Structuring an investment portfolio for someone looking to achieve or maintain financial independence or other financial goals will generally be a two-stage exercise involving first, what kind of assets to hold and in what proportions and second, what specific assets to acquire. This quarter we will look at the first of these.
The primary reason for planning, organizing and managing your financial affairs is to ensure that you have the cash you need when you need it. In order to do that however, you must first establish why you will need the cash, how much you will need and when will you likely need it. This is the case whether the financial objective is a specific sum such as a down payment for a house or a longer-term ongoing cash flow to support your lifestyle.
The conventional approach to structuring an investment portfolio is to allocate a certain proportion of the portfolio to each of the major classes of assets – cash, bonds, equities etc. – with a view to maximizing investment results while minimizing “risk”, usually defined to mean volatility. The thing is though, that for someone who has accumulated a significant amount of capital or has a significant amount of time before cash needs to be extracted, volatility represents an opportunity to buy or sell at attractive prices. It is not a risk.
We think it makes more sense if the asset class with the greatest capacity for growth makes up the largest component of any portfolio subject to ensuring the achievement of the overall objective – having the required cash at the required time. Asset allocation therefore should be an exercise in balancing assets with the highest potential return with the timely availability of cash.
To the extent that a significant amount of cash will be required within the relatively near future, say within three to five years, that amount should be put aside and either held as cash or deployed in short-term interest-bearing instruments that will mature within the required time frame. This is a specific dollar amount, not a percentage of the portfolio. The balance of the portfolio can be deployed in those assets providing the highest probability of achieving growth – shares of successful businesses.
As the cash component of the portfolio is drawn down it may need to be replaced, for example if cash is needed for ongoing lifestyle expenditures. Since the initial cash component is guaranteed to meet cash needs for the stipulated period, you now have the luxury of raising cash from the growth component of the portfolio at times, prices and amounts of your own choosing as the individual company shares achieve, surpass or perhaps fail to meet expectations.
This approach can be applied to any portfolio. It doesn’t matter the age of the owner, the size of the portfolio (although if cash needs exceed portfolio size you might wish to revisit near-term financial objectives), or the particular financial objectives to be achieved. All that is required is that you know how much and when cash will be required.
As always, should you have any questions or just want to chat, we would be delighted to hear from you.