012 | How to Optimize Your Investment Portfolio with Kevin Smith

Liquidity, market shifts, and risk return —what do they mean for your investment portfolio? Get the answers today!

On the latest Vital Strategies Podcast episode, host Patrick Lonergan welcomes Kevin Smith, CFA, for a deep dive into building a resilient investment portfolio. Kevin brings his top-tier industry expertise to discuss liquidity, time frames, tax implications, and risk management. The conversation explores the positives and negatives of various investment opportunities, emphasizing the importance of strategic portfolio structuring for favorable outcomes.

Kevin’s wealth of experience provides listeners with a deeper understanding of investment portfolio design and risk considerations. Whether you’re a seasoned investor or just starting, this episode offers valuable insights that can positively impact your financial decisions. Don’t miss out on this opportunity to enhance your approach to investments.

Key takeaways:

  • Strategic Portfolio Structuring
  • Proactive Corrections Navigation
  • Turning Securities into Cash


2024 Planning Resources

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Sponsored by Vital Wealth

Music by Cephas

Produced by BrightBell Creative

Research and copywriting by Victoria O’Brien

Patrick Lonergan: Welcome back to the Vital Strategies podcast. I’m your host, Patrick Lonergan, and today we’re going to discuss building an investment portfolio with Kevin Smith. Kevin is a critical part of the Vital team. He oversees the team managing all of the investments for our clients. Kevin is a CFA, which is a chartered financial analyst, which is the top investment designation in the industry.

In our conversation today, we’re going to dig into everything from stock valuations and how one company is trading at 13 times sales, which means they would have to eliminate all expenses, fire all employees while maintaining the same sales. It would take 13 years to pay back shareholders, their investment from cashflow.

We’re going to discuss how that might be a problem to how entrepreneurs can build liquidity and how valuable that margin of safety is. This episode is for anyone that wants an easy to understand, but sophisticated perspective of how to approach investments. Let’s get started with today’s guest, Kevin Smith.

Kevin, I’m excited about our conversation today, really digging into investments, portfolio, we’ll call it, stocks, bonds, alternatives, all of those other things when it comes to investing. And I want to start off outlining, we really think there’s three pillars of wealth building. And the first one is the, the business that our clients and the listeners own that really creates tremendous cashflow.

That’s, that’s sort of the foundation of it. That’s where most of our client’s net worth is held. And then we look at the second piece, and we think real estate’s an important part of that. It’s, obviously the business is the least passive. Real estate’s a little more passive, but we don’t think it’s a completely passive opportunity, because even if you have a management company, you’re managing the management company.

And sure, there’s some REITs and that type of thing out there that you can go invest in. But we like the appreciation, depreciation, amortization, all of those factors. It’s a hard asset that has a nice hedge against inflation. Those things are all great. And then the third pillar is portfolio assets.

And we feel like this is the place where you can truly get passive income. I can go sit on the beach, Kevin, you and your team can design a portfolio for me that will just send me checks and I don’t have to worry about it, uh, which is, uh, which is awesome. And I’m looking forward to, really digging into that conversation today.

So thank you for joining us. If we could just start off, you know, I think there’s some, some objections sometimes our clients have of like, hey, the, the stock market sounds risky to me. You know, uh, I can control my business, but, uh, the market. It, uh, you know, there’s some risk in that and I don’t like the fact that, you know, if we look back to 2000 and 2008, like we lost 40, 50, you know, the NASDAQ was down tremendous, percentage there like that, that I don’t, I don’t like those unknown risks out there.

So yeah. Can you just talk a little bit about, the markets and their risk.

Kevin Smith: First of all, thanks for having me. This is a really fun conversation. I’m in this all day, every day, like you talking to clients about it, it’s really fun to chat with you about it. The first thing that comes to mind is you mentioned these three pillars, traditional business ownership, uh, real estate investing, and then portfolio investing.

Those are three very different things. There’s some overlap between all of them, but I think it’s very unusual that you find somebody who’s very comfortable in all three at the same time. In fact, I don’t know many, I know a lot of real estate investors who are very comfortable in real estate. But in terms of running a traditional business, you know, oftentimes not their forte, uh, and plenty of business owners who are very comfortable with that, maybe they dabble in real estate, but they’re a little less comfortable with traditional investing.

So, I think it’s the norm to not be really comfortable and astute in all these areas at the same time. And I can relate to this, because, you know, I’m in a similar situation in preparation for this, this call, I just, I was curious. So I did a little back of the napkin and, and my portfolio, my personal portfolio is maybe 20% of my, my asset base on paper. Now that’s the key here on paper, that’s assuming I got the offer that I feel like I should get and that it actually closed hypothetically, but that’s not real.

So that’s like some, somewhere close to 70% or 80% of my assets that aren’t real, uh, in the sense that I can’t spend them, I can turn them into cash. Uh, so I very much, uh, have to wrestle with this myself every day, and, uh, as I try to increase the size of the proportion of my portfolio assets to the rest of my, less liquid assets, I like to think about what are the specific things that this portfolio can do for me and my, and my family, and that’s how I encourage other people to think about it.

It’s what is the very specific purpose of these assets? And one perspective is, as I was thinking about this conversation, it might be helpful is to think about how portable, these assets are. If you have, you got a hundred thousand dollars, in your business, you could buy a tractor, buy some, buy some equipment.

You can hire somebody with that and get some utility out of that specific asset, which is tied to your business or tied to real estate. The cool thing about portfolio investing is it is unbelievably portable. You could, at this point, you could, you could allocate $10 to own a portion of Google and have legal rights to the assets, cash flows, and growth of Google.

You know, it’s really unbelievable that you can do that. And that’s what our securities are. That’s what financial securities effectively are. So, when I think about, when I think about this portfolio, I think about turning, cashflow that I earned from my business and do these portable assets that I can use for very specific and discreet uses.

So, the first thing that comes to mind is, is liquidity. One of the coolest things about these securities is that they’re portable and they’re liquid, which means they can be turned into cash very easily, you know, some more than others, but that’s really important. And liquidity is an underrated topic. Without it, you might not make it, you know?

Patrick: For sure. Just to just to touch on that, you know, we, we don’t know if there’s a more important asset for a business owner and just an individual in general than liquidity. And it, I don’t know. I wish there was a way to put a, uh, a value outside of just the. You know, when I have money in a bank account, let’s go back to the $100,000, right?

Like, I know I have $100,000 in there, but I, I’m going to argue there’s more than $100,000 of value in there because if my life gets upside down and I need to tap into that, I’m not filing bankruptcy. My house isn’t getting foreclosed on. I’m still in business. You know, all of those things are still there in place.

And that, that margin of safety is one of those things that I, again, it’s really hard to value. But it is when we think about the one thing that we really manage with our clients, we, we have a, what we call a cashflow calendar. And so we’re, we’re mapping out their cashflow and on there’s the liquidity and we have a floor and we do not go under that floor.
Like we will cancel tax strategy. We will cancel whatever we need to, to make sure that that, that liquidity is maintained. So I appreciate you, uh, bringing that point up that’s excellent. Thank you.

Kevin: When we think about designing portfolios, that’s the first thing we get into. And when we talk about liquidity, we’re talking about cash, money market, you name anything that you expect to want to be able to turn into cash over some timeframe that you’ve got in mind.

So like everything, there’s levels to this. There’s the simplest level, which is just put it in bank, a bank or multiple banks, get your FDIC insurance, call it a day and that’s fine. That’s a good starting point, but there’s more sophisticated ways to look at liquidity.

There’s liquidity, I think of it as all the time liquidity, which means I can get to it today, this moment, immediately. There’s liquidity in bad times. Inflation is high, markets are down, we need liquidity in bad times to patch a hole in our financial, personal financial system, that can be a little bit different.

And then there’s liquidity associated with specific timeframes. For example, if you have a specific objective of needing access to capital to buy a piece of real estate for your business or personally or as an investment in two to three years. You have a discrete timeframe of two to three years. You can use that to your advantage.

You can align very specific liquid financial products to maximize your yield over two to three years. Which is not the case in the bank account or in a savings account. You’re just getting whatever they’re paying you, which.

Patrick: Yeah, no, that’s, that’s fantastic. And if it’s okay, I’d like to go back to something you said that I think was, was fantastic.

You talk about, we all have different levels of comfort, whether it’s running the business, owning the real estate, having portfolio assets. The thing I love about the way you operate is, you guys do a great job educating clients on, here’s our philosophy. Here’s how we do it. Could you talk a little bit more about that?

And my guess is there’s a spectrum. There’s, there’s some people that need and want the education. There’s other folks that are like, yeah, I got it. Just, I trust you, Kevin. You and your team do your thing. Can you talk a little bit about just how you bring clients along in the process? Because we’re, we’re introducing new ideas to the client and sometimes it takes a minute to really get a firm grasp of everything that’s going on.

Kevin: Yeah. Education is imperative because really what it means education, the only reason it’s useful is if it brings the client to a place of having a reason for doing something, and knowing when they might do something different. I mean, it’s kind of that simple. Where we start is, essentially you don’t have a choice but to invest.

You’ve got to do something with the cash that you don’t spend. So by default, you’re investing. When you put it in the bank, you know, you give it to the bank, they, they pay you almost nothing, and they loan it out for, for a spread. You’re loaning the money to the bank. That’s an investment. You can loan the money to all sorts of institutions.

So there’s no escaping it. So that’s number one is just to kind of come to terms with the reality. And, there’s no risk free investment either. That’s the other thing as we’ve learned over the last couple of years. The dollar is, has its own risks, and that’s inflation, of course. So, and, you know, these things are kind of obvious statements, but it is difficult to internalize them and, and, and kind of change your thinking to start approaching the world in this way, which I think is foundational.

So, so we started those. With those basic ideas and then build off of them by then assigning specific purposes, like I kind of got into already with liquidity being one of them. Now, why do we want this liquid portfolio? What can it do for us? It can provide liquidity. That’s a super important one. That’s why we already started there.

And we’d probably spend seriously an entire podcast on that topic. Another reason you mentioned is tax benefits. The government has associated some tax benefits with portfolio assets. So, we can take advantage of that. Now of course there’s trade offs with that accessibility, et cetera, but that’s another reason to consider, uh, investing in a portfolio.

So we’ve got to bake that into the equation. Another is the potential long term compounding effect of portfolio investing, and we’re, we’re talking to a lot of entrepreneurs and business owners out there. I think it’s important to distinguish between the expectations on returns from a diversified portfolio versus, real estate investing versus investing in a personal business.

And I was, I was looking back again, in preparation for this, I started putting this in perspective in my own life and there’s really, unless you just enjoy the suffering and, and the, and the process and many of us do, there’s no really, there’s no reason to invest in a business or personal business or real estate without having some expectation of doing better than what you might otherwise get.

In a traditional portfolio, the S&P 500 and bonds or whatever, I would suggest might not be worth it, you know, to, to go through it. So I think it’s important to, to draw some distinctions between these things. And it’ll also, and in using that framework, it allows you to establish minimum required returns on how you allocate your time and your risk.

So everybody has a different, I like to say, what, what is your required rate of return on a real estate project? What’s going to be different for everybody? Some people might be happy with 10% compound returns. I wouldn’t, it sounds like a big hassle to me. 10% is not nearly enough for me to get involved or even consider it.

I think I need to be in the 15-20% percent range. And that’s just because I really, I’m not that comfortable with it, you know, direct real estate investing. So, I set my required return higher and the same for my business. So, it’s all, there’s this relationship between risk and return expectations that are critically important.

Patrick: And that’s fantastic. And I think, uh, you’re, you’re touching on a key point. And if we think about the number of people that filed bankruptcy because their business went out of business or their real estate project went bad. It’s much, much higher, like I, I’m sure it’s a multiple higher than the people that their S&P 500 index didn’t perform the way they wanted to, you know?

So, there’s just so much more risk involved in those things. Now if you know how to manage that risk and operate those things well, like the returns can be, be outsized, but it is definitely a different animal than building an investment portfolio. That’s great.

Kevin: So you can think about each of, your assets serving a different purpose and having a different return expectation and a different risk expectation, cash and liquid assets. These days, you’re looking at close to zero to five, close to six. I mean, there’s a lot of range. If we had this conversation two years ago. The upside was 2-3%.

Now that’s double it. It’s become very interesting. So as those safe assets reprice and that all markets, financial markets are just a way of pricing risk. That’s all it is. And now the low-risk stuff is priced way more attractively. So that can influence the overall equation because we’re trying to balance this giant risk return, um, continuum where a lot of entrepreneurs have kind of a barbell approach where you’ve got this super high risk stuff over here and then liquidity over here in the portfolio fills in a lot of the middle, middle range, which is moderate risk assets with, you know, a pretty high likelihood of compounding at a rate in excess of inflation. And that serves a lot of utility and in the portfolio over different timeframes, intermediate and long-term timeframes.

Patrick: I really like that. Um, so sometimes we, we come across our clients who are, are super busy. They’re busy running their business, but they, they also think like, Hey, I’ve got a hot stock tip.

And can you talk a little bit about, uh, you know, when, when we come across the client that wants to sort of that thinks they can self-manage the portfolio compared to, you know, having somebody like yourself and your team manage the portfolio. Like, can you just talk a little bit about that and why that may be not a great idea?

Kevin: Yeah, this is a fascinating subject. There’s, there’s the, the research that’s been done on this, which suggests that the average individual investor does not actually enjoy the average return on the market. They enjoy something far less this research. I think some of it’s been conducted by Vanguard and other major institutions. I forget who, but there’s been plenty of it done.

And it just simply suggests that people make poor timing decisions and they don’t stay committed. And so over a long period of time, their returns compounded a much lower rate. Then if they had just say, bought the index and, um, and done nothing, they literally done nothing.

So, you know, that’s the average investor, but nobody thinks they’re average. Right. We think we’re above average and in the land of entrepreneurs, small business people, not we’re wired differently, but we tend to share this common, uh, mentality of winning. We like to win. We like to compete. We like to win.

And, that tends to, whether it’s on the golf course or it’s stock picking or whatever. That’s the mentality. And that’s the expectation. I would say that’s even more important. That’s the expectation is we expect to win all the time. Not that we do, but that’s, that’s where we set the bar. So you take that mentality and you apply it to the stock market and it quickly evolves into a very addictive game.

And when there’s been some recent success, it creates either the illusion of skill or maybe you actually have skill, but it’s very difficult to distinguish between the two, particularly say the last five years, there’s been a major run up in the US stock market, particularly. Large tech companies, we’re all familiar with them.

We use their products. Such to the extent we’ve invested in them, we’ve done really well and makes us feel like we can, we can do this. My dad and his buddies were doing the same thing in the nineties. And they tell me the stories now, uh, and they all felt very confident about their stock picking skills. They were humbled once in 2001, and then again in 2008.

And unfortunately for some of them, that meant getting nearly cut in half twice. So there’s a lot of danger in the illusion of skill, and I’m not saying that some people aren’t good at this. They’re out there. I think the, the real risk is believing that you have a method for picking stocks when really your intuitions happen to be in alignment with what worked well at the time.

And what makes it even more difficult is when there is a correction or whatever you want to call it in that portfolio that had done well gets whacked and has a big loss on paper is what do you do now? Mm hmm, right. That’s the part that we haven’t had to experience as investors in quite a time. Even the COVID crash didn’t last very long The last big one is 2008.

It’s been a long time since investors have had to deal with that and even investors who have had a lot of success with stock picking or stocks in general, they’re going to have to decide whether to, to stay in or get out. And a lot of them will get out at the wrong time, lose faith in the market, not get back in.

And now we have a permanent problem, a permanent loss of capital. That’s my biggest concern with folks who have that level of confidence from a psychological behavioral perspective. But then you’ve just got the empirical evidence that suggests, you know, we’re not that good.

Patrick: Yeah, and I think if we if it were even remotely easy, okay, or even attainable, we would see a multi billionaire that got uber wealthy by just picking stocks.

Okay, now we can maybe look to one of those Warren Buffett. But if we go outside of Warren and we look at the Forbes list, we don’t see anybody on there that’s done it by just being you only have to be about 51% right, you know and if you can be 51% right on your guesses like eventually you will amass so much wealth, it will be amazing.

And nobody seems to get there. Like I just look at that high level from a macro point of view. And then I look at our clients and we’ve seen it with stocks. We’ve seen it with Bitcoin where they think I’ve got this figured out. I’ve cracked the code. And then there is a little humility that comes into the picture when it’s like, Ooh, I missed that one, you know?
And, and now I’m trying to recover from a, a catastrophic loss. And it’s really hard. You know, you, you think about. You know, a 505 loss needs a hundred percent gain to get back to even. And so, if we lose beyond that, it’s like, uh, the, the catch up we need to do is just really hard to make up.

So, I appreciate that perspective very much on, uh, that anything else to add to the, the, the stock pickers out there?
Kevin: I think, well, one, the cost of being wrong, like you bring up is often overlooked and the cost of being wrong can be, you know, the difference of over time, we can be talking about tens of millions of dollars, you know, in a compounding way.

So cost of being wrong is, should really be considered. But when I talk to people who are really enthusiastic about markets and investing, and maybe they have some philosophy they’d like to apply, I tend to encourage it. Um, because one, there’s nothing wrong with it. There’s not one right way to do this.

They may be onto something. I’m not the one to tell them that, that they’re not, you know, we can argue about it, we can discuss it, but if people want, really want to directly participate in markets, they should, I just think it’s a matter of right sizing the risk. I think that, you know, when it comes to investing in stocks, there are different types of risks you can take.

There’s market risk, which is just being in the market. That is market goes up, you go up, market goes down, you go down. And if you buy like the S&P 500 or some broad market index, you’re taking broad market risk. So, that’s a lot of risk on, in and of itself. But then if we make, if we add on top of that, we’re introducing additional risks when we, when we deviate from doing that.

If we have heavy concentration in a particular industry or sector, we’re introducing higher risk for that particular bed. If we introduce high exposure to a single company, now we’re taking on all of the individual risks related to that company, including the personal behavior of the executives and all of that.

And then to make matters even more complicated, if we’re involved in some sort of a market timing strategy, we’ve got to be right a lot. And all of that just adds additional risk. So if at some point you’re in the, in the realm of speculation, and I don’t even have a, I don’t have a problem with speculation being built into this portfolio of liquid assets, real estate, business assets, speculative assets, I don’t have a problem with that.

Moonshots, some of that stuff might pay off. And if you have enough liquidity, a big enough portfolio, ample cashflow, you can justify doing some of that. I would say personal stock bets should fall into that category. I would say things like, you know, a new, a relatively new asset, like Bitcoin that is extremely volatile might fall in there.

I would put, private investments and startup companies into that category. As much, you can do all the due diligence you want. But it remains a very speculative asset. It’s hard to assess the probability of success. And I do these things, you know, I was mentioning my own portfolio. I have the whole thing sketched out with different types of assets for different purposes.

And I think the key is to right size those allocations over time. And as long as you do that, you know, I think you can really manage the risk of any one of those types of assets or strategies not performing as you hoped it would.
Patrick: That’s fantastic. And I also love that, uh. You know, as a business owner, you’re, you’re taking all of those pieces into consideration. So, one question that, that comes up. So when we think about Bitcoin and some, some of our moonshots are, are you looking at that as a part of the total allocation?

And if we hit some home runs, we’re going, okay, we’ve got this many dollars allocated to our, we’ll call it moonshot speculation piece of our portfolio. We hit some home runs. Do we allocate those? Do we sort of capture some of those gains back into the general portfolio? And then if we have some, I’m just thinking of like a global rebalance, we have some catastrophic losses.

We go, okay, cool. Those moonshots didn’t work out. We’re going to move a few more bucks back into the moonshot bucket and see if we can, we can connect on one of those. Yeah. How do you handle that?
Kevin: I think that approach is why, and this is when we, we, uh, look at a household, a portfolio, um, we really encourage an investment policy statement.

And that’s, that’s what allows for some more discipline around this. So you look at the big picture and we usually use ranges. So speculative assets might be. You know, 0-10%, 0-5%, something like that. So you work within that range and then you can rebalance over time as asset values change.

Another category I should just mention because Bitcoin serves two purposes. There’s, there’s the moonshot element of it, which is, if this thing becomes a widely adopted, the price would likely escalate dramatically because there’s a limited supply by its nature. So that’s the, that’s the moonshot element.

There’s also a, what we call a tail risk concern here. So in this portfolio, we haven’t brought this up yet, but it’s the, what if things go terribly wrong part of the portfolio? Some refer to it as portfolio insurance. This could be handled a number of ways. Bitcoin could serve that function hypothetically.

If there’s a collapse of the traditional financial system, and Bitcoin survives that situation and becomes, and ends up having a lot of utility. In that situation, it serves as a very defensive asset. It may increase in value dramatically as well, but it, but it serves as defense as well as offense.

More traditional approaches to that would be gold is the more common way to go about that. We think it has a place in most portfolios for these kinds of reasons. And then there’s other types of investment strategies that I would put in this category. These are often lumped under the heading of alternative assets, which all that means is something different from traditional stocks and bonds.

So, it can mean a lot of things, but in this sense of portfolio insurance or the ability to have positive performance when everything else, is not. For example, last year is a great example last year being, I’m sorry, 2022. I’m talking about 2022 it’s January 2024 stocks were down 15-20% bonds were down 15% the worst year.

Ever buy a lot for bonds, a retired person with a 60/40 stocks to bonds portfolio had the worst experience in, in the history of investing for that. It’s horrible. So, there was almost nothing gained value that year. The exception was this category of alternative investments. Doesn’t always work that way, in every downturn, but it often does.

And, and that’s the reason to consider owning them. And particularly for an investor with a large complex estate, who has in mind a very long-time horizon and has a, has values optionality, which means when, and in this sense, Markets are in decline when markets are in decline, savvy investors become buyers.

And if, all of our assets have lost value and we need liquidity. We’re forced to sell them at a loss that could become a permanent loss. We don’t want to do that and then spend it on, on some other asset. So if you have a combination of truly liquid assets, which have no market risk and assets that can make money in a down market, now you have purchasing power in an opportunistic sense.

So, this category of alternatives serves a number of functions. There’s this end of the world, terrible function that we’re trying to protect to some degree against low odds, but massive consequences. And then there’s also an opportunistic element of that, which is financial markets survive. But by having these assets, we have the ability to rebalance into other assets that now are attractive, even cheap.

Patrick: Would it be fair to say when we’re talking about alternatives that if we, if we just take a regular stock bond allocation, and then we mix in alternatives, would it be fair to say that we, we generally get a little less volatility and then slightly better returns. Is that a fair statement or is that, is that completely out in left field or is it one of those scenarios where it depends?

Kevin: So the, the back test, which is what investment managers like to put in front of you, suggests that when you introduce. Say 15% or 20% of this, of this alternatives, uh, category, you get, you know, roughly the same returns for less risk. Which sounds great. We, we call that the Sharpe ratio.

It’s your risk adjusted return, your return per unit of risk and financial engineers are always trying to optimize that. So just from a mathematical perspective, you, you run the models back through the history of time, you recreate them. It looks really great. The challenge. If that’s, if that’s true, if it remains true, if it happens in the future, that way, that’d be great.

The hardest part, harder than just being a traditional investor in the S&P 500 is the FOMO that will come with adding alternative investments. You’ll love them when the markets seem to be on fire and they’re performing well. You’ll hate them when it’s a raging bull market. And some of these are actually going to be down, they’re actually going to be losing value in a raging US bull market, stock market.

That makes, that makes these assets very difficult to hold. Which requires back to the beginning of this conversation, education about it, about what, what is the timeframe you really need to be committed to? What’s the long-term benefit?

Patrick: And I think there’s to go back to something that we, we love with our clients is that investment policy statement, right?

Like the investment policy statement in my mind says, hey, when the markets are doing something wonky and we want to go make emotional decision. This is what we consider solid financial principles, so let’s review back to that and go, yep. Here’s why we have the alternatives in the mix, and this is why we made this decision.

I think that document can be really helpful for some of those scenarios and go. Oh, yes, you’re right. This is why we did that, and we’re not going to Emotionally react because our brains are sort of wired to, you know, when a bear is chasing us, we should run away. Right? And that means when the markets are down, we want to like sell out and like get out completely.

And then when there’s opportunity, we want to shovel more money in, which is the exact opposite of what we should do in the markets, right? Like when there’s blood in the streets, the Rothschild statement is like, that’s when you buy, you know, when everything is going bad, you, you, you push your chips into the table.

And then, you know, when you’re doing really well, it’s like, okay, maybe it’s time to take a few chips off and put them in those assets that aren’t quite performing as well. So, yeah, I don’t know if you have any comments on that, but it seems like that investment policy statement does a nice job of helping in those scenarios.

Kevin: I think it does, and it helps, it helps the investor, you know, remind themselves about what is the purpose of each asset. And I get all the way back to every asset should have a purpose. Some real estate investment, the purpose might be income, um, rather than appreciation. You know, there are certain markets that provide better cashflow and certain markets that provide higher appreciation potential.

We need to accept it for what it is and then review it. If it no longer has a place in the portfolio, we can get rid of it. But if it’s serving a useful function, we keep it. It’s like, you know, you, you got, you got the Jeep, the 4WD Jeep in the garage. You don’t take that to work every day.

Cause it gets 12 miles to the gallon, but when you take the family up to the, to the mountains, you know, you love having it, right? So that’s why you have it.

Patrick: Yep, absolutely. So I want to rewind to something you, you were talking about, and I think this is important. You brought up the S&P 500 and the S&P 500 index and how that can be a tool for diversity, but I think we’ve had some discussions, about how the S&P sort of dominated by a small number of stocks.

Now, I’m curious what your, your thoughts are about that and how to sort of maybe offset that, uh, maybe lack of diversification that we end up with in that scenario.

Kevin: It’s really fascinating that, I can’t, it’s, it’s mind, mind blowing really how concentrated the stock, the US stock market in specific is, and it’s not just the magnificent seven.

I mean, we can take it a little further Apple and Microsoft within the S&P 500 index. The market capitalization, which is the total value of those companies, the share price time, shares, outstanding total value. Well, you would have to pay to own the whole company. Greater, those two companies, their total value is greater than the energy sector. The real estate sector, the utility sector, and the material sector combined. Isn’t that amazing?

Patrick: It’s incredible. Wow.

Kevin: It is absolutely mind blowing. So, uh, one question is what, what happens now in order, in order for this to continue, those companies, some combination of things has to happen. Those companies become even more valuable, or the rest of the market and other sectors catch up and you can go either way.

So, it’s kind of like place your bets and what would have to, a question I always like is what would have to happen to make this particular asset worthwhile investing in what, what would have to play out? Like you could think about an easy example is a piece of rental real estate.

You know, if I’m going to pay a half a million for this and I require a 10% compound return, I need to get that through some combination of cashflow and price appreciation, and I’ll take it either way. Maybe I had a preference for one or the other. But I need to get there one way or another, you can do the same thing with stocks.

At the price you have to pay what has to happen in order for you to get the return on that investment in stock that you really need. And for some of these stocks. What would have to happen is extraordinary. And I, I mean, I’m talking about like the market share, the dominance of that company, the size it would have to grow to what, what, what all that implies would have to be absolutely mind blowing.

At some point and I haven’t kept up with it, but maybe about a year ago, the implication for Tesla at a certain price. Is that it would take about a 25% share of the entire automotive industry and operate at a margin double that of the profit margins that any car company has ever been able to achieve. And it might have been more extreme than that. I mean, it could happen, you know, but that’s the bet you’re making.

Patrick: Yeah, I remember looking at it. I think. If I recall correctly, I believe it was the CEO of Sun Microsystems back in the tech bubble burst and, and the company was trading at a like 10x revenue number, not profit, but it, he was like, this number was absolutely insane.

And I remember looking at Tesla’s number when it was, you know, it’s still crazy high number, but I looked at the revenue and I looked at the price. I’m like, it’s trading at a multiple of revenue. Like the, the exactly to the point you’re talking about, like there’s some business principles that have gone completely out the window when we’re analyzing these opportunities.

And it’s really just, it’s like, okay, we should maybe protect ourselves against owning some of that stock because it really doesn’t have a lot of room for upside. So, I guess that leads us to the question of, well, what do we do about this?

Kevin: So to extend your example here, look at Microsoft. Revenue growth last five years, almost 15% compound revenue growth.

Return on equity, 40%. And the fundamentals of this company are absolutely amazing. What, at what price, price to sales? You just mentioned price to revenue, same thing, 13. I don’t, I don’t, I mean, maybe that’s expensive. Uh, so some amazing things have to happen for that to play out in a positive way, using the same example of Microsoft.
Going back to the tech, uh, boom and bust of 2000 that you just brought up, the share price, going into that, reached $58 a share. It took after the bubble burst, it took about 15 years for the price to make it back to $58 a share, and it was an amazing company most of that whole time. So my point with that is, investing in great companies is a good idea.

No, nobody’s going to disagree with that. Right. But, uh, at what price and the price matters. And that’s the concern about that, that we have about just dumping every dollar into an index that buys indiscriminately without consideration of price or value and, to what end would come, what compounds that risk, we think, is what are called, referred to as market microstructures. So, what’s going on behind the scenes in markets. And one of these things is pretty simple. It’s every employee who has a 401k across the land is dumping part of their paycheck, every pay cycle into a 401k. Most of those 401k investments are now passive index fund vehicles like the S&P 500.

So, this has been referred to as the infinite bid. So, it’s just constant buying pressure at any price. So, the question has to be asked, what happens on the, on the other way, on the, on when they’re selling? And when could that be a concern? It’s anybody’s guess, but these, the combination of having a massive concentration in just a handful of companies, that are trading at massive premiums and these market structures that seem to be, uh, potentially manipulating prices, by their nature. That’s hard to understand and hard to measure. This is all concerning. Our preference would be to abandon that game plan in favor of a more traditional approach to investing, which is to consider price and value in combination.

So, to pay a reasonable price for what we’re getting essentially is all I’m talking about.

Patrick: Yeah. Okay. That, that all sounds great. But I, think all of the, the data over the last 20, 30 years has just said, Pat, go buy the S&P 500 index. Don’t be a stock picker. So, are you, are you telling me to go? Start picking stocks to, to create this portfolio or how, how are you doing this?

Kevin: That’s a really good point. So there’s, there’s two elements that I want to bring up. One is that that assessment is correct at just by the S&P 500 call a day. If back to my previous point, you expect the next 10 years to look a whole lot like the last 10, I mean, a lot. So one part of that is, well, what are the conditions that caused the last 10 years or led to the last 10 years and are those conditions likely to continue, so should we expect more of the same. And for an investor who truly does expect more of the same, which would be something like continued US global stock market dominance, more specifically, US big tech dominance, more specifically, dominance by five to seven companies within that index. If that’s the bet the investor is going, wants to make, then they should do that.

I’m not so comfortable with that bet. I think different things could happen. I think something like mean reversion, which is what goes up and lets come down can happen. Just very simply prices get more normal. I’d be happy to buy Microsoft at the 16 price to earnings ratio by a ton of it. Right. But 37?

Maybe let’s wait till it’s more, a more attractive price. I mean, that’s all we’re talking about. So how to do that? Um, yeah, you could, you could pick stocks. You can come up with some sort of a scheme for how to evaluate price to value or whatever you want to come up with. Um, and anybody could really do some version of that and probably be reasonably effective if they stuck to it consistently over time.

The, the low cost efficient way to do that these days is through managed exchange traded funds. The price of the management of these things has come down from over 1% on average to under ¼%. Some of them a lot less than that. And it just keeps the prices just come down and down and down.

So what’s interesting about these is you can, you can, pay a fund company a bit of a premium over what you paid for the S&P 500 to run an algorithm or an algorithm to lay up a preference for buying and selling behavior on top of the S&P 500. That’s all it really is. And there’s a bunch of different ways to do that.

Patrick: That’s great. And, uh, so I think about there’s, there’s a couple of things that we just hold true. As a busy entrepreneur, I like to have who’s in my life versus how, like you could tell me exactly how to go, you know, create that portfolio. I don’t care. I’m going to go find, you know, Kevin and have him and his team like manage my money.
It’s just the way I’m going to do it. So, I think that’s a, a critical piece cause somebody could go out there and sort of start sifting through all the ETFs and try to find the best one. And, you know, and then there’s like the question of like, well, I actually then need to create a portfolio allocation, not just necessarily maybe own that one ETF.

So can you talk a little bit about how. You know, to bring some of these discussions, topics together, we’ve got, you know, an ETF that pays attention to these, I’m going to call them, odd market conditions. And then we’ve got alternatives that need to come into the mix. We still need some, what I’ll call safe assets in, in that equation as well.
Can you, can you talk about like what goes into constructing that portfolio and how we’ll say the investment team comes to those decisions?

Kevin: I’ll try to summarize it as simply as I can. The first thing to do is to understand some important elements of the overall financial plan. So that the portfolio design can align with that plan, which is a lot of the stuff we’ve already talked about.

Timeframes matter a lot. Liquidity needs matter a whole lot. Tax implications matter and risk return requirements matter. And you could work through a financial plan with somebody, and conclude with them that they need bare minimum, for example, a 6% annual compound return for the next 30, 40 years.

That’s net of everything compound, not in any given year, but on average over time. And if they can manage that, their odds of success are quite high, and if they do better than that, that’s fantastic. You know, you might come to that conclusion. So, with that in mind, you know, we then seek to strike some kind of a balance.

The other element to the, the investor’s preferences is their appetite for risk, which is hard to assess. It for anybody. The way we like to think about it is how bad can things get before you toss out the plan, scrap it and do something else. That’s kind of the risk tolerance. So is it, the portfolio is down 30%, 40%, 50% at some point, we’re all going to throw in the towel probably. Right?

So that’s a way of thinking about drawdown risks. So how much can you withstand? Because as investors, we’re essentially being paid for risk. So that will establish how much risk we can really take when we, as we think about these things. And then another element, which is, has, we’ve touched on a whole lot today in this conversation is what has been termed Maverick Risk or FOMO risk or whatever you want to call it.

It’s how different are you willing to be? And we all have a different version of that. I am personally willing to be very different. My portfolio is the extreme version of what we recommend. Um, and some of my colleagues are the same way, but we understand that that’s not for everybody and everybody has a different tolerance for being different.
You can think of different as how much can you justify deviating from the S&P 500 with your US stocks and for how long that would, that’d be a prime example of it. So, we put all these, we take all this information and then we try to match those preferences and requirements and timeframes. With the portfolio tools that we have, and broadly speaking, there’s the safe liquid tools, and then there’s an array of those tools.

Then there’s the higher potential return, higher risk tools. And then there’s a great, an array of those, and then there’s the other stuff, the alternatives, right? So that’s, so we looked at start by blending those appropriately, and that will change over time once that’s established, and everybody’s happy; what I like to say is you can more or less stop there if you wanted to, like, you could just stop, put the liquid stuff in the bank by a diversified bond portfolio, ETF, muni bonds, whatever you want to do by a stock index and just be done. So only move past that if you’re interested in trying to improve upon those basic ideas. And that’s where we get into the sub allocation within the liquid assets.

How are we going to align them and try to maximize the yield per risk over whatever timeframe, the same for bonds, and then of course, for stocks, and that’s where we get into international investing, diversifying internationally.
What types of elements of stocks, are we more interested in? I mentioned the price to value. There’s also a momentum factor, which is interesting. There are other dividend yield is interesting. That’s real cashflow. So we start to bake into the equation, our preferences for what characteristics of stocks do we want more of?

And then all of that leads to the last layer of decision, which is now we have to go out to the market and actually find those investments to satisfy. That plan, and that is exchange traded funds, mutual funds, limited partnerships, hedge funds, REITs, you know, the whole, all the investment products that are available under the sun.

We then assemble the ones that we think are available at the most reasonable price that have, you know, a management team, which seems to be the most durable, reliable, process oriented, all that kind of stuff. I won’t bore you with the details, but that’s how it all comes together for an actual portfolio that is. Petrol, Schwab or Fidelity or, or whatever.

Patrick: I love it. Thank you. And, and we’ve talked a little bit about tax. If I have money in an IRA that I’m not going to touch for 20 to 40 years, depending on my timeframe, like that’s going to have a different allocation. Then I’ll call it my brokerage account that, you know, I maybe I don’t have any opportunity in the short term, you know, the next five years on my mind, but something could come up and I might want to, you know, change that risk profile and maybe get some of those dollars out to go, you know, either invest in my business, buy another business, uh, buy some real estate to sort of diversify on some of the things we’ve already been talking about.

I guess there’s a question on the brokerage side of things, you know, we just got done. Working with the whole investment management team on tax lost harvesting and that type of thing at the end of last year. And so is there anything else on the tax efficiency side we can do to make sure that our portfolios are running as tax efficient as possible? I don’t like paying any more money to the IRS than I have to, so.

Kevin: Oh yeah, this, I love this topic and this is A big part of what we’re doing in 24 is assembling, uh, all these tax efficient investing tools, uh, and packaging them up, which super excited about, so I’ll just sketch out, how we’re thinking about it.

So there’s layers. Like when, when you’re working with your clients, there’s layers of sophistication and tax strategy, it the same thing is true at the. So once you’ve decided how much to have in a, an after tax accounts, a brokerage account, which is completely subject to taxation on interest income, dividend income, capital gains, all of that.
So, once you’ve decided how much to put there, then if there’s a preference for being more tax efficient, which is true for most people, there are layers of steps that can be taken. It’s important to note that there are tradeoffs here, of course. So, the more tax efficient you become, the more you have to give up in terms of investment strategy, the available types of investments you might consider, there are potential higher returns and all that’s difficult to estimate, but it is a real trade off.

So, the most tax efficient investment account will look very different from the optimally diversified account as a reality. So, then you have to look at, well, what’s the trade off in terms of potential returning risk that all needs to be considered. But I’ll just give you some of a rundown of the tools.

So, the way we think about it, we have a tax sensitive strategy. Which is very kind of easy to execute, small account balance, can use this strategy. And then there’s the maximum tax optimizer strategy, which is far more complex, often requires a much higher minimum investment to execute upon. So, the simplest version would be to look at the broad categories of investments.

We’ll start, so you got stocks, bonds, and alternatives. So, as it relates to, to stocks, the taxation is going to come from tax on dividends and tax on gains, right? So, the simple things we can do there are to invest in strategies that have low turnover, so they don’t buy and sell a bunch and generate those gains, whether or not you want them.

So that’d be, that’d be one thing. And then the other would be to have a higher percentage of qualified dividends, which have preferred tax treatment. Those are some very simple things that you can do there. And then to your point, you could also run some tax loss harvesting. To capture losses on purpose, stay invested and offset gains.

So those are just some very simple things that you can do on the bond side. You can emphasize municipal bonds, get that tax free income. And there’s actually some interesting things you can do to transfer treasury bill returns from taxation at your income tax rate to a dividend tax rate. I’ll tell you more about that later.

Patrick: Yeah, that sounds good.

Kevin: So there’s some fun stuff to do there that is effective. And on the alternative side, a lot of those strategies tend to be very tax inefficient. They kick off all kinds of gains in income. So we might look to Reduce the exposure to those in a brokerage taxable account and have maybe more in a qualified account.

But if you want portfolio protection, downside protection, you may just have to pay some tax to get it, you know, as part of the tradeoff. So a couple of quick things on the more advanced. So, to kind of continue on my last point, asset location is, is important. So you could truly optimize if you had a brokerage account, an IRA, a Roth IRA.

You could exclude the least tax efficient assets from that brokerage account and put them elsewhere and into IRAs and Roth IRAs. That would be great. Unfortunately, a lot of investors have a specific need for that brokerage account. It might be better off if they made use of some of those assets. So, it’s important to know that, but if an investor is treating all those accounts with the same timeframe and same purpose, you could truly optimize that.

The other thing that happens with tax loss harvesting is let’s say you put a million dollars into a brokerage account and you invest it. And, and then the, there’s a bull market, stocks are up 20%. You may never have an opportunity to harvest a loss because you’re never going to get behind your cost basis. Right?

So it’s over. And that happens on average, there’s no tax loss harvesting opportunities after a few years. They, they declined very rapidly unless you’re just in a recession. So, an interesting way to deal with that is to use a long, short portfolio, which has short positions and long positions constantly that are creating losses.

So that’s an advanced strategy, but that kind of stuff exists. And you can also use direct indexing, which is basically build your own index on the individual stocks. This is the year of direct indexing. These technologies have been created through, they’ve been around, but they’ve never been more available and more effective than we’ve seen them just in the last year.

Lots of great options for that, which allows you many more opportunities to harvest losses at the individual stock level while you own something like an index fund. So, there’s a lot you can do there, but it gets more hands on and in some cases requires a much larger balance of the account.

Patrick: Yep. Absolutely. I’m not going to do that with a hundred thousand, you know, the, the dollar figures need to be up there so I can own, enough of everything. So that’s exciting. Kevin, I feel like we need to have you on regularly to just give us, you know, we could dive deep into these topics.

Some of the, the things we covered high level, we could, we could go deeper into, and then the market’s going to be changing over the next. Look, it’s going to change every day, but, uh, you know, every quarter, every year, we’re going to have, uh, a whole different set of variables that we need to be taking into consideration when we’re looking at our accounts. So very good. Is there anything else we should touch base on before we, before we wrap up?

Kevin: I think we, uh, we, we surveyed the, the area pretty, pretty well. I mean, one thing I guess we didn’t touch on is. Um, non-liquid assets, there’s a lot of interest, particularly among higher net worth folks in private equity, you know, private real estate funds, limited partnerships, things like that, and I think there’s a place for those.

So, I just want to touch on quickly that, um, although there is a place, the, uh, the failure rate is unfortunately high. In these, in these strategies. So, the due diligence requirements or, or a bar should be raised quite a bit. The fees can be, extraordinary and can consume any of the potential excess returns one could hope for.

And the lack of liquidity can be problematic. You can’t get to the money. It also creates, you know, complicated tax situation sometimes. Which we’ve seen particularly, you know, if the investment is only $50,000 and it’s, it’s now worth $25,000 and it’s generating a K1 that doesn’t come in until after the due date, you know, it can get airy and frustrating.
So, I’m mentioning a lot of the negative things. There are some potential positives, I guess. Because I know we’re short on time. Among the most successful hedge fund managers and private equity fund managers, it seems to be the data suggests that the winners are the most likely to win, which is not always the case in markets and in other areas of the market.

The challenge with that is even if you can identify those who have done extremely well. They don’t have a hard time raising money and they may not want your money. And the minimums tend to be very high. So, although there are some outperformers out there that have been great and will likely persist, they probably have an advantage they can be difficult to invest in.

Patrick: Yeah. And you bring up an interesting point on the due diligence side. I due diligence can actually be awfully challenging on these opportunities because I read some fun documents recently that a client was like, Hey, I want you to look at this opportunity for us. And the fund documents basically say, don’t invest in this.

It’s going to go to zero. We have all sorts of potential conflicts of interest. You know, we’re going to take a fee before you get any return. And it’s, it’s just awfully interesting. And so I think about, you know, going back to, to bringing things full circle, the conversation around, you know, having some of those moonshot investments.

Okay, great, let’s allocate some of those dollars into these things that, uh, could blow up and do really, really well or blow up in a bad way. And I get a little nervous about, you know, especially when we think about our business owner who. Has a micro-cap business, right? That they’re running to go buy into more of that.

You know, I think we should probably be a little more down the fairway with, uh, some of our strategies. So if everything goes sideways in the business, we’ve got this, these portfolio assets that we can lean back on and go. All right, we’re, we’re, we’re still okay. We still got some assets that, are going to protect us and, we’re not going to be living in the van down by the river.

So good. Good. Anything else before we wrap up, Kevin, this, this conversation has been wonderful. I do appreciate it.
Kevin: I feel like I just need to mention that there are way more types of risks than we’re, as investors, we’re typically paying any attention to. We pay attention to the market risk, which is what did the S&P 500 do?

But, even banks and some big ones learned, uh, that interest rate risk remains real and put some of them out of business recently. That also has a big impact on the real estate market, on the ability to borrow money. Currency risk has not been a problem for US investors for, for a while. If the dollar loses its power, you know, that that’s a significant risk, which has implications to investors.

Nobody was concerned about inflation until about two years ago, because it was one or 2% for a decade. Turns out, um, that’s a real risk that is, that is looming. So when, when thinking about investing. I just, I think it’s important to think about the exposure that an investor has across the portfolio to the different sources of risk.

Patrick: Absolutely. And the thing I love about working with you is you and your team are taking all of those things into consideration when we’re, we’re designing portfolios, thinking about what the client’s trying to accomplish. And so, uh, I appreciate that it gets us better outcomes than a client out there. Just doing it on their own. So keep up the good work. I appreciate it very much.

Kevin: Pat, I enjoyed the chat. It’s been cathartic in some ways. It’s always a pleasure to talk to you.

Patrick: Thank you for listening to the Vital Strategies Podcast. This conversation today is for informational purposes only, and we recommend you talk to your investment professionals before making any investment decisions.

For links to the resources mentioned in today’s show, see the show notes of this episode at vitalstrategies.com/episode12. Follow the Vital Strategies Podcast. Wherever you listen to podcasts, and if you’re enjoying the content and have a few minutes, we would appreciate it. If you would rate and review the show, we look forward to having you back next week, where we will help you pay less tax so you can build more wealth and live a great life.

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