As of 2018, with the average savings rate hovering around 4%, a median 401(k) of only $110,000, and an average 401(k) balance at retirement age 60 of around $230,000, many Americans are financially screwed. Just do the math yourself. Add the average Social Security payment per person of $18,000 a year to a 4% withdrawal rate on $230,000 and you get $27,200 a year to live happily until you die at 85. That’s clearly not enough!
Let’s think about this some more. You spend almost 40 years of your life working just to live off minimum wage in retirement. Hopefully you were able to live it up during your working years, otherwise, how else can we explain a national sub 5% savings rate? Blowing lots of money for fun is fine if you expect to live like a pauper when you’re old. The better way to do things is to smooth out your spending across your expected life expectancy to reduce stress and live a much steadier lifestyle.
We’ve talked in detail about the proper asset allocation of stocks and bonds by age. Just know that stocks should be a minority portion of your net worth by the time you are middle age. If you so happen to have 100% of your investment allocation in stocks before retirement and 2009 happens, well then you are out of luck. Calculate how much you lost, equate your loss to how many years it took you to save the value of the loss, and expect to work that many more years of your life. Now that’s depressing.
We also found out that the median net worth for 2010 plunged to $77,300 from a high of $126,400 in 2007. Meanwhile, the median home equity dropped from $110,000 to $75,000. In other words, the median American’s net worth almost ENTIRELY consists of home equity! Take a look at this chart highlighting how a record high 30% of American households have no wealth outside their primary residence.
Finally, despite a ~200%+ rebound in stocks since the bottom of the crisis and savings interest rates of only 0.1% due to a dovish Fed, a lot of people missed out on the recovery as evidenced by a tremendous amount of cash still sitting on the sidelines due to fear. Anybody who has lived through the 1997 Russian Ruble crisis, the 2000 internet bubble, and 2006 – 2010 housing correction probably has a good portion of their net worth in CDs, bonds, and money markets because they’ve been burned so many times before.
The question we must all ask ourselves is, “What is the right net worth allocation to allow for the most comfortable financial growth?” There is no easy answer to this question as everybody is of different age, intelligence, work ethic, and risk tolerance. I will attempt to address this question based based on what has worked for me, and what I believe will work for anybody who is serious about building enduring financial wealth for the long run. I’ve spent over 20 hours writing this post in hopes that every Financial Samurai reader can build a rock steady net worth portfolio to make money in good times and lose less in bad times.
THE MENTAL FRAMEWORK FOR NET WORTH ALLOCATION
* You are not smarter than the market. I don’t care how much you’ve been able to outperform the stock market over the years with your $10,000 stock trading account. The fact of the matter is your performance will normalize over the medium-to-long run. As you grow your assets to the hundreds of thousands or millions of dollars, you aren’t going to be whipping around your capital as easily as before because your risk tolerance will change. The most dangerous person is one who has only experienced a bull market. They think they are invincible, confusing a bull market with their brains until the next inevitable downturn comes and wipes them out. Get it in your head that you will underperform and you will lose money at some point. There is no risk-less investment unless you are putting less than $250,000 in CDs, money markets, or buying US treasuries.
* You are not a financial professional. If you are a software engineer, your expertise is in creating online programs not giving investment advice. If you are an artist, your expertise may be in painting portraits, not recommending a pair trade with Apple and Google stock. If you are a Major League pitcher, your expertise is throwing a nasty cutter, not investing $50 million in a gaming company and going broke like Curt Schilling did of the Boston Red Sox.
I’ve spent the last 20 years investing my own money since opening up a Charles Schwab account in 1995. I worked in equities on Wall St. for 13 years and I received my MBA in finance. Regardless of my credentials, I’m still going to make suboptimal financial decisions because I don’t know the future. If I knew the future, I’d probably be on a mega yacht in the South of France getting a massage right now! The only thing I can do is come up with rational expectations, and invest accordingly. If you can’t come up with a coherent 10 minute presentation to a loved one why you are investing the way you are, you might as well be throwing darts.
* You only have at most 110 years to live. Statistics say the median life expectancy is around 82-85 years old. Less than 0.1% of the 6 billion people on earth live past 110 years old. As a result, you must plan for roughly 80-90 years of life after secondary school. The good thing is you have a time frame to plan for your financial well being. The bad thing is you might die too early or live too long. It’s better to plan for a longer retirement and have money left over to give to others than come up short. This is why managing your finances easily in one place is important. Personal Capital makes staying on top of your net worth easy and free. The internet has made things free and easy to track your net worth, analyze your investments, and run various retirement scenarios.
* Your risk tolerance will change over time. When you’ve only got $20,000 to your name and you’re 25 years old, your risk tolerance is likely going to be higher than when you have a net worth of $2 million and are five years away from retirement at 60. When you’re young, you naively think you can work at your same job for years. The feeling of invincibility is incredible until something happens. Do not forget to give yourself a thorough financial assessment at least once a year to make sure your net worth allocation is appropriately dispersed. Ignoring your finances is not the way to financial prosperity. If you gamble with your finances during the latter stages of your life, you will have a much lower chance of recovering.
* Black swan events happen all the time. A black swan is supposed to be rare, but if you’ve been paying attention for the past couple decades, incredible financial disruption happens all the time. Nobody knows when the next panic induced correction will incur. When Armageddon arrives, practically everything gets crushed which is not guaranteed by the government. It’s important to always have a portion of your net worth in risk free assets. Furthermore, you should consider investing your time and money in things that you can control. If you want evidence of people not knowing what they are talking about, just turn on CNBC and watch them trot out bullish pundits when the markets are going up and bearish pundits when the markets are going down.
* Bull markets can make you incredibly rich. Not everyone got crushed in the dot com bubble. Plenty of people sold their Webvan stock at the top! Bull markets generally last in 4-7 year upward cycles. The direction is almost always up and to the right over a long enough time period. It often times feels worse missing out on a huge gain than losing money. Therefore, it’s important to have at least half of your net worth exposed to an improving market. The power of inflation cannot be underestimated. If you are a price taker without inflating assets, you are losing.
NET WORTH MIX RECOMMENDATION – BASE CASE FRAMEWORK
* All percentages are based off a positive net worth. If you have student loans right out of school, or a negative net worth due to negative equity, use these charts for the asset side of the balance sheet equation. Systematically look to reduce non-mortgage debt as you build your wealth building assets.
* Stocks include individual stocks, index funds, mutual funds, ETFs, structured notes. Bonds include government treasuries, corporate bonds, municipal bonds, high yield bonds, and TIPs.
* For the first eight years of work, the majority of your net worth is in stocks and risk free assets such as CDs, higher yielding online savings accounts, and money market funds. Online banking is the best place to park your cash and it’s very convenient to deposit or withdraw money. Don’t let traditional banks get away with paying you nothing in interest as you fall way behind due to inflation! At the age of 30, you should have some idea of where you want to live, and what you want to do for a living. With this confidence, you shift a major portion of your net worth into buying your first home.
* Risk Free assets also start off high given you’ve first got to save money to build a financial foundation. It’s not wise to dump all your savings in the stock market if you don’t know what you’re doing. Gradually leg in the more comfortable you become with investing. Stocks have proven to be the most straightforward way to grow one’s net worth over the long run. You’re also not that interested in bonds because your risk tolerance is high and interest rates are so low. The Risk Free column can also be called the “Emergency Fund” column if you like.
* The return on rent is always -100%. After 40 years of renting, you have nothing to pass on, nor do you have a place to live rent free in retirement. As long as the government is subsidizing homeownership, and as long as people don’t have the discipline to save and invest the different, renting is discouraged if you can afford to own. And if you just don’t want to own property, then you should consider gaining real estate exposure through REITs or real estate crowdfunding across lower value, higher yield parts of America. I’ve personally invested $260,000 in real estate crowdfunding to gain exposure to the heartland.
* Alternative investments stay at 0% given it’s hard enough to get people to save more than 20% of their income, come up with a downpayment for a home, consistently invest in stocks and bonds, and pay off debt.
* The ultimate goal is to have a roughly equal balance mix between stocks, bonds, and real estate with a 10% risk free buffer in case the world comes to an end. In a difficult economic environment, stocks and real estate will decline (60% of net worth), but at least 30% of your net worth (bonds) will increase, while your 10% emergency fund remains intact.
NET WORTH MIX RECOMMENDATION – NEW LIFE FRAMEWORK
* After five years of savings, you purchase your first property and reduce your Risk Free percentage down to 10% from 30%. If you own the property you live in, you are neutral real estate. The only way you can make money in real estate is if you buy more than one property. If you are a renter, you are short real estate.
* After 13 years of saving and investing, your net worth increases handsomely. The decline in stocks as a percentage of net worth doesn’t mean a decline in the value of your stock portfolio. Rather, due to the increase in your overall net worth, the absolute value of your stock portion increases despite a decrease in the percentage of total.
* With a larger net worth, you invest some of your savings into Alternative asset classes by age 35. Alternative asset classes may include: private equity, venture capital / angel investing, or starting your own company. You’ve got stocks, bonds, and real estate down pat. With free liquidity, you dable into the unknown because you never want to look back and say, “what if.”
* After the age of 40, you’re looking for a more balanced mix in your net worth. As a result, you purposefully invest less in stocks and more into bonds and alternative investments. Your real estate equity also holds steady, market willing.
* By the time you’re 60, you have a wonderful net worth balance that is practically implosion proof. Your Risk Free percentage increases along with your Bond percentage because you enjoy the feeling of stability and security as you plan to live until 110 years old.
* I’m currently following the New Life framework, but plan to work towards the Self Belief framework below. In order to do so, I need to aggressively grow a business.
NET WORTH MIX RECOMMENDATION – THE SELF BELIEF FRAMEWORK
* The Self Belief Framework assumes you have better control your own financial future than other investments. When you invest in stocks, bonds, and real estate, you are depending on someone else and favorable macro conditions to make you money. When you invest in You, you believe you have a superior ability to build wealth.
* The Alternative column’s name changes to the X Factor. The X Factor assumes you no longer invest the majority of your savings in stocks, bonds, and real estate, but in building a business that may one day grow to be an enormous percentage of your net worth. The X Factor can also include creating anything of financial value.
* You don’t have to own real estate in the Self Belief Framework given you’d rather use the downpayment capital on your own business. Feel free to increase the X Factor column percentage by the Real Estate column percentage if this better fits your goals.
* After decades of building your X Factor, you take some risk off the table and increase your Risk Free percentage. By this time, your net worth has grown large enough where you can live off interest rates as low as 2-4%.
* If you are wildly successful in building your own business, the X Factor column can easily dwarf all other columns.
THE PROPER NET WORTH ALLOCATION IS WELL DIVERSIFIED
As we discussed in the Mental Framework portion of this post, financial returns are not guaranteed. Given there are no sure things, it’s best to keep a diversified net worth mix that can withstand the hits of severe economic downturns, while benefitting from multi-year bull runs.
When it comes to building wealth, I encourage everyone to focus on a realistic worst case scenario where all assets except for the risk free portion goes to zero. This way, you’ve addressed your biggest fears so you can move on with your quest. Imagining a realistic best case scenario is fine as it’s always good to dream. There just has to be a balance with your wealth building approach as to not come up short when you can no longer work.
I’m confident that if you follow any one of these net worth allocation recommendation charts, you’ll do just fine and achieve an above average net worth. Remember, the average American has over 90% of their ~$100,000 net worth in real estate. This is absolutely preposterous because it means that the average American either is buying more house than they can afford, is no longer saving after they buy a house because they think a house is savings account, or is not actively investing in other asset classes. Beware of having the large majority of your net worth in any single asset class.
My goal is to help every reader achieve financial peace of mind in order to do whatever your heart desires. Good luck everyone! Please share your current net worth mix and your desired mix if interested.
Recommendation To Build Your Wealth
The best way to build wealth is to get a handle on your finances by signing up with Personal Capital. They are a free online tool which aggregates all your financial accounts on their Dashboard so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 28 different accounts (brokerage, multiple banks, 401K, etc) to track my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing, how my net worth is progressing, and where my spending is going.
One of their best tools is the 401K Fee Analyzer which has helped me save over $1,700 in annual portfolio fees I had no idea I was paying. Their Investment Checkup tool is also great because it graphically shows whether your investment portfolios are property allocated based on your risk profile. Finally, they just came out with their Retirement Planning Calculator, which uses real data to come up with various financial scenarios based on Monte Carlo simulations. You can input multiple expenses to come up with as realistic an assessment of your finances as possible.
There is no better free online tool that has helped me stay on top of my finances more than Personal Capital. It’s important to aggregate all your accounts to get an entire overview of your net worth to make proper changes. It only takes a minute to sign up.
Updated for 2018 and beyond. The bull market is alive and kicking due to optimism about earnings growth, low interest rates, and a business friendly environment that has cut taxes and reduced red tape.