. But I think when rates rise mortgage applications will continue to slow and you might pay a little higher interest rate, but could get a much cheaper price.  This is a little more opinion than fact.

You are in a great position as far as assets, and if you employ a solid strategy that simply makes reasonable returns but protects and minimizes downside risks, you should be fine.  Whatever you do, do not do an indexed annuity where the salesperson promises you "much of the upside but none of the downside."  While it is true you will not get any of the downside, you will hardly get any of the upside either.  They will show you "illustrations" of 6%, 7%, or even 8% but most all of them get in the low single digits and they have long surrender penalties.  They are also very tax inefficient when you take the money out.  What you need is strategy not products.

This was a lot to think about and I hope it helps, best of luck Dan Stewart CFA®


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