In the last two articles of this series, we discussed several important biases and how to overcome them. This has included the overconfidence bias, loss aversion, and the risks of inertia. In this article, we will discuss the use of framing and shaping your assets. If you have not read the first two articles, you may want to go back and read such articles as well.
Modern finance theory recommends we frame all of our investments as a single pool, or portfolio, and consider how the risks of each asset offset the risks of others within the portfolio. This is precisely why when we manage wealth, we frame your overall investment allocation first, and then consider your investments on a more granular account level. It is much easier to comprehend why individual accounts are allocated in a particular fashion after you understand the end game – your overall allocation. Many people frame their investments at an account level only, and this can lead to an overall comprehensive allocation that is too conservative or aggressive – they fail to see the forest from the trees.
We see this often in a few particular set of recurring circumstances. First, we sometimes see an individual/couple with the following set of circumstances:
In this case, Mrs. Client tries to match her target allocation of 60/40 within each of her investment accounts. This may seem to make sense at first glance, but fails to consider her cash. Putting aside whether Mrs. Client’s target allocation is too conservative (it probably is – a 70/30 allocation is more appropriate in a perfect world), her overall allocation is too conservative because of one key attribute – her cash, which many people do not consider when matching their target allocation to their investments. If we take into consideration Mrs. Client’s cash, her overall allocation is actually 43/57, significantly more conservative than the 60/40 target.
We would reconfigure Mrs. Client’s investments in a number of ways. First, many of our clients may know we utilize a mental accounting approach to investing (or the “bucket” approach), meaning we will “bucket” each account into a specific allocation that best matches the account. Cash is the most conservative bucket, followed by brokerage (which should be more aggressive), then traditional qualified accounts (traditional workplace plans/IRAs, which should be even more aggressive), and lastly Roth IRAs/Roth(k) (which should be the most aggressive).
We would then have Mrs. Client invest a portion of her cash, since she currently has too much of her overall portfolio held here. The amount that should be invested is fluid, and depends on the client’s risk tolerance, job/income security, client spending, etc. These factors may require more to be kept in cash. For instance, the more risk intolerant the investor, the better the client may sleep at night knowing that such cash is there (even at the concession of less overall return). Another factor may be the security of the client’s income given their profession – the more variability there is in their income or the greater likelihood of the client losing their job, the more the client should keep in cash (a general rule of thumb is 6 months of income). Lastly, the more the client spends on a monthly basis, the more they should keep in cash. In the case of Mrs. Client, given that we know she is more risk intolerant, we decided upon leaving $100,000 in cash (even though this is double the amount of 6 months of her income).
Next, we would determine the proper allocation for her brokerage. This is the account she would utilize if she ran low on cash. Given that she is still a long way off from reaching retirement and has a significant amount held in cash, a 60/40 allocation makes the most sense – this allocation will provide some level of growth while still being conservative enough to withstand a pullback in the market. Given Mrs. Client’s cash and brokerage allocation, we would solve for the rest of her allocation, keeping in mind that we would want her Roth IRA to be the most aggressive account (given she would utilize this account last most likely). Here is how the overall allocation will look:
You can see that if we have her cash (which is fixed), a brokerage in a 60/40 allocation, and the Roth in an 80/20 allocation, we would need a 70/30 allocation for the remainder of her assets in order to obtain an overall 60/40 allocation for this client. By framing the overall allocation first, then reviewing the individual accounts, the client can better understand how each piece fits into a comprehensive investment strategy.
Real Estate - The Unforgotten Overweight
If we include real estate in the discussion, it is only natural that most people will have an overweight to real estate; in the end, if you own your home, this very well could be one of your largest assets, and this is perfectly fine. This type of non-disposable asset is not included in an investment discussion, since we do not consider your home as an “investment” – you need to live somewhere.
And while a small allocation to real estate is perfectly fine, it is the extremes that you may want to avoid, as in the following circumstance. If we change the above hypothetical, and assume that instead of investing the $400,000 in the brokerage and $400,000 in her 401k, she instead owns two real estate rental properties – each with equity worth $400,000. We see this type of situation when people are in the real estate business; it is much easier to invest in something that you know well.
In this case, $800,000 of Mrs. Client’s $1,050,000 in investments is invested in real estate, or 76% of her overall allocation. As a general rule of thumb, you should not have more than 30% of your investments in real estate, and this is on the high end. We have covered this in much greater detail in two previous articles (Investing in Real Estate vs. the Market I & II), so we will not belabor the point. If we frame your investments to include real estate, it is much easier to see such an overweight.
We covered quite a bit in this article – if you have any questions, feel free to reach out to us!
Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.
Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Ryan Financial Group is not an affiliate of Lincoln Financial Advisors.
This article is for educational purposes. All situations are different and this article does not have regard to the specific planning objectives, financial situation and the particular needs of any specific person who may read the article.
*Licensed but not practicing on behalf of Lincoln Financial Advisors.