Sunday, July 22, 2012

A Portfolio of Viable Investments

Over the past month or so, we discussed what a viable investment constitutes and how to recognize one. So how does one translate that into a portfolio?  If you go to a financial planner, he will ask how long you plan to live or otherwise assign you a life expectancy based on actuarial statistics.  Isn’t that fun: “Oh Bill, you are a non-smoking white male of 35 years old, thus you are expected to live until the ripe age of 83 years. Oh Nancy, you are a 40 year old female who doesn’t smoke, eats organic foods and exercises 3 times per week; you are probably dead by the age of 86 and your husband will likely croak at 56 because he is fat and boozes too much." J

The financial planner continues:"So let’s see: if we assume that there is no inheritance for the kids then at an average ROI of 5.3421%  and your current level of savings and continued savings of $333.21 per month until the age of 60 years, thereafter in retirement you will be able to spend $431.76 per month until the day you’re scheduled to die. If you live longer, too bad because you’ve no money left and have to eat out of other people’s garbage bins." Do you notice a certain flaw in this form of financial planning apart from the unpleasant prospect of eating out of garbage bins if you outstay your financial welcome on this earth?
Everyone who once believed the demographic studies predicting a 1930’s style of depression on November 23 in 2012 because baby boomers would stop spending should know the futility of predicting the future. If you didn’t fall for that form of clairvoyance, then what about those rock solid stock market predictions or the prediction that nobody needs a computer with more than 32K RAM?  Let me make a prediction about the future that is probably much closer to the truth: Nobody knows what tomorrow will bring!
So, maybe we’re all dead on November 29, 2013 or maybe we all reach immortality provided for a minor monthly fee by Wasser Life Insurance Ltd. Really, we don’t know what tomorrow brings and thus we should plan our retirement as if we will live forever. You know there is something very tempting in such a scenario: From age 0 until 3 we’re home with Mommy and Daddy; then between 4 and 6 we’re spending a great time with the daycare ladies; next we’re spending 6 years at elementary school before graduating to high school.  At age 18 we’re car driving adults – if you can believe that – by age 30 were moving out of our parents place and live off our girlfriend(s) whom we dump upon completing university followed by marrying a hot chick with a great career in engineering. After a strenuous professional career of 10 years, we’re retiring at age 55 to never have to work again unless we really, really want to and when our busy holiday schedule allows us. From 55 until age 120 we’re leading a truly financially independent live and then we’re getting a much deserved upgrade that allows us to live another 500 years at which point we’re so bored with live and we’re so rich because of the financial ideas from a long forgotten blog titled “Canadian Diversified Investor” that after one last party we commit euthanasia surrounded by our smiling favorite offspring which counts by that time in the hundreds.
So we need a retirement plan that is aimed at living nearly forever. Hmmm… So we need inflation indexed income from inflation protected assets not something that runs out of funds after a mere 30 years and preferably something that did not force us to work for much longer than 10 or 20 years. So, using roughly the average Canadian household income as guideline, we need an inflation indexed income of $30,000 per year supplemented by another $20,000 to $30,000 in Canada Pension and old age security (whatever that will be called 500 years from now).  In the past, I showed you two ways of designing a portfolio:
1.       A diversified Asset Portfolio   (July 2010)

2.       A diversified Cash Flow portfolio  (Nov 2011)
Either portfolio will deliver cash flow and capital appreciation but one is focussed on assets while the other is set up to create a series of income streams. In this post we will use the Asset Portfolio because it is a bit more specific in what asset types you can select. From our earlier discussion you know we’re focussing on assets that produce cash flow from rents, dividends and to a much lesser degree interest.

You may want to consider one other asset that is not included in the portfolio but is extremely valuable and capable of throwing off impressive amounts of cash flow every single month of the year.  That asset is you and your job.  Your labor translated into a salary is one of the most profilic ways of generating cash flow – even at age 80 you could take a job at Wal-Mart.  So what is the value of a $40,000 per year job these days?  It depends on your discount rate which may range from 1 to 10% and thus your own asset value ranges from $400,000 to $40,000 respectively.

According to my estimates to generate inflation indexed income of around $40,000 you will need a portfolio of around $1.5 million in assets which comprises a net worth of $1.3 million plus $200,000 in mortgages. The portfolio asset mix is: 38% stocks, 9% fixed income, 47%  actively (by you) and passively (by someone else) managed real estate and 6% cash. The details are shown below. The stock portfolio is also subdivided into active and passive managed. Passive managed stock investments are ETFs and Mutual Funds (I prefer the ETFs), the active portion are stocks selected by yourself based on criteria outlined in this blog before.  Depending on your personal taste and risk, it is not too drastic to change the proportion of active versus inactive stocks.  When dealing with real estate, I would want to keep control and manage most assets myself (possibly with help of a rental manager).
Click to magnify
One minor thing when planning your retirement and building up your assets accordingly.   You MUST live BELOW YOUR MEANS!!!!

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