3683: Asset Allocation by Steve Pavlina on Investment Strategies

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[00:00:54] This is Optimal Finance Daily, asset allocation by Steve Pavlina of StevePavlina.com. And I'm Justin Malek, your narrator, reading to you from the best articles online every single day of the year with permission from the authors. So with that, let's continue the tradition as we optimize your life. Asset allocation by Steve Pavlina of StevePavlina.com.

[00:01:24] Recently, I took a three-week course on financial planning offered through UNLV. The most important topic covered was asset allocation. Asset allocation refers to how you allocate the money you have available to invest. What percentage of your money goes into your secure, moderate growth, and aggressive growth baskets? You have many options for where to invest your money. And every option has a different risk-reward ratio.

[00:01:53] You could put all your money in the high-risk-reward baskets, such as aggressive growth stocks, and you may enjoy great gains. But you'll also suffer huge losses when things go badly. On the other hand, you could put all your money in the low-risk-reward basket and keep your assets secure. But then your gains will be very modest.

[00:02:14] If your gains are taxable, you need to make about 7% just to stay even since you have to cover inflation plus taxes based on typical USA figures. The point of intelligent asset allocation is to enjoy strong gains without taking on too much risk of losing your entire principal and having to start over from scratch. So you want to have some money in the aggressive growth bucket so you have the potential to enjoy some big wins when things go well.

[00:02:44] But you also want to keep some money in your secure bucket so you have backup funds to get back in the game if your aggressive investments go bust. Asset allocation involves determining how much to put in each bucket. I've made mistakes on both sides. As a young adult, I kept all my money in a regular savings account, earning minimal interest while the market was soaring.

[00:03:08] Then, in my late 20s, I put most of my money in stocks that lost 70-80% of their value during the dot-com bust. And it took me a while to rebuild those cash reserves. Both of these were good lessons for me. A financial investment example. As an interesting illustration from the course, consider this hypothetical example.

[00:03:31] Suppose Aaron and I are each going to invest $100,000 for 25 years and we want to maximize our returns. I decide to play it safe and stick the whole $100,000 in a fairly secure investment that yields 7% per year. Aaron decides to split her money into $20,000 chunks and invests in 5 different vehicles which perform as follows. $20,000 is lost completely.

[00:04:01] $20,000 returns 0%, so you only get the original $20,000 back. $20,000 is invested at 5%. $20,000 is invested at 10%. And $20,000 is invested at 12%. Who gets the better total return? Let's see how the numbers add up.

[00:04:22] My 7% investment turns that $100,000 into $572,542 after 25 years. Aaron's returns are as follows. The $20,000 lost returns $0, obviously. The $20,000 at 0% gives back $20,000.

[00:04:47] The $20,000 at 5% becomes $69,626. $20,000 at 10% becomes $241,139. And $20,000 at 12% turns into $395,769.

[00:05:14] So Aaron's grand total is $726,534. That's $153,992 more than what my 7% investment earned. It's interesting that 40% of her initial investment returned 0 or negative returns. And another 20% underperformed my 7% return.

[00:05:41] But those higher returns of 10% and 12% really pay off. Even though most of Aaron's picks were poor performers, being right just 40% of the time was all she needed. By diversifying her investments, Aaron was able to participate in the big winners while not being wiped out by the losers. Of course, it would have been great if she could have invested the whole amount at 12% or more.

[00:06:08] But this example assumes she did her best to pick five potential winners. To optimize your long-term investment gains, you need to optimize your asset allocation. Maybe you start with a third of your money in safe investments like municipal bonds, another third in growth funds, and the last third in aggressive growth stocks. Over time, these percentages will drift as each bucket grows at a different rate. So you need to rebalance them.

[00:06:38] When your riskier investments lose money, rebalancing means transferring money out of your secure bucket to get back in the game and try again. And when your riskier investments pay off big, rebalancing means transferring money back to your secure bucket to lock in your gains. This strategy allows you to continue enjoying some big investment payoffs without taking on too much risk. Beyond Financial Planning

[00:07:06] After the financial planning course, I realized that the strategy of asset allocation can be applied to other areas of life, such as work, relationships, and health. Consider how you allocate your time. You can think of your time as consisting of several buckets, each having a different risk-reward ratio. If you have a full-time job that pays a flat salary, then most of your time is allocated to the security bucket.

[00:07:34] So you might want to shift some of that time to the entrepreneurial bucket to participate in the game for much greater gains. Maybe your job pays $20 an hour, and you have the option of trying to make $50 an hour doing consulting on the side, but your consulting efforts don't always pay off. Some hours you make $50, but others you make zero. And as you slide the risk-reward ratio further,

[00:08:00] you may put yourself in the game for some of those delightful $10,000 hours. You can also use non-monetary criteria for each bucket. With physical exercise, you could have different buckets for allocating your time to aerobic conditioning, endurance training, strength training, stretching, sports, and fitness education. Each of these buckets will have a particular impact on your physical health.

[00:08:28] You would then allocate a certain percentage of your available exercise time to each of these buckets in accordance with your fitness goals. I remember when I started exercising regularly, all I did was running for aerobics. Then I got into distance running for endurance. Today I do about 40% aerobics, 45% strength training, and 15% disc golf for sports. I had the most balanced allocation when I trained in Taekwondo,

[00:08:58] which was a great blend of everything. It's up to you to decide what particular allocation works best for you, whether you're trying to get better returns on your money, your time, your energy, your goals, more something else. Working like a monomaniac on any one thing for too long will unbalance you, as will neglecting a key area for too long.

[00:09:24] Intelligent asset allocation can help you consciously determine the right mix that keeps you in the sweet spot of balancing risk versus reward, work versus leisure, strength versus flexibility, solo time versus social time, and so on. You just listened to the post titled, Asset Allocation by Steve Pavlina of stevepavlina.com And I'll be right back with my commentary.

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[00:10:47] That's takeultra.com for 15% off with code OFD. After you purchase, they will ask you where you heard about them. Please support our show and tell them our show sent you. This episode is brought to you by Accenture. When your advertising operations fall out of sync, everything else follows. Spotify and Accenture are working together to reinvent the rhythm of ad sales. Using automation, analytics, and smarter workflows

[00:11:15] to simplify campaign delivery and access better data across the business. The result? Less time spent on operations, more time connecting brands with the moments and fandoms that matter most. Learn more at Accenture.com slash Spotify. Thank you to Steve. I really liked how he took something that can feel intimidating, like asset allocation, and simplified it with that one simple example. The part that surprised me was the comparison between him and Aaron.

[00:11:43] He plays it safe and puts everything into one steady 7% investment. She spreads her money across five different bets, and most of them flop. Two lose money or go nowhere, and yet she still comes out way ahead because the couple of picks that did hit paid off big. Being right just 40% of the time was enough. We tend to feel like we have to pick the perfect winner every single time,

[00:12:11] but spreading things out means a couple of wins can sort of fix all the misses. What I found even more interesting though was the second half, where he applies the same idea to your time and energy, not just your money. Like, if all your hours go into a steady paycheck, maybe a few of them could go towards something with a bigger upside, even if it doesn't always pay off. And it works the other way too.

[00:12:39] Balancing work with rest or strength with flexibility. Same concept, just a different kind of currency. So thank you to Steve for this one. And thank you for being here and listening every day. That's what keeps me going. It really means a lot. Have a great rest of your day, and I'll see you tomorrow, where your optimal life awaits.