The Perfect Portfolio
Close your eyes and imagine your perfect financial situation.
Did you just say “Enough money to buy whatever I want”?
Despite what you might hope for, “unlimited money” is not a thing. There are certainly people with unfathomable amounts of wealth. But that doesn’t always mean they have the cash on hand to buy certain things in the moment they want them.
So, on a more feasible level, what does “enough money” really mean? There is always a bigger house, a bigger boat, a bigger plane, that you could have. Lifestyle creep is a very real thing. The only way you’ll find out what “enough money” means for you, is by defining your personal goals.
Then the question becomes, how do you get whatever that perfect amount of money is for you? I can’t be the only person who started off my investment journey looking for the “perfect investment allocation”. What was the exact percentage I should have invested in bonds at my age? Stocks? What about alternative investments like crypto or investing in other people’s businesses?
I’ve realized over the years that you really need to take a holistic look at your entire portfolio of financial assets to determine what makes the most sense for you.
I believe there are three critical pieces that make up your financial foundation. When you have them you can be confident that you have what you need for a healthy financial life. Will you always be able to afford every single thing that you want? No, probably not. But, you could someday. These three pieces will put you in a position to live well, both now and in the future.
Cash Flow for Expenses
Investments to Compound Your Wealth
Assets to Preserve Your Wealth
Cash Flow is the base, and the first step because without money coming in to begin with, you’re really not going anywhere.
The next step is to take what you have and help it build through compounding—absolutely essential if you want to get beyond the daily grind of trading your time for money.
And lastly, once you have some wealth to speak of, you’ll need a way to make sure you can hold onto it.
Cash Flow for Expenses
Your life runs on cash flow. In order to live, you have expenses and you need money to pay for those expenses. Income can come from a variety of places, but at the end of the day it has to come from somewhere in order for you to sustain your expenses.
Pro Tip: If your income and expenses don’t balance, you have a cash flow problem. That is outside the scope of this article. But one of the most important things you can do is make sure your cash flow is balanced and that you are giving an objective and use by date for every dollar that you bring in.
Most people have at least one income stream, and getting yourself multiple is a great way to accelerate the growth of your overall portfolio.
Let’s break down the common sources of income:
1. Job
A job is probably the simplest, easiest way to generate cash flow. You work for someone; they pay you; you use that income to pay for things.
2. Business
You can also own a business that pays you. This can be in the form of an owner/operator or as an investor. Businesses create cash flow and, hopefully, make profit which can be used for your expenses.
3. Real Estate
There are many different ways to invest in real estate (and this is not the place to get into all of them), and certain types of real estate investments (rental properties) can pay you ongoing income. Assuming the property is cash flow positive, this generates income for you.
4. Dividend/Yield Paying Asset
Certain types of investments can also pay you for holding them. Sometimes labeled: interest, dividends, or yield, this can take the form of many different things. For example, some stocks pay dividends, bonds have a yield, savings accounts pay interest, etc. If you have enough of this asset, you can make a good income off of these payments.
Investments to Compound Your Wealth
As Albert Einstein famously said, “Compound interest is the 8th wonder of the world”. My favorite, and probably the most commonly used example that illustrates this wonder, is the example of the doubling penny. If you start with a penny on day 1 and double it every day for 30 days, you end up with $5,368,709.
Not a small number.
Investing in assets that compound is the best way of building wealth. You aren’t going to cash flow your way to wealth (sure you can make $1,000,000 in income but if you just spend it all, you have nothing left and you need to maintain the effort required for that $1,000,000 year after year).
You also aren’t going to save your way to wealth. Saving $3,000 a month for 30 years gets you to $1,080,000 which is good, but nothing compared to what it could have been with compounding ($6,781,000 with average historical stock returns of 10%).
And we can’t forget the impacts of inflation which reduces your purchasing power over that 30 year time frame. At a 2.5% inflation rate over 30 years, the effective purchasing power of that $1,080,000 becomes $510,000.
Over a 50% reduction!
In order to build your wealth you want to invest in assets that are going to compound at a rate higher than inflation.
This looks like:
1. Stocks
Stocks are probably the most traditional asset that compounds over time. If you look at the S&P 500 (a good representation of the US stock market) it has returned on average around 10%. As mentioned above, 10% returns can be a very powerful compounding force! That should outpace inflation to grow your purchasing power and not just maintain it.
That is wealth building.
2. Real Estate
Certain types of real estate investments can be made with the goal to grow in value. By buying property that is either under valued or has the potential to grow in value over time, you can also build wealth. Again, the goal is to outpace inflation, so you need to make at least 3% annualized to really grow your wealth.
3. Digital Assets
Digital assets, while still an emerging asset class have posted significant annualized returns since their inception. There is no guarantee of similar performance in the future and more than likely they will normalize to a level seen with other assets. They are similar to investing in high growth stocks and/or early-stage companies. Lots of growth potential, lots of risk.
Investing in compounding assets has risks. There are no guarantees. On aggregate, they grow over time. But that does not mean that it is a straight line up, and it does not mean that every investment will work in your favor. Making sure you have a diversified and well-balanced portfolio based on your needs and risk tolerance is key.
Assets to Preserve Your Wealth
At the end of the day if you have all this cash flow for your expenses, make all these great investments to build your wealth, but then something happens and it all disappears, you are no longer in the perfect financial situation.
At a certain point you also need to make sure to preserve your wealth. You don’t want to end up being too conservative such that you limit your growth potential; the goal is to make sure that you don’t have everything on the line all at the same time.
As you build your wealth, squirrel some away so that you have something to fall back on in hard times or when things go against you.
This is going to look different for different people and situations, but the principle is important to consider as you are developing your Perfect Portfolio.
Wealth-preserving assets can be:
1. Cash
As long as the US Government doesn’t fail (no guarantee), holding cash provides a level of security. There are risks associated with holding cash (inflation risk, opportunity risk, etc.) but that doesn’t mean there isn’t a use for it.
2. Bonds
Bonds have traditionally been a more conservative and less volatile asset that can be used to help preserve your wealth. Make sure to do your research on what kind of bonds you are purchasing prior to using them as a preservation asset, because some are more volatile than others.
3. Collectibles (Precious metals, art, etc.)
Gold, silver, certain art, etc. can also help with preserving your wealth over time. Gold has done well maintaining purchasing power over long periods (less so over shorter time frames <10 years). Other types of collectibles can be volatile too but things with a long track record can be a safe place for your wealth to sit.
4. Real Estate
Location, location, location! Real estate can be a way to preserve worth as well. They aren’t making any more land, and real estate has historically done well at preserving wealth. Land, building materials, and shelter will always be worth something.
Putting it Together
The Perfect Portfolio consists of cash flow for expenses, investments for compounding your wealth, and assets to preserve your wealth. The objective is to maintain a balance of these three elements in your pursuit of financial success.
Depending on your stage in life, you are likely to be more focused on one over the others. This is normal since you have different priorities as you age. Understanding your priorities and how they relate to your goals is key to developing your overall portfolio strategy.
There will also most likely be asset classes that you are more drawn to. For example, some people are really into real estate. Some people are really into stocks. Again, there is nothing wrong with that. There are a million ways to make money. What is important is to not neglect the advantages of the different types of assets.
At the end of the day, a diversified portfolio of income, wealth building, and wealth preservation assets is critical to have a well balanced and strong financial foundation. That strong financial foundation is what will enable you to reach your goals.
