Friday, July 16, 2010

Asset Allocation is also a planning tool

We have talked about the importance of a diversified portfolio – protecting cash flow and reducing volatility that fits an investor’s temperament. But there is another important aspect to Asset Allocation that is often forgotten.

Remember when we talked about visualizing our life goals and the role money plays in that vision? I am often referring to that as ‘reaching one’s Belize’. To financially define the travel route to reaching your Belize would require you to know how much cash flow and net cash flow you will need to live your personal Belize.

Cash flow used to service your debts and cash flow to pay for property maintenance; etc. Also, and even more important, you need to know the net cash flow that is used (like in any business) for reinvestment and for paying dividends to the investor. The dividends are a different way of saying the costs of financing your lifestyle.

As you may have noticed in the allocation spreadsheets, it reports your net cash flow (net operating income minus interest payment – but not loan principal reduction). Of course, this is ‘projected net cash flow’ anticipated based on your net worth AND asset allocation. So you can use it to forecast you future net cash flow, in other words you can use it to estimate the net worth and asset allocation you will need to generate the cash flow required for your Belize.

Suppose to live your Belize, you will need $75,000 disposable income plus another $100,000 for re-investment. By playing with the net worth and asset allocation in your spreadsheet, you can now determine what you have to own in order to achieve that. In our example and using the asset allocation of the ‘5 million portfolio’, you would need total assets of approximately 6.5 million and a net worth of 5.3 million. But you may argue that you only need $75,000 disposable income and that all re-investment will result strictly from portfolio appreciation and rebalancing. In that case you would ‘only’ require assets worth 2.8 million and a net worth of 2.3 million. Something a lot easier to achieve. Next you could look at your debt load by playing with LTV to see if you can achieve your goals with an even lower net worth but with higher risk (increased leverage), or by concentrating on higher dividend paying stocks or only to invest in properties with a higher cap rate (yield column). Once you know this, you can plan how to get there.

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