“All men can see these tactics whereby I conquer, but what none can see is the strategy out of which victory is evolved.” – Sun Tzu

Principles of Wealth #34* 

According to the financial planning community, asset allocation is the single most important factor in building wealth. This is misleading.  The most important factor is actually risk management. Asset allocation is just a part of risk management. The other two parts are position sizing and loss limitation.

 Risk is an element of every investment transaction. But if you know what you’re doing, most of it is unnecessary. And by knowing what you’re doing, I mean following the “best practices” I’ve discovered over the years.

Asset Allocation

Asset allocation means dividing your investment capital into different asset classes. By doing that, if one asset class tumbles, you have money invested in other classes that may not drop as fast… or may hold strong… or may even increase in value.

To show you how important asset allocation is, let’s look at would have happened to two investors in 2008.

Our first investor is “Joe.” He had 100% of his money invested in the stock market in 2008. Let’s say $100,000. In other words, he had no diversified asset allocation plan, and his money was wide open to stock market volatility. So when the S&P 500 dropped 37% that year, Joe lost $37,000.

Our second investor, “Nancy,” also had $100,000 invested. But she took a more conservative approach. She followed the traditional Wall Street asset allocation model – 60% in stocks and 40% in bonds.

Like Joe, Nancy lost some money when the S&P 500 dropped 37%. But she had fewer of her dollars in the stock market. Therefore, she lost less than Joe did. That alone makes her strategy superior. But it gets better…

Bonds are typically inversely correlated to stocks. And in 2008, when the stock market was plummeting, bonds rose 5%. So while 60% of Nancy’s money dropped 37% (her stock market losses), the other 40% of her money rose 5% (her bond gains). So Nancy actually lost only 20% of her money in 2008, or $20,000.

Had you invested your money with the “average” financial planner back then, this would have likely been your outcome. That’s why the two-asset class “Wall Street” model is far from optimal. And that’s why I recommend reducing your exposure to stock market risk with an expanded asset-allocation strategy that includes such things as real estate, gold, cash, and entrepreneurial businesses.

Position Sizing

Position sizing is a simple strategy dressed up in a fancy name. The idea here is to limit risk by deciding you won’t put more than $X or X% of your capital in any single investment.

Where asset allocation reduces overall risk, position sizing reduces the risk within each asset class.

If, for example, you had $800,000, you might put $100,000 in each of eight asset classes. That’s asset allocation. Position sizing would determine how you divide the $100,000 in each asset class between individual investments.

You might say that you’ll invest no more than $8,000 in any one deal. $8,000 is 1% of $800,000. So if one investment of $8,000 went down to zero, your Free Net Wealth ($800,000) would go down by only 1%.

Like asset allocation, position sizing is a way for conservative investors to protect themselves from catastrophic losses. I’m a strong proponent of position sizing. This is an important safeguard – especially if you ever find yourself wanting to “go big” on some gamble.

Keep this in mind: The smaller you can make your position limit, the safer you will be. My position limit is 1% of my Free Net Wealth on many of my stock investments. But when you are starting out, it will be hard to set such a small limit. A good rule of thumb for most people is 3%-5%.

Loss Limitation

When you use position sizing to buy stocks, you are limiting your potential losses to a percentage of your portfolio (1% for me – maybe 3%-5% for you). But you can further reduce your risk by attaching a “stop loss” to each stock you buy.

A stop loss predetermines the price at which you will sell a stock if its price drops that low. If, for example, you set a 25% stop loss on a $20 stock, you will sell it if its price drops to $15. This reduces your risk for that stock to 25% of its position size.

Getting back to our earlier example and assuming that you have $8,000 invested in the stock (your position limit)… If the stock’s value dropped 25% to $6,000, you would sell it. You would take a loss of $2,000 and no more. And if, as in our earlier example, you had a total of $800,000 invested, your total loss on that investment would be only one-quarter of 1% of your Free Net Wealth.

Stop losses allow you to control what you are willing to lose. They remove emotion (an investor’s great enemy) from consideration when a stock, a group of stocks – or even the entire stock market – is tumbling.

And as you can see, when you combine stop-loss limits with position sizing, you reduce risk dramatically.

* In this series of essays, I’m trying to make a book about wealth building that is based on the discoveries and observations I’ve made over the years: What wealth is, what it’s not, how it can be acquired, and how it is usually lost. 

 “If you are not happy now with what you’ve got, you won’t be happy later if you get more.” – Michael Masterson

Just One Thing: You’re Not a Pharaoh. Don’t Act Like One

Several years ago, The New Yorker published a cartoon of a man on his deathbed saying, “I wish I’d bought more crap.”

That says it, don’t you think?

The pharaohs apparently believed they could take it all with them. So they did. But when their bodies were found years later – as desiccated, linen-wrapped bones – their treasures were gone. Plundered.

That’s the thing about Mother Time. She’s a Socialist. Sooner or later, she’s going to put your hard-earned things into the hands of others. Whether you like it or not.

You can write a will. You can spend a small fortune on an estate plan that will ensure, for some amount of time, what will happen with your “things.”

But even the best legal work can be thwarted by legal work that comes later, when you are no longer around.

The problem is people. As the late, great Joe Gondolfo, life insurance salesman extraordinaire, used to say from the podium: “People change when people die.”

* You leave all your money to rebuild the local library, where you volunteered during your retirement. A year after you are gone, there is a change in the board. The new board decides to sell the library and invest the proceeds in a technology school. “Books are passé,” the board president says.

* You have three rare coin collections, each worth $150,000. You leave one to each of your children. By the time you go, one is worth $300,000, another is still worth $150,000, and the third has depreciated by 300%. Your kids are unhappy with the situation. They secretly blame you.

Your financial life can and should be divided into two parts:

Part 1. Earning money to acquire things you need, and

Part 2. Deciding what to do with those things when you no longer need them.

Most people put off Part 2 as long as they possibly can, until death is knocking at the door. Many never face up to Part 2. They go to their graves owning everything – the house, the valuables, and the money.

This is not a good idea. I’m assuming you know that, so I won’t belabor the point here.

My view is this: Once you have bought all the things you need to live comfortably, additional buying will be counterproductive. You will be spending money on things you don’t need for the very ephemeral dose of dopamine it will give you. But buying them won’t give you half the pleasure it once did… when you needed them.

Moreover, these “things” will start to accumulate – in your basement and attic and closets. You may even rent storage units to hold onto them.

And then what? You die and Mother Time distributes them as she sees fit. Your wishes no longer matter. And she’s a Socialist.

There is only one thing you can do about this. No, two:

1. Stop accumulating things you don’t need.
2. Start giving away the accumulated things you don’t need now.

So before you buy anything else, ask yourself these questions:

* Am I going to actually use this thing?

* How much pleasure or satisfaction will it give me?

* Is there something else I can do with the money that would give me greater pleasure?

If, after answering these questions, you decide to buy the thing in question, ask yourself this: Who should I leave it to after I’ve stopped using it?

Then don’t wait till you die to give that thing away. Give it away the moment you stop using it.