Investors often want to know how a financial advisor is investing their money and how a portfolio is being built. This is especially true in times of economic uncertainty, like we're experiencing now. Today, Lou Melone of Melone Private Wealth rejoins RJ King to talk about this.
A portfolio begins with understanding the client and their goals for their future. Once that's established, it comes down to asset allocation, diversification, and rebalancing. Lou explains each of these, citing a study that shows 93% of a portfolio's success comes down to this plan. Only 7% is tied to timing, selection, and the other things you'll hear about in the financial media.
The word risk is often misused - a better term would be market volatility. Whichever term you use, Lou talks about employing a 1 to 99 scale for a client's comfort in this area, as opposed to small, medium, and large.
The primary tools in building a portfolio are stocks, bonds, bills, and cash. Which of these have performed the best over time, dating all the way back to 1802? The answer may surprise you.
Lou talks about the "3 bucket strategy" for investing - putting money away for bear markets, for expected big ticket items, and finally, for your long-term future.
One of the key qualities in being a good financial planner is also being what Lou calls a "behavioral coach." This involves educating clients so they don't give in to their natural, human emotions, and stay the course.
In our next episode, we'll talk to CFP Brandon Carney about the largest generation of wealth transfer that we've seen in quite some time.
Resources:
Lou Melone's book, "Unpack Your Financial Baggage:" https://www.amazon.com/Unpack-Your-Financial-Baggage-Misconceptions/dp/1948237776
Melone Private Wealth Website: https://www.meloneprivatewealth.com/
D Business Magazine Website: https://www.dbusiness.com/
RJ: Hello, Lou. How are you today?
Lou: Doing good. It's nice to be back for another discussion. And yourself.
RJ: Great. I know. Today's episode is one a lot of people will enjoy is it seems to be on everyone's minds.
Lou: Yeah. Often, conversations we have with prospective clients. Eventually they get around to the question of so where do you plan on investing the money for my plan?
RJ: Today we'll talk about building the portfolio and how to take withdrawals. So your money outlives you. We'll talk about a portfolio as it adheres to a long-term plan, and this can be essentially up to a 50-year portfolio. So, in that perspective, it's an ongoing plan and not a one-off.
Lou: Yeah, that's exactly right. We always begin the portfolio conversation with this. We're financial planners first, and our client's portfolios are the funding mechanisms for their lifetime plan. So we view the portfolio as a tool for the realization of our client's goals.
It's never an end in itself or the primary focus. As we've mentioned in past podcasts, the order of importance is always gonna be goals plan. Then the portfolio.
RJ: I would imagine many people believe they have a plan, but it is a one-off exercise. It isn't a plan as much as it is a stagnant document someone at some point created for them. Many people refer to a document as their plan. But they may not even know how this document was created. Let's start at the beginning. Where does the conversation start?
Lou: The first thing we determine is what you're trying to accomplish in the timeframe you've got to accomplish it, and the resources to achieve your goals.
Then what we do is we develop a planning strategy, essentially a plan for reaching your goals. Finally, we designed the portfolio using long-term historical returns to get you to where you need to go. And this is really all based on how that family has described it to us.
RJ: So it's the conversation before the conversation.
Lou: Exactly. A constant and consistent reminder that we're building a goal focused financial plan, which is completely different from where most would think to begin. They always start with the portfolio and that's why they've consistently underperformed throughout their lifetimes.
RJ: So how should people start thinking about their portfolio?
Lou: There's really three things. Asset allocation, diversification, and rebalancing.
RJ: Can you break each one down for our listeners?
Lou: Yeah, a absolutely. So the first one, asset allocation. So asset allocation is the percentage of stocks versus bonds and cash that are in your portfolio over your investing lifetime.
To most, this would seem like a pretty novel concept. However, this percentage, more than any other portfolio value will likely dictate the majority of your lifetime investment returns. That's really how critical this concept is to your financial success. So do not overlook it. The second thing is diversification.
So diversification is as important as asset allocation. So if asset allocation tells us what percentage of stocks, bonds, and cash diversification is what we own within each category. So for example, large, medium, or small companies or value versus growth. So the best idea or best thought on this is author Nick Murray.
He explains diversification best as I'll never own enough of any one thing to make a killing in it, but I'll never own enough of any one thing to get killed by it. That's diversification. And then the third thing is rebalancing. So rebalancing is as simple as the planned readjustment of your portfolio back to its original long-term percentage blends that we had.
So what this does is, this forces investors to sell what just did well and add to what just did well, not so I know it seems strange to hear, but it's been a proven strategy and as counter-cultural as it gets.
RJ: Now, these are probably terms people might be familiar with and naturally they might ask, why are these terms so important? And what kind of data supports these conclusions?
Lou: I think two things. One is there have been numerous studies which verify the conclusion that I just mentioned. And two, it's really countercultural. The most recognized study was performed back in 1986, a paper that was titled Determinants of Portfolio Performance.
It was by Brinson Hood and B. Bauer, and it was from the Financial Analyst Journal. Essentially, it's stated that, on average, a portfolio's static target asset allocation accounted for some 93% of its variation of returns and the volatility. The other 7% came from timing, selection, and everything else other than asset allocation.
So in plain English, asset allocation is where your returns will come from. Period.
RJ: What's the countercultural part?
Lou: It's not what the financial media is exhaustingly regurgitating every minute of every day. The financial medium and media in all its wisdom focuses on the 7% from the prior study, meaning the timing when to be in the market, when to be out of the market, the selection. What do you own now and everything else that doesn't necessarily matter to a long-term investor in history has shown it can't be done consistently.
RJ: So why do you think the media's focus is on the seven percent?
Lou: You know what? It keeps the average investor, again who's driven, as we've talked about in prior podcasts, who's driven by emotions. It keeps that average investor glued to their sites minute by minute, which is what brings an ad revenue, hence pays their bills. And secondly, if they focused on the actual facts, which are asset allocation and leave the portfolio alone. How boring is that? There is nowhere near enough excitement to keep viewers entertained.
RJ: From a business standpoint. That would make sense. Now, for the big question, asset allocation, the question most people likely start with when they start asking about their plan is where to put the money.
Lou: Yeah. And really it depends. Meaning, what are your unique cash flow needs based on your financial plan, your comfort level with uncertainty? Meaning, can you stomach the ups and downs of the markets in your life stage? By the way, that's a nice way to say, how old are you?
RJ: Yeah. That can be a tough, touchy subject for some. So stomachs. To stomach, the ups and downs.
I know that's a big question and people are asked about, is their appetite for risk. Is this what you're talking about?
Lou: In a way. I've always mentioned in prior podcasts, I think the word risk is often misused. When it comes to the portfolio, the more appropriate word to use is volatility, meaning the day-to-day swings in the portfolio.
The better definition of risk is having one's money run out before they do. However for the sake of the discussion, we'll use what most associate with the portfolio, which is the word risk. Now that that's out of the way. The question of risk appetite is a classic question with a vague metric used in our industry.
It's confusing for so many people. Many people see high risk is scary and low risk as boring. because those extremes paint pictures of low to potential negative returns. In turn, they opt for saying they have a medium risk appetite.
RJ: That makes sense. It's the adage of given too many choices, people tend to choose the middle or less extreme. We're also told to have a high appetite for risk when we are young and a low appetite for risk when we're old. And we're supposed to go from stocks to bonds as we age.
Lou: You're hitting a lot of the ways people build plans, and as a result, they may lose out on higher long-term returns because they're not planning, they're investing without a plan.
Let's look at some tools that can help define that risk appetite a little bit better. So we use tools that takes the clients through various scenarios visually and ask them questions. They can actually see how each portfolio historically has performed in both good markets and bad. It's powerful because they can see what has happened. We've essentially stress tested the portfolio. So this helps reduce the potential surprises that come along with those generic, high, medium, low risk categories. And the saying goes, surprise is the mother of portfolio destruction there. Then after this process, they're then given a score between one to 99, which is the risk appetite.
It's not high, medium, or low. It's a number on a spectrum that guides our planners in building a customized plan for our clients. Again, it's based on their financial planning goals.
RJ: That sounds more comforting and understandable than high, medium, low. An actual number, I would imagine, allows people to start to put a stake in the ground and I would guess allows them to understand how their plan is being built.
Lou: For many people, understanding that number, again visually tied to the historic up and ups and downs that a portfolio has encountered, it allows 'em to bre breathe. Really, it's a sigh of relief. They've let us know that they're learning to understand themselves and their behavior better with that number.
And as a bit of a side note, the old school high, medium, low risk isn't, in my opinion, why most investors can't stay invested over longer periods of time and underperform their plan.
RJ: What do you mean by that?
Lou: There's an enormous difference between seeing how the portfolio may perform, which we just spoke about, versus experience experiencing as it happens. Two completely different concepts. So using those generic terms doesn't give them the realization of what will happen to their money in bad markets. Kinda like the Mike Tyson quote of everyone has a plan until they get punched in the mouth. And just this last year, in 2022, most got punched in the mouth.
RJ: I would agree with that. This is what's happening this year as investors are experiencing their statement values, go down and stay down for many months. Not a fun experience. So what are the tools for the portfolio and how do you build it?
Lou: Before any portfolio can be built, I think the investor needs to understand how each component of the portfolio works. So for example, if you were to build a house, you need to know a hammer wrench and a screwdriver's primary functions. You wouldn't use a wrench to pound in a nail. Most wouldn't, or a hammer to drill in a screw. So each tool has a purpose. And when that tool isn't used for its primary purpose over time or in extreme stormy weather, the house is gonna collapse.
Or what Warren Buffet has said, when the tide goes out, you find out who's been swimming without shorts.
RJ: Always loved that quote.
Lou: Yeah. When it comes to investing, the investors' primary tools, historically have been stocks, bonds, bills, and cash. Now, while there are other areas to invest, I understand this, but these have been the investor's core tools as far back as 1802.
Understanding that each component is critical to the investor's long-term investment success. So I'll use real returns of these tools now. Real returns. Are defined as after inflation, which the world has experienced a crash course in the true meaning of this concept recently. So these figures are provided by the book Stocks for the Long run by Professor Jeremy Siegel from The Wharton School.
So here we go. So real returns, I will provide her as follows since actually 1802 to 2021. And the second set of numbers I'm gonna give are for those who want more recent figures. And that's gonna be from 1946, which is since the end of World War II, to 2021. So it gives a little bit more recency on these figures.
So the first one is, if you're following me here, I know there's gonna be a lot of numbers I'm giving. So large company stocks since 1802 have averaged after inflation. 7% per year, and if you go from 1946 to the end of 2021, it's been 7.3% per year. You go to government bonds, that number now is 4% versus two.
T-Bills, 2.5% versus 0.2. If we look at gold actually did about 0% since 1802 and since 1946 has done 1.6% per year. And if we look at cash, just cash, like cash in your pocket, that number since 1802 has been negative 1%.
RJ: That seems incredibly countercultural. This is counterintuitive to stocks are risky and bonds are safe. If we view these returns as a way for retirees to grow their wealth over time, I would imagine you experienced some friction when explaining these concepts.
Lou: Yeah. Correct. I do. When viewed by the common belief that someone moving into retirement should begin to shift a large portion of their portfolio to bonds, for both income production and less volatility. It's just not true today. And it's not true once the average couple understands money is purchasing power and that life expectancies have and will continue to rise, now the wisdom begins.
RJ: But does this account for shorter swings in the portfolio that retirees are all worried about?
Lou: Then it becomes even more countercultural. Okay, so according to the book I mentioned he looked at the holding period returns for each asset class since 1802. So what he found is this. So again, holding period returns are essentially gonna give you, it can go one year holding period, five years, 10 years, 20 years, 30 years.
Okay? Again, this is going from 1802 to, 2021. So to give you an example, again, I'm gonna be given some numbers, so I'm gonna try and explain this real simply. So if you look at any one-year period, right? Every one year holding period from 1802, the best return stocks have done is 66.6% return. The worst is 38.6% over any one year holding period.
Now, if you move to bonds, The best one year was, I'm gonna round up. So 35%, the worst one year is 21%. If then we go to T-bills, the best one year is 23. The worst is 15. Again, those are negative 15. So the best and worst. Now, as we move over and we look at from a one-year period, which as you're talking about RJ, this is essentially what most people view.
But once you go to a 10-year period, this is when it becomes really critical. The worst 10-year period since 1802 stocks have had is a negative 4%. Why is that strange? It's because bonds are down five, and T-bills down five. So actually, what happens is stocks have a lower negative return once you hit 10 years and once you get to 20 years, the worst one-year return that stocks have had is a positive one and the other two are still negative.
So now knowing this, what asset class is the riskiest when it comes to a two-person 30 year retirement? After factoring in what I call the silent killer of inflation.
RJ: I would say bonds.
Lou: You probably didn't think you'd ever say that. Just like the rest of those in retirement. So again, the worst real return over any 20-year holding period since 1802 that stocks have provided have never been negative. Never.
RJ: That's good to know. Now let's move on to the next area. How does the concept of withdrawals work, now that we know these facts?
Lou: Well. The appropriate way to build a portfolio is what can be ascribed in our industry as goals or needs-based planning. Or visually think of it as buckets to place your dollars into, again, based on your goals or your needs and their timeframe for the use of that bucket, so to say.
RJ: So how does the bucket approach work and how many buckets?
Lou: It's a three-bucket approach, so you have an emergency bucket. What I call a large ticket bucket, and then the wealth accumulation bucket and the first bucket is your emergency money. So those are set aside into a zero to 24 month timeframe.
These funds are to be used when, not if, but when the market takes its normal bear market dip. About once every five years, which again, we've been experiencing over the past 12 months.
RJ: How much is in this bucket?
Lou: Really it comes down to how nervous of an investor are you and your family? Meaning how much can you stomach these temporary depths? It can be from six months to 24 months of living expenses.
RJ: The first bucket I think is very relatable to people today, probably more than ever. I don't think people see it as a bucket, as a means to survival. A three-bucket strategy would probably put some minds at ease.
Lou: Yeah, the second bucket is really once you get to that first bucket and understand that concept. The second bucket is for any large items, let's say a boat, roof repair, vacation, a wedding, again, those large items that was or is planned to happen in the next five years, these are the dollars that need to be there for a set timeframe to cover a known cost.
We wanna make sure they're not exposed again to those day-to-day fluctuations like I'd mentioned historically of equity markets, which again, we just revealed.
RJ: So "known knowns," maybe the events that you dread as an expense, but look forward to in terms of emotions. For your mental state.
Lou: Absolutely. Absolutely. So the third and final bucket is what we put is for long-term investment planning and what we would call wealth accumulation, which is tied directly to the comprehensive financial plan that you and your certified financial planner are crafted and should update annually for the longer- term bucket.
RJ: The plan. The retirement buckets. What goes into these buckets?
Lou: The first bucket's gonna be invested in either a money market, a local savings account. It'll have about 13 months of living expenses. And again, based on what our plan told us, you need think of this bucket as, let's call it a nightlight for emotional safety.
Although we're, we're not really getting a good return on these monies, it's okay because it's not this bucket's purpose, it's primary purpose: when the bear market or whatever crisis of the day hits, is to keep those normal emotions from driving you. To behave yourself out of the third bucket's, purpose. Hence, it's a nightlight in stormy weather.
RJ: What normally happens in a bear market with the first bucket?
Lou: Well would typically happens during a regular bear market. Again, this is a 20% drop or greater from the peak. Is that a sense of fear? It blankets most investors, again, piled high and deep by the media and it triggers the anxiety that this temporary down is gonna become a permanent loss of your investments.
So using market history as our guide, which is the only thing we have to rely on. I can say that I don't know when it will stop dropping. But I know it will stop dropping. However, when clients are in the midst of this storm, I've done this long enough to realize that any rational facts I provide at that moment will matter zero when their emotions are in full force. Simply put, fear does not care about facts.
RJ: We covered the second bucket pretty well. What are some details about the third bucket? What should people keep in mind regarding that third bucket?
Lou: This bucket's primary goal is for long-term total return over a five year or longer timeframe.
It's a diversified equity portfolio built for your cash flow needs, according, again, to your comprehensive financial plan. Remember, investment success is based on really three principles. It's very simple mindset, patience, discipline, flat out. If you cannot stomach the temporary downs, that equities, again, meaning stocks provide historically, you will never be a successful long-term investor, period.
Sorry to be the messenger of this reality, but this is really the truth. This is why the bucket concepts, the buckets concept is used. It's a guide, and these are really used as a guide to calm the emotional mind.
RJ: That makes total sense. I don't think many retirees have ever had it explained to them that way.
Let's talk briefly about withdrawals. So the retiree has these buckets filled based on their plan, and then a bear market hits, like the one we are in now. Then what?
Lou: Let's review the buckets right, and then we'll move into, again, what we're talking about is the real-life scenario. So we've set aside up to two years of living expenses in a money market fund.
We added the known future one-time expenses into fixed income, whether it's, again, it's bonds or CDs, those type of areas. We invested the rest into a well -diversified equity portfolio. Now we begin to withdraw from the equity portfolio about four and a half percent per year from both dividends and longer-term gains.
Then each successive year, we increase the dollar amount to be withdrawn by about 3% per year to offset the rise in cost of living. Again, that's inflation. Then the bear market hits, or some other crisis the media has for us. One that is more along the average time and maybe the drops since the end of World War II, which again is around 30%. And it usually lasts for 13 months.
We can turn off all the withdrawals and reset our holdings to dividend reinvest at the same time. We now turn on bucket number one with our two years of living expenses and we begin to live on it.
RJ: That makes sense. I like the concept and it's easy to understand, which makes us feel better. What if it drops further or lasts longer?
Lou: It's very possible this is gonna happen. There, there are modifications that we take to battle this possibility. And again, anything is possible, but we can only plan on the probable which is why we've kept up to two years of living expenses in one bucket, even though 13 months is the roughly the average timeframe of these bear market drops, again since the end of World War II.
RJ: So if the retiree wanted to be more exact based on these events and the probabilities, it would be 13 months in bucket number one.
Lou: Now you're understanding how planning really works, right? I would say welcome to the beginning of retirement planning wisdom.
RJ: Okay, the plan is built. Choices have been made to fund the plan. What happens now, Lou? What does the financial planner do to continue the coaching for their clients?
Lou: Actually now the real work begins. Once we've created that diversified portfolio of investments, that are suited to their plan and their cash flow needs. We become what I call their behavioral coach, coaching them over the next 30 years to make good financial decisions and avoid making emotional decisions regarding the portfolio.
These decisions that really can blow up the plan and it may never recover. So our approach is goal focused in planning driven rather than being based on some attempt to outguess the economy or the markets. I'm convinced that successful investing involves constantly acting towards your goals.
And unsuccessful investing is based on reacting to whatever the markets are doing now.
RJ: We talked about them in previous podcasts, but let's go over a few of these behavioral risks.
Lou: Well, RJ, suddenly this could turn into a multiple day podcast if we go through most of 'em. So let me restate one of our firm's philosophies.
The dominant factor determining the long-term investment returns people get in real life is their own behavior. It's just that simple, meaning the issue won't be in predicting when markets will peak or bottom which no one can do, again if they're truthful. But guiding how clients respond to those phases of whether it's euphoria at market peaks or panic at market bottoms. Both of which are normal human reactions to these events.
RJ: Could you give our listeners an example? An event everyone remembers is the.com bubble which was around year 2000. Money was flowing, people were riding high, and suddenly the bubble burst. How does your philosophy fit into that moment in time? What should a financial advisor do in that scenario?
Lou: The dot com bubble was a popular event and one could probably say a case study in both emotions we just mentioned. Again, euphoria and panic. So in addressing both, I'd never had tried to prognosticate when the.com bubble would've ended in the year 2000.
Our discussion would have been about trying to make sure clients never got exposed to the dot com mania to begin with. And on the other hand, I wouldn't have been guessing when a decline a declining market bottom as bottom as you've listened to ad nauseam on the, cable news sites. Instead our conversations would be geared toward guiding clients not to panic out of the bear market, but to continue to invest in what we call end of the world prices, which would enable them to get much closer to their goals we laid out in our plan.
So by providing families with this behavioral advice, we, we can't guarantee that the investments will be outperforming the market at any given moment. However, we're fairly confident saying that we'd be achieving much better long-term results than most, primarily because we'd help you avoid the common human mistakes that investors are making just about every day.
Quite frankly, much of the behavioral coaching families receive, it's really a value that's intangible. In other words, It's not something that'll show up on the client's monthly statement in the short run as most would like to see. However, it will provide an enormous amount of anxiety-free lifetime planning as they'll be witness to as the wealth begins to compound over multiple generations of their family. This is true wealth.
RJ: With so much noise, I would imagine having a behavioral coach can be beneficial. It's impossible to tune out the financial media every day, all year. Even the steadiest individuals must feel the panic over time. And it's incredibly hard to ignore the noise, especially today with the seemingly endless election cycles, economic news and information flowing from everywhere.
Lou: Really, it's human nature. Human nature, feeling panic, doesn't make you less of a person or irrational. And not feeling it doesn't make you better. It makes you human. Realizing you have a plan and a trusted advisor who can act as your behavioral coach is where you may feel some inner calm.
RJ: Inner calm would seem to be not only the operative word, but the key phrase. Building a portfolio that has its fundamentals based in financial planning should provide a sense of calm in the most turbulent times. If not, it's clear where a coach can step in and only help.
Lou: Well said. Yeah, well said.
RJ: So what's the next podcast going to cover, Lou?
Lou: What we're gonna do is Brandon Carney, one of our firms CFPs. He'll be discussing his perspective on what younger generations see as wealth management and the challenges they may face. As the talk of the largest generation of wealth transfer that's gonna be seen in decades if not, you could probably say, centuries. That is coming very soon.
RJ: I look forward to hearing that.
Lou: It will be interesting.