How does an award-winning Chief Investment Officer invest his own assets? In this episode, Peter shares how he handles his own assets, liabilities, and spending habits. 

Listen in and learn:

  • The story of Peter’s first money lesson
  • The metrics Peter uses most often to measure his progress
  • The investments and asset allocations for each of his personal accounts
  • The system Peter uses to manage his cash and liabilities 

Episode

Outline

We don’t live in a spreadsheet.

I remember the first time that statement popped into my head. 

I was sitting in an apartment in the fall of 2008. 

  • I had been working for a wealth management firm for a little over a year. I absolutely loved it.
  • I loved investing because there was so much to learn, but I loved personal finance because it felt like a puzzle to be solved or a game that could be won.
  • Blogs were just starting to become popular. 
    • I used to read VivaElBirdos to learn nuances about the Cardinals, their farm system, and it was my introduction into basic sabermetrics.
    • I was obsessed with Barry Ritholtz’s The Big Picture, which felt like the only objective source of investment commentary at the time. For what it’s worth, Barry is the reason I wanted to start a blog of my own.
    • Then there was the personal finance blogs such as Five Cent Nickel and Get Rich Slowly. These sites were maybe my favorite because they focused on things you can control that would improve your personal finances. 
      • At the end of the day, good personal finance is basically spending less than you earn and efficiently allocating your savings to meet your goals.
      • These websites were obsessed with finding the little savings in life and sharing systems that worked for them in their personal finance journeys.
      • Now, these websites are a lot different. They are very much a business now devoted to ad revenue.
  • Given that we were in the middle of a recession, I was obsessed with finding extra savings to invest.
    • Automated savings were only just becoming available. There were instances where I was manually moving money every two weeks to an account named after a specific goal of mine.
  • I kept an extremely detailed budget and held to it pretty consistently.
    • My girlfriend and now wife never missed an opportunity to tell others how I cheap I was. I’d always respond, “I’m not cheap, I’m frugal.”
    • I’d say that is true today, but back then – no I think she had it right. I was cheap.
  • I remember sitting in my apartment, leaning over a coffee table with my laptop open, punching expenses into the spreadsheet I maintained for my budget.
    • Thanksgiving was coming up and a lot of my close friends from High School would be home for that weekend, which meant I would need to budget more for “Bars,” the all important line item for 20-something year olds 
    • The problem was that I couldn’t make the numbers work
  • Because I had been tracking my expenses so closely and meticulously budgeted out future expenses, I had known this budget discrepancy was coming. It stressed me out because I was so focused on creating a surplus at the end of the month to invest.
    • My wife, who lived with a few of her closest friends, texted about people making plans to go to a hockey game and I remember thinking, “ugh how is this going to work?”
      • Hockey tickets are expensive. Then beers are $10 bucks and I’ll probably have a lot of them.
    • So I replied, “I don’t know…I have some big expenses coming up”
    • She replied, “what expenses?”
    • I didn’t really feel like explaining the minutiate of the budget I was actively working on, but I also knew her question was more specific like what is this one big expense you have that would prevent you from having a good time with me and all your friends?
  • That’s when it dawned me. It was almost a moment of weakness. One of the hundreds and eventually thousands of times when a significant other gives in to the other because they know they’re right.
    • So, I literally responded with, “It’s fine. I don’t live in a spreadsheet. Let’s go.”
  • I remember here responding with 3 question marks…haha, so I started to explain myself, but the text was getting long, so I deleted what I had written and replied with a simple “let’s do it.”
  • So while I didn’t start texting my girlfriend and now wife a long string of thoughts about how we don’t live in a spreadsheet, I did start writing about it in my journal.

I wrote a lot in the early years of my career and – well, I guess I write a lot now too – but early my career my writing was mostly note taking. It was the only way I could remember stuff I learned throughout the day.

By that time, I was actually circulating the notes I took to the firm’s Portfolio Managers as a resource for them called Afternoon Review. Back in 2008, there was seemingly earth shaking news on a daily basis. Whether it was the latest financial institution teetering on the brink of bankruptcy and, as a result, getting some kind of bail out or being acquired; or if the Fed had introduced a new monetary policy tool; or we would get historically horrific economic data points to digest – there was always something to write.

But there was one day during the week I texted my wife “we don’t live in a spreadsheet,” where the news was light, so I wrote some notes about budgeting. Now, I don’t have the original copy of the internal email I sent that day, but once I write what a few of my colleagues at Plancorp refer to as a “Peter-ism,” those one-liners don’t change much over time, so I’m going to read four sentences from my book, Making Money Simple:

“Most people find it difficult to stick to a budget because the process is time-consuming and restrictive. Traditional budgeting forces you to make every decision as if you live in a spreadsheet. But guess what? You don’t live in a spreadsheet!”

Us Financial Planners Love Our Spreadsheets

There is a crispness in deriving a solution to a problem in Excel that is satisfying to most of us. But the “right” outcome isn’t always the “best” outcome. 

And the “best” solution for one person is not necessarily the “best” solution for someone in a similar situation.

I want to explore some of the areas where this concept is most prevalent. 

Let’s start with budgeting, since that’s how this concept, this “Peter-ism” if you will, dawned on me for the first time.

Creating a budget and sticking to it is difficult for most people because the process is time consuming and restrictive. Traditional budgeting forces you to make every decision as if you live in a spreadsheet. But guess what? You don’t live in a spreadsheet.

Rather than focusing on expenses, Reverse Budgeting focuses on savings. What occurred to me after countless nights updating my spreadsheet (something I knew I couldn’t advise others to do because they wouldn’t stick with it) is that all you need to do is:

  • Figure out how much you need to save, 
  • makes those savings automatic and 
  • then you can spend the remaining amount of money as you please.

If you have spent your budgeted amount on restaurants, but something very important comes up unexpectedly that requires you to dine out, then you can shift spending elsewhere to fall in line with your priorities and values.

Because reverse budgeting focuses on saving, you can’t spend what you don’t have.

  • Increasing the amount you save naturally reduces the amount you spend, but it also forces you to prioritize your expenditures.
  • This is important because most people find that gradually saving more allows them to cut spending that doesn’t really fit with their values.

Best of all, reverse budgeting requires very little maintenance. A traditional budget requires weekly or monthly reconciliation of financial transactions. Once a reverse budget is set up, the entire thing can be automated.

The lack of ongoing time commitment makes it much more likely you will stick to reverse budget.

Here is how to set up a reverse budget:

1. Add up the amount per month that you need to save to reach your goals short-term goals.

Writing down a goal with an estimated date and expected cost dramatically increases your likelihood for success. It also allows for you to understand the things that are most important to you.

Start by writing short-term goals (five years or fewer), the date of desired completion and the expected cost. You can download a worksheet on the Resources page of TheLongTermInvestor.com

If you add up the expected cost of all your goals, then you can determine how much you need to save on a monthly basis to make this happen. Once this is completed, then number the goals according to your priorities – now you know where to begin directing your monthly savings.

Once your short-term goals are in place, do the same exercise for intermediate-term goals (five to 15 years) as well as long-term goals (15 years or more).

It may be difficult to assign an expected cost to your long-term goals, but that’s OK, the benefit of this exercise is thinking about it.

Then start by setting up several automatic withdrawals from your checking and deposit into your savings accounts.

Invest Vs Pay Down Debt

Okay, so if you’re using a Reverse Budget, that’s a great first step towards removing your personal finances from a spreadsheet and instead utilizing a system that is far more realistic.

Of course, we run into the spreadsheet issue when it comes to prioritizing goals.

In my opinion, retirement savings and contributions should be your top two priorities in a Reverse Budget no matter what.

  • That doesn’t necessarily mean maxing out your retirement accounts or building an emergency fund as quickly as possible. Those are both good things, but maybe you have high interest debt that needs to be paid off. Or maybe you want to start a business or buy a home – there are other good goals to direct your excess cash.
  • But you should always contribute something to these top two goals.

One of the most common questions people have when they are setting goals with me for the first time is whether they should invest or pay down debt.

Everyone has different circumstances, but there are some common variables to examine, including:

The financial advisor in me wants to know:

  • Expected return on investments
  • Interest rates on debts
  • Tax benefits associated with your debt
  • Tax benefits associated with investing
  • Matching contributions
  • Private mortgage insurance
  • Variability of your income
  • Number of years to retirement

Evaluating these variables can help you arrive at the optimal solution from a purely mathematical perspective. However, the decision is based as much on your personality as it is the math – because again, we don’t live in a spreadsheet.

Some people will prefer paying down debt to capture a lower, but knowable, return. Others will prefer to invest in order to capture higher, but less predictable, returns.

Even if there is no one-size-fits-all advice, here is my general opinion of how to prioritize investing and debt payment decisions. And I link to an article of mine that has this framework in the show notes: https://peterlazaroff.com/invest-or-pay-down-debt/ 

  1. Make contributions to your company’s retirement plan up to the level at which your employer matches.
  2. Create an emergency fund.
  3. Pay down private loans with the highest interest rates relative to your expected return on investing that are not tax deductible.
  4. Make the maximum contributions to employer sponsored retirement plans, then if you have it…Definitely HSA, too
  5. Pay down debt in which you are paying private mortgage insurance.
  6. Pay down debt with high interest rates relative to your expected return on investing and is tax deductible (think student loans)
  7. Make investments in accounts with no tax benefits that are expected to earn returns greater than the interest rate on remaining outstanding debt (taxable investments)
  8. Pay down debt with reasonable interest rates (3% – 4%) and that is tax-deductible (think mortgage)

Nearly everyone will encounter a situation in which your money personality will dictate a re-ranking of some categories.

The hardest for me to rank were #3, #4 and #5. Assuming you are able to meet your regular minimum debt service payments, maxing out tax-deferred accounts can have a strong mathematical advantage depending on your tax bracket and time horizon.

On the other hand, my personal bias towards low levels of debt often makes me want to reshuffle the order of those three. Another option might be devoting your excess cash flow across multiple categories rather than just one.

In these situations, it is important to understand your emotions and perception of financial freedom. Using a financial advisor that acts as a fiduciary can be a great resource to help you work through these decisions and set up an intentional, disciplined plan that meets on your life goals.

Pre-Paying Your Mortgage

For some people, being completely debt free is the only thing that matters. 

And for most people, the biggest debt they owe is their mortgage. Student loans come into play as well, but those often have an interest rate that is high enough that accelerating payments to those loans, rather than investing in a taxable account, can be the mathematically sensible solution.

When I think about the payin

But pre-paying a mortgage is almost never mathematically the best decision. 

  • Let’s say you have a 30-year mortgage with an interest rate of 3%. At the onset of your loan, around 70% of your payments go directly to the cost of borrowing.
  • Even over the first 10 years of payments, the average is well over 60% of payments going to interest. You don’t start making a huge dent in principal for a long-time.
  • This is why so many people like the idea of prepayments on a mortgage – the money goes directly to principal repayment, which in turn lowers your overall interest payments overt the life of the loan.

Ben Carlson walks through the math of this in a great blog post from a years ago that I’ll link to in the shownotes: https://awealthofcommonsense.com/2019/02/whats-the-return-on-mortgage-prepayments/

So if you are making early principal payments, you could think of the “return” on those payments as being roughly 3% because of the interest savings you are realizing. Now, it’s actually less than 3% for some reasons that are probably not worth diving into the math behind it, but let’s go with that number for simplicity.

If you are working through a Reverse Budget and have an extra $1,000 to allocate somewhere, the expected return you’d earn by investing in the market is much higher than 3%. Maybe it’s 8%. Maybe it’s 10%. Maybe it’s 6%. Whatever it is, the compounding of that return differential over multiple decades is massive.

That’s the math of it. But now let’s step out of the spreadsheet to better understand why some people might ignore the math.

  • For starters, Not once in my career have I ever heard of someone that regretted paying off their mortgage early.
  • I’ll also note that the idea of being debt free personally is intoxicating. The thousands of extra dollars that would be available for spending, savings, or whatever – that’s a ton of flexibility. 
    • There is a reason being debt free is important for retirees, because the more you are forced to spend in retirement, the less flexibility you have in taking risk in your portfolio. And the more you draw from your portfolio in the early years, obviously the less lifetime income a portfolio can producec.
    • While I’m working, having a few extra thousand dollars a month means I would be able to hit savings goals that I’d be excited about. It also means that we’d be able to afford some luxuries my family always talks about as being desirable.
  • And even though I wouldn’t prepay my mortgage using my normal cash flow, it would be the first thing I did if I won the lottery.

The emotional considerations with pre-paying a mortgage are important. I don’t think such a decision should be made without understanding the math behind the decision, but I never fight anyone too hard if they decide to make the choice that isn’t optimal in a spreadsheet.

We’ve been talking a lot about personal finance decision, but the concept of not living in a spreadsheet is probably most prominent in my day-to-day conversations around investing.

The most common one being the decision to a large amount of cash that’s accumulated either over time or as the result of a sudden wealth event (equity comp, inheritance, divorce, legal payout, etc)

Dollar cost averaging means contributing a set amount to your portfolio on a regular schedule over time. 

  • An example of dollar cost averaging is contributing $1,000 to an investment account on the 15th day of the month for a long period of time. 
  • This allows you to diversify not just among asset classes, but also across time. 
  • When you make equal dollar purchases over time, you buy fewer shares when prices are high and more shares when prices are low. And because of this, it’s possible you can lower your average purchase price.

A lower average purchase price isn’t by no means guaranteed, though, but dollar cost averaging can be behaviorally advantageous because investing at regular intervals reduces the risk of buying at the worst possible times and experiencing an immediate loss in value. 

  • Investing a large sum of money at a market peak often leaves emotional scars that cause poor investment decisions throughout the rest of your life. 
  • Dollar cost averaging doesn’t prevent losses—losses are a normal and expected part of investing— but the process allows you to scoop up shares at a discount. 

Dollar cost averaging is also the simplest way to invest paycheck by paycheck with the planned savings from your reverse budget. In fact, you’re already dollar cost averaging if you have regularly scheduled automatic investment contributions going to your employer-sponsored retirement plan.

While dollar cost averaging is the best way to systematically invest your savings, it isn’t the way to give yourself the best chance of maximizing your wealth if you’re deciding how to invest a large sum of cash. 

  • When I have this conversation with people, Nobody wants to invest at the wrong time, but you must remember that market timing is a game that nobody can win. 
  • If we look at historical probabilities, investing a lump sum has a higher expected return than dollar cost averaging because the market is up more often than it’s down. 
    • In fact, the S&P 500 had positive returns in over 72 percent of 12-month periods from 1926 to 2017. The frequency of positive returns jumps to 88 percent when you look at all rolling five-year periods and 94 percent when you observe rolling ten-year periods.
  • In 2018, Newfound Research published a more detailed analysis that compared the percentage of periods in which investing a lump sum all at once provided a better return versus using dollar cost averaging to invest cash in your portfolio over time. 
    • When comparing the performance of the S&P 500 to bonds and cash over rolling 12-month periods, a lump sum investment beat cash 68 percent of the time and bonds 63 percent of the time.  
    • So if you receive a big bonus, inherit money, or slowly build up a large cash position in your portfolio, investing the lump sum gives you the best odds of earning the most return possible. It also lengthens the amount of time you benefit from compounding. After investing the lump sum, you can turn to dollar cost averaging for future contributions to your portfolio.

Choosing how to invest a large amount of cash (whether from a windfall or that’s accumulated from savings over the years) is an important decision, but the fear of making a mistake can make it feel overwhelming. It’s tempting to think about the possibility of buying at just the right moment. But here’s a dirty little secret that most of the investment industry doesn’t want you to know: time is more important than timing.

That being said, I’m fine with people dollar cost averaging if that’s the plan they can stick to.

It’s a tough decision because the spreadsheet tells us the probabilities, but those are not guarantees. If 100% of the time a lump sum investment beat dollar cost averaging, then we wouldn’t let emotions get involved in the decision.

Even though the future is completely unknowable, the act of choosing something, even if we don’t know whether it’s right or wrong, optimal or less so, gives us a sense of control and responsibility over our decision.

  • When the outcomes eventually reveal themselves, it’s easy to feel regret when they aren’t what we hoped or expected. And regret is painful – literally.
  • When I experience regret, it’s not just in my head. It feels like my heart swells up and makes it harder to breathe. It’s not pleasant, and it’s something I obviously prefer to avoid.

Knowing there will always be a “best” or “optimal” answer after the fact, you should seek to minimize regret by understanding the evidence supporting a decision, using a probabilistic approach, and thinking through how you might feel about a variety of potential outcomes.

And once you minimize regret, it’s much easier to stay the course and let financial theory do its thing.

In this case, would you feel more regret if the market having it’s greatest year in history and you miss some of the appreciation because you’re dollar cost averaging? Or would you feel more regret investing a lump sum and having the market immediately decline 10, 20, or 30%? 

There isn’t a spreadsheet in the world that can solve this problem. Like the other decisions I’ve discussed, it’s important to understand the information a spreadsheet can provide (in this case, the probabilities and expected returns), but I find it’s best with investment to minimize regret so that you are more likely to stay the course.

Because at the end of the day, staying the course is the most important thing with just about anything investment related.

That’s actually a pretty good Segway into Investment Strategy more broadly.

There’s no such thing as a perfect portfolio.

That’s like asking what is the best ice cream flavor. The right answer is a matter of taste. Of course, we can be fairly certain that soap-flavored or fish-flavored ice cream is not the best.

Fortunately, investment success doesn’t require a perfect portfolio. But the probabilities of a spreadsheet help us understand that there are approaches that are not effective. But even once you eliminate those decisions, how do you decide?

Because I believe the to investment success is minimizing mistakes and making sure you don’t interrupt compound interest, then the primary thing to decide with a portfolio strategy is whether or not you can stick with it through thick and thin.

For example, owning a portfolio of index funds that simply track the market and give you the returns the overall market returns is a perfectly acceptable solution. If the market is up, you are up. If the market is down, you are down.

  • You’ll never beat the benchmark these funds track, but you also won’t ever lose to it.
  • And historically index returns have been perfectly sufficient in aiding investors in meeting their goals.

Of course, emotions get involved with such decisions once the allure of beating the market is introduced. 

  • The spreadsheet will tell you that strategies that rely on timing and security selection to beat the market are historically awful bets to actually do so – and yet a lot of people still do it. 
  • The probabilities of a spreadsheet will also suggest you can systematically overweight your portfolio towards companies with certain types of characteristics that have higher expected returns. 
    • Of course, there aren’t 100% guarantees of such a strategy working, otherwise it would be an easy decision, but there is a very very large probability of such an approach earning higher expected returns over a 20 year period
    • Financial theory tends to work pretty darn well in the long-term, but the long-term is an eternity to live through.
    • For the sake of an example, and this is truly hypothetical, imagine you choose a strategy that a spreadsheet says will work 99% of the time over a 20-year period. 
      • Let’s say you’re 13, 14, 15 years into having implemented the strategy and it’s not working yet.
      • Would you bail?
      • I’ve seen people bail after 3 or 4 years in such scenarios.
  • The point is that the highest expected return strategies are far from being the guaranteed best solution for any given investor.
    • When I’m working with a client to determine the best investment strategy for them (Index, Factor, ESG), again, I’m focused more on the emotional side of minimizing regret.

The same thing comes into play with asset allocation.

The primary driver of investment returns is risk. Investing is all about earning a return in exchange for accepting volatility, uncertainty, and the potential for permanent loss. 

  • The key is to find the right balance of risk and return by dividing up your investment dollars among stocks, bonds, and cash. This process, known as asset allocation, is the most important decision a long-term investor makes. In fact, the most commonly cited research on the topic determined that asset allocation explains 93.6 percent of variation in portfolio returns.  
  • Your portfolio will always rise and fall with the overall market, but the specific mix of stocks and bonds dictates the range of possible outcomes. Portfolios with a greater percentage of assets allocated to stocks have historically earned a higher return. However, those same portfolios with the highest return also experienced the most years with a loss and the widest range of possible outcomes.
  • The goal of investing is to grow your savings faster than inflation without taking undue risks. You can accomplish this through choosing an asset allocation that appropriately blends risk and return.

The way to do this is to assess your ability and willingness to take risk. Assessing your risk tolerance is all about finding the best portfolio for you—the one that you can stick with for decades at a time.

Measuring your ability to take risk is an objective process. This is the spreadsheet portion of the exercise. The purpose is to determine how much volatility a portfolio can withstand and still meet your goals. The ability to tolerate risk is driven by your time horizon, liquidity needs, size of human capital, and goal flexibility.

Gauging willingness to take risk is more subjective because this is where emotions come into the equation. 

  • Willingness to tolerate risk is difficult to accurately assess on your own. Even the most self-aware individuals could benefit from the expertise of a human advisor.
  • There are few hard and fast rules available, but I can share what I do to understand a client’s comfort with risk and how that translates into their asset allocation.

I start by listening to an investor’s statements about risk, which means different things to different people. 

  • For example, one person might consider the ability to withstand a 5 percent portfolio loss as having a high risk tolerance, whereas another person considers the ability to withstand a 40 percent portfolio loss as high risk tolerance. 
  • Other people believe they have a high risk tolerance because they own a small percentage of stocks. In my experience, the more that someone talks about risk or losses, the more risk-averse they tend to be—regardless of their self-assessed risk tolerance.

Reviewing past investment statements can provide clues about an investor’s willingness to tolerate risk, too. Was the investor buying or selling in 2008? Does the investor trade heavily in volatile markets? What has the investor’s mix of stocks and bonds been over time?

If I’m concerned about someone’s willingness to tolerate risk, particularly when it seems like their willingness widely conflicts with their ability to tolerate risk, I’m usually going to opt for a less risky portfolio, even if the spreadsheet says that isn’t the optimal approach.

In my opinion, it’s better to get more aggressive in the midst of a downturn than need to get more conservative in a downturn (which locks in losses).

Resources

About the Podcast

Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence. 

Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.

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