Join John this week as he examines whether cash is king. Plus, John is joined by Creative Planning’s Chief Investment Officer, Jim Williams, to discuss all things alternative investments.
Presented by Creative Planning, each week Host and Managing Director John Hagensen cuts through the headlines and loud takes to challenge the advice you may have been given and reaffirm what you know to be true. Plus, don’t miss his weekly interviews with Creative Planning specialists as they cover investing, taxes, estate planning and many other areas that impact your financial life!
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John Hagensen: Welcome to the Rethink Your Money podcast, presented by Creative Planning. I’m John Hagensen, and ahead on today’s show, we’ll be discussing whether in fact cash is king, and all things alternative investments. Join me as I help you rethink your money.
I want to begin, though, offering you some encouragement. This show is appropriate for you even if you are unfortunately maybe feeling discouraged, and not just because the markets are in a drawdown, but maybe you’re feeling discouraged because you didn’t win the $1.34 billion Mega Millions jackpot. Hey, if it makes you feel any better, I didn’t win either.
But while sometimes it’s fun to dream about what it might look like to suddenly become a billionaire, it’s in part because what do you have to risk to win the Mega Millions jackpot? Maybe $10, $20. But when it comes to our financial plans, it’s not just about how much money you made, it’s about how much risk did you take to achieve those returns. If someone walks into a casino and puts their entire life savings on the roulette wheel, bets on red and they win, and they double up their $500,000 life savings and make it one million, most all of us would acknowledge that was an insane gamble with their life savings.
And they might be touting their winnings at the Bellagio buffet later that night. Oh, and by the way, the glorious precut king crab legs dipped in hot butter, all you can eat? My mouth is watering right now. I should not have used the Bellagio buffet in that example. But if some other person’s sitting a table over, stuffing their pie hole like I do at that buffet, and they didn’t have any context around the enormous risk that they absorbed to double up their net worth in 30 seconds, they might actually think the person was smart. Those are exceptional returns. When in fact it was completely imprudent.
Remember my rule for money. Risk and return are two sides of the same coin. And when it comes to your retirement plan, you need to manage risk. So the question becomes, with the housing market softening, the stock market in bear market territory, and a sputtering economy with 40 year high inflation, how do you do that? How do you manage risk effectively?
Fortunately for you, there are only two things you need to do. The first? Have a detailed financial plan. Chad Fletcher, a colleague of mine, chartered financial consultant, certified financial planner, one of our wealth managers here in Arizona, was telling me recently about a huge gap in a new client’s plan that they uncovered together in the planning process. And this client had a higher net worth and no umbrella policy of any kind, and they were shocked. They thought they had one, but by going through all the insurance policy deck pages in that detailed planning process, we discovered that.
If one of their kids’ friends is over and breaks their neck on the trampoline, poof, their net worth evaporates. Nothing else of the plan matters. They weren’t insured properly. Their risk management strategies weren’t thorough and weren’t in place.
And yes, I know. If you’ve listened to the show for any amount of time, you know that my answer to most things, when I put my certified financial planner hat on, is “Have a good plan.” It’s a broken record line, but truly is the first step in managing risk for your situation. But you think about how that will help manage risk. The plan’s going to hit on income, expenses, estate planning, tax planning, insurance needs. And of course, it’s going to account for various scenarios where the market doesn’t perform well or inflation’s high, or you live to a hundred, like our plans here at Creative Planning project out to. And so it’s not a shock to the plan when those sorts of events occur.
So the number one way to manage risk? Have a detailed financial plan. And the second way to manage risk? Have no big bets in any one spot. You’ve got to be well diversified. By the way, this doesn’t just mean owning a bunch of stuff. It means investing intentionally and strategically using various investments that move dissimilarly to one another. And I’ve been asked before, “Well John, why wouldn’t everyone diversify? It’s pretty obvious.” Because while you protect from having concentrated exposure to a huge loser, you also prevent yourself from having concentrated exposure to the best performers as well.
I want to change gears a little bit to a question that I’ve received multiple times over the last couple of weeks from my clients, specifically regarding whether they should even be maxing out 529 plans that we have in place currently for their kids. Well, to answer this, I’m going to play an excerpt from our President’s podcast, Peter Mallouk. It’s called Down the Middle, where he and our Director of Financial Education Jonathan Clements discussed this very topic.
Peter Mallouk: So I think this situation’s become very political. You can’t have any discussion without it being political in America now, unfortunately, and this is just an economic answer, right? It’s not unique to education, but let’s just take the way money works.
When the federal government created loan programs to make it have very, very low interest and give very big loans to people who go to college, what happened is, colleges raised their prices. Right? This is basic economics, right? You have a bigger supply of money at a lower carrying cost, so universities can raise their prices. Just move over to the real estate market. If you have all the same homes out there, some are wonderful big homes, some are wonderful small homes, some are middle homes, and you lower interest rates from six percent to two percent, guess what? All the people selling their homes can raise their prices. Because the cost of entry is less.
That’s what happened with education. It was the federal programs that encouraged education being more inflationary. The biggest rising costs in the United States in the last 20 years have been education and healthcare. Education is not a coincidence, it’s because of the government programs. Now I’m not saying there should not be government programs, in fact I think the United States would be way better off if there was a free university in every state. I think the cost to the taxpayer would be less than what we’re spending on prisons and everything else. But saying we’re going to have all these universities charge and we’re going to lower the rate? It drove this problem. The same math applies when you forgive loans.
You also have this concept called moral hazard. Moral hazard’s the same thing we have with corporate bailouts. If you have a corporation take a bunch of risks and it goes well, and they get to keep their reward, but if they take a bunch of risks and it goes poorly, like happened with the big banks in 2008 and ’09, and the government comes and bails them out, you change the math in their minds, right? If you’re JP Morgan, Goldman Sachs, all these places that got in trouble, where’s the incentive to not take risks? If you do well, you keep the money, and if you do poorly, the government’s going to bail you out.
That’s the same thing that’s happening here. Obviously we’re talking about very different populations. We’re changing the math for the borrower. Why would you pay off your debt now, when there’s a chance that more of it can be paid off? Why would you work three jobs to go through school? Why would your parents scrap together? Why would you go to the lower cost school, so the more expensive school? So it’s created that issue, and again, it’s not political, it’s just math. Right? The same math applies to when we fund wars, the same math applies to when we add a new benefit program, like say President Bush did with the prescription plan. It applies here with education too.
Jonathan Clements: So, you didn’t answer my question, Peter. Okay, we’ve created a moral hazard. Should the typical family be taking advantage of it? Should you be saying, “All right, I’m not going to put the full sum into 529 plan. I’m going to make sure that little Johnny graduates with ten or twenty thousand dollars in debt, so that maybe down the road, he too will be a beneficiary”?
Peter: If I did not have debt, I would not be creating debt. Debt’s generally bad, generally does not go well when people take on debt. If I had debt already, I was a student that graduated and I’ve got debt, I’m probably not in a hurry to pay off that last 10,000, right? Maybe something else is going to happen. So it depends on where you are in the cycle.
Jonathan: In terms of the effect on the economy, this has the potential to drive up the price of college even more. But what about the effect in terms of short term inflation? Is this concern for people?
Peter: This is also a topic that’s become very politicized. If you’re for the student loan forgiveness, you say it’s not inflationary, and if you’re against it, you say it is inflationary. And it really applies to everything. Corporate bailouts, forgivable loans, when we borrow money to go to war or when we forgive student loans.
A hundred percent of these things are inflationary. There’s no economic debate about it. Anybody that says it’s not inflationary does not understand basic concepts of economics. So it’s just quite simple. You have a certain amount of stuff out there and you have a certain amount of money, and when the government gives people more money, doesn’t matter how they give it to them, and they pay for their healthcare, they pay for their education or they pay for a corporate bailout or they pay for a forgive loan or whatever. Right, left, whatever. Both parties have no problem giving away money. It’s just who they’re giving it to.
A hundred percent of the time when you do that, it’s inflationary. Just common sense, right? Let’s say I have 10,000 of debt. I have a little bit of assets. The government forgives my debt. Can I go spend more money? Of course I can. Because the money I was doing to make payments is now gone. Same thing with every other example, right or left. Any time the government throws money into the system, people focus on where it’s going and develop their opinion from there, but from an economic perspective, you can almost pretend the government is just taking helicopters and dropping the money from the sky. Right? You put more money in the system, you’re going to have some inflationary pressure.
John: That again was our President, Barron’s two time financial advisor of the year, Peter Mallouk on his monthly podcast Down the Middle, which you can find and subscribe anywhere you listen to podcasts. And here’s what this illustrates. While the values and broad vision of your financial plan may be more hardened, the methods needed to achieve those objectives have to be flexible as new information arises. And when a 60/40 stock bond portfolio is having one of its worst years in the last century, you want to reexamine your investment plan.
Announcer: At Creative Planning, we provide custom tailored solutions for all your money management needs. Why not give your wealth a second look, and learn how the team at Creative Planning covers all areas of your financial life? Visit creativeplanning.com. Now, back to Rethink Your Money, presented by Creative Planning, with your host, John Hagensen.
John: Well we are sitting here in September, and the markets are getting clobbered. We’ve had plenty of periods in the past where we experience stock market volatility. In fact, if you’ve been investing for any period of time, you know that you should be expecting that. But here’s what’s different right now. Generally you own bonds as the ballast in the portfolio, it’s sort of your life preserver, to wait out bears that occur in the stock market on average about every five years. But you likely haven’t experienced that safety net when it comes to your bonds here in 2022.
Government bonds that have long durations, they’re down nearly 25% year to date. And as a side note, this is why we advocate, here at Creative Planning, staying shorter with the duration of your bonds. Because if you look at one to three year government credit, that’s down only about three percent year to date. So it’s more or less done its job, unlike long bonds.
And if you’re wondering, the reason for this is that when rates rise, bond prices fall. And this is similar to a seesaw at a playground. The long bonds are out where the kids are sitting, at the end of the seesaw. And so when one side goes up, the other side smashes into the sawdust. But if you look near the axis of the seesaw, this represents short duration bonds, and that portion isn’t moving dramatically up and down, even though the squealing kids on each side are experiencing swings of four feet up and down.
And so remember, any time you migrate portions of your portfolio from stocks to bonds, the purpose of that is not because you expect higher long-term returns. It’s because you’d like more predictability and safety. Be very careful to not cheat out to long bonds to pursue higher interest rates and a little more growth because you have now, as we’ve seen here in 2022, changed the entire risk profile.
So if you’re like many of the clients that I work with as a wealth manager here at Creative Planning, you might be looking around after the worst 50 year period for stocks and bonds, wondering, are there any other options? Does the world of investing only consist of publicly traded stocks and bonds? Well, and the answer is, for some financial advisors, the answer’s yes. But for us here at Creative Planning, the answer is absolutely no. The world of investing doesn’t stop at stocks and bonds, and for more discussion around non-traded, alternative investments, I have an extra special guest. I am being joined right now by our Chief Investment Officer here at Creative Planning, Jim Williams. Welcome to the show, Jim.
Jim: Hey, thanks for having me.
John: Let’s simply start with defining, what is an alternative investment?
Jim: I’d consider an alternative investment to be something outside of the normal stock, bond, or publicly traded REIT space.
When we think about alternatives, they typically come with certain drawbacks. There can often be a lack of liquidity, meaning that when you think about buying Apple stock or an ETF, you can always get or out. Well, that’s not always the case with a private or an alternative investment. In addition, they could have certain restrictions on who can invest in them. Anyone, the stock market’s democratized, anyone can buy a stock on the exchange and everyone gets the same pricing. Whereas you could have more complexity within the alternative space.
You could also have a lack of transparency. What I mean by transparency is, if you buy an ETF, well, you know exactly what that ETF owns, or you buy a mutual fund or you buy a stock, you know exactly what you’re getting. Sometimes in the alternative space, you might be faced with the dilemma of, “Do I invest in something that I don’t know exactly what it’s going to be prior to making the commitment?”
So in general, I would just consider an alternative anything outside of the traditional scope of publicly traded stocks, bonds, ETFs. And the vehicle for that doesn’t make the difference, whether it’s a mutual fund, an individual stock, or an ETF.
John: Well, I think it’s helpful when you’re looking at investments to start with the drawbacks, because as you and I both know, Jim, there’s no unicorn. Everything has give and take and some pros and cons, and those are some of the cons that people need to consider with alternatives. And if those exist, which they do, why would anyone even want to invest, or consider investing, in alternative investments? What are some of the positives?
Jim: The two drivers here for most investors is, we’re either looking for excess return to the public markets, or we’re looking for diversification. And depending upon the alternative, it’ll have different characteristics, but that tends to be the two drivers of why alternatives are considered for the portfolio.
John: Let’s suppose someone’s looking for that excess return, wants additional diversification, and isn’t scared off by some of the cons of lack of liquidity and long life cycle and added complexity. Now that we’ve overcome those, who would be eligible to invest in an alternative investment?
Jim: There’s different levels, depending upon the alternative that we’re looking at. In general, we’re going to have three different areas that we’re going to consider. We’re going to look at some investments that are qualified purchaser only. This means that the investor needs to have five million of liquid investible assets. Examples of this would traditionally be private equity. It could be something in the structured capital space that has the look and feel of private equity, with a little bit more downside protection.
When we move downstream and we look at accredited investment offerings, what we’re doing in the private real estate space is typically accredited in investments. What we’re doing in private debt is accredited investment. In addition, we could have a rung below that, where there is no minimum investment size. So as an example, through Aries, we use a liquid credit option that you don’t even have to have the million dollars. You could have $500,000 and still be eligible for the Aries product.
And so when we look at that, if you were just to broadly break it up, when we look at private equity or structured capital, typically we’re going to have to have a higher total investment size. Whereas when we look at private real estate and private credit, we’ll have lower thresholds, and the magic thresholds are one million and five million.
John: We’re talking alternative investments with our Chief Investment Officer here at Creative Planning, Jim Williams. And I know it can be a crowded space, and it’s a proverbial fat head long tail, where there are certain managers that tend to outperform consistently and others, a vast majority of them in particular, that just don’t, they’re not able to deliver that excess return. So how do you think about choosing managers when there are thousands out there?
Jim: When it comes to manager selection, I think this becomes more and more important when we look at the private side versus the public side. When we look at the public side, the distributions of returns are actually fairly narrow. And what I mean by that is, what separates a top quartile versus a bottom quartile US stock manager? That gap’s not as wide as people might expect. It’s typically a few percentage points. That gap widens dramatically when we look at something like private equity.
Historically, we buy into the research that supports private equities delivered around a four percent excess return to the public markets. But when we look at distributions of returns, if we end up in the top quartile, we could be talking about 10 or 20 percent excess returns over the public market. But vice versa, if we choose poorly and you end up in that bottom quartile, you could be looking at significant underperformance. So the range of outcomes is far wider in the private markets than the public markets.
This puts an emphasis on, who are we actually going to invest with? And so we believe the most likely way to achieve the results our clients are looking for is sticking with the firms have a long track record of delivering consistent performance for their investors. Our relationships in the private space are with Aries and Apollo and Bain and Blackstone and Carlyle and KKR, Silver Lake, Thoma Bravo, Vista. I run you through the names because the names mean something to you. Then you go, “These are some of the places that I’m already familiar with that do have that type of track record we’re looking for.” If the names mean nothing to you, well that’s okay too. If you just Google “top private equity firms,” these are some of the names that you’re going to start to come across.
So big picture, what we’re delivering to our investors is really access to some of the very top end managers that they have a very difficult time accessing on their own. And I think this is the space that that manager selection is hugely important to those investors, because again, if we choose poorly, you could be looking at significant underperformance, and you wonder, “Why did I go through this giant hassle to only end up with a smaller return than if I just invested in publicly traded stocks?”
John: Jim, I’d like to transition us over to specifically private equity. Can you share some of the pros and cons related to private equity?
Jim: Sure. The first con to be familiar with is, the investor needs to have five million dollars of investible assets. This allows us to meet qualified purchaser guidelines. This is an SEC rule, and so it’s very straightforward that we need to be able to meet that minimum.
The second drawback is, it’s a liquid. When you think about most investments, you can get out. With this, the way that the private equity unfolds is, at the beginning we make a commitment. Then they will call capital as they make investments. They will return capital as they start to sell those portfolio companies. That’s a long life cycle. So in years one, two, three, four, capital’s being called. Probably starting around years five, more in six and seven, eight, nine, 10, capital’s being returned. And most likely around a year 11 or 12, the portfolio’s kind of in the mop up stage as they liquidate the final portfolio companies.
But let’s say come year five, they haven’t returned any capital back, but the fund looks like it’s doing really well, and they call you up and they say, “John, go ahead and cash me out. It looks like we’ve doubled their money. This has been great.” Well, there is no cashing out. You are in it for as long as they’re in it. You get the capital returned when they liquidate or sell those portfolio companies, but you no longer have control over the liquidity.
The third drawback is, 12 years, right? From start to completion, that’s a really long time. The average American owns a home for roughly seven years. So when you think about this, this is a longer commitment typically than when we go buy a new house. So that’s the third drawback we should be aware of.
John: Well, the reality is, a lot changes in our lives over a 12 year period. I can speak for Brittany and I, we went from zero kids to seven over that timeframe. So that’s not a short period of time when looking at life or our investments.
Jim: Yeah, your kindergartner goes from being a kindergartner who goes to becoming an adult and can start voting in 12 years. Right? So it is a long time.
Jim: The next drawback is, we add complexity to your life. Complexity not only in the form of things like capital calls, but this is also going to spin off a K-1. A K-1’s going to be a tax form. That tax form is worse than maybe some other ones, because you’ll get this in June or July. This now means that you’re on the hook if you’re not already extending your taxes to extend your taxes for the next decade plus.
And the final drawback is, there’s this lack of transparency. Typically everything you buy in your life, you know what you’re buying. You buy a stock, an ETF, a house, a car, carton of milk, doesn’t make any difference. You typically always know what you’re buying. This would be one of the few things that you’re going to buy without knowing what you’re buying ahead of time. You’re making a commitment that you’re going to purchase whatever it is that they allocate capital to, and you’re just on the hook for that.
So we have to weigh these four drawbacks of, “Am I eligible?” The lack of liquidity. A long life cycle. Lack of transparency and added complexity. Versus the idea we’re looking for higher expected returns. And two smart people could come to different conclusions on which side of the fence they’re on with that.
John: Okay Jim, well now you’ve basically told us all the reasons why private equity is terrible. It’s like a quasi SPAC that you’ve got to hold onto for 12 years. Okay, so where are the pros here? Because obviously, we utilize this for clients that are in situations where they believe it makes sense with the added diversification and potential for excess return. But can you go into maybe a bit more on why someone may want to invest?
Jim: When we look at private equity, the biggest driver here is we’re looking for excess return to the public markets. The secondary driver is, it gives us exposure to investments outside of the publicly traded stock market. The public markets can move up and down significantly in a relatively short period of time, and we’re now subject to the volatility of the market. I would be satisfied if the private equity investments we’re in deliver somewhere between a four to an eight percent excess performance to the public markets.
And you might say, “Well Jim, even if we, let’s say, get in the middle there and we get six percent, did we really accomplish much?” Well, what’s interesting to note, if we get six percent over the course of 12 years, we average that, the difference is, we had twice the amount of return. We’ve doubled the money one more time by getting an excess return of six percent over the course of that time period.
And so I do think it’s worth it, even though six percent may not sound like a lot. When you start to annualize that year over year, it starts to have a huge and meaningful impact to the clients. Anything less than four, I think you question, “Why did I go through the hassle?” And anything over eight, I would just tell you to count your blessings and hopefully the next one will be just as good.
Announcer: The team at Creative Planning can walk you through the world of alternative investments if they make sense for your portfolio. To find out more or schedule a visit, go to creativeplanning.com any time. That’s creativeplanning.com. Now, back to Rethink Your Money, presented by Creative Planning, with your host, John Hagensen.
John: Well I’ve decided to keep Jim with us for another segment. And in my entire time as a host, I don’t know if I’ve ever spent half of a show on investment strategies specifically, or with one guest interview. But I think it’s that important, because I’m confident this is top of mind for you.
Remember, when I’m not hosting this show, my main job… By the way, I love hosting the show, but it almost doesn’t even feel like a job because it’s so fun. My real job is as a wealth manager here at Creative Planning. I’m a certified financial planner. I sit down with clients and prospective clients each week, and I’ve done that for nearly 15 years now. So outside of coming off the great financial crisis of ’08/09, and for about two months during the pandemic before the markets snapped back, this is the most concern and questions I’ve heard from my clients regarding investments and the strategies around how to grow and preserve your wealth.
And it makes sense, because when both the broad stock and bond markets are down between 15 and 25 percent year to date, it’s really normal that you start to question, “Am I well diversified?” When the fit hits the shan, we perk up and pay attention. And of course, the reason we do that’s because we’re human beings. We’re not concerned about things until we’re concerned about them.
And as an example of this, we just had one of our air conditioners go out. And when it’s a hundred and ten degrees in Gilbert, Arizona, an air conditioner isn’t a luxury, it’s a necessity. I’ve got seven kids, one of which is still a baby. And so you can’t even possibly be in the house at those temperatures. But here’s the irony, and where it ties into this discussion around alternative investments.
I’ve used the same air conditioning company that I like a lot for many years. About eight months ago, they offered to me an ongoing maintenance program. Well, of course, what did I say? “Oh, I don’t need that. You’re just trying to sell me some program that’s not worth it.” And the reason is because I wasn’t worried about my air conditioner until my house was 90 degrees. And because of that, I suspect, if you’re a lot of my clients, that for the first time in a while, your AC isn’t cooling like it should.
All right, so Jim. I’ve kept you waiting long enough. Let’s get back to this. Some people listening last segment, I’m sure just loved the idea of diversifying into some non-traded investments. Then you crushed their dreams by saying that they needed five million dollars of investible assets and a $250,000 minimum investment pertaining to private equity. So I want to transition over to a couple of alternative investment options where the barriers to entry are lower.
This may be an area that people are less familiar with, certainly Jim, than the public markets or even private equity. Can you talk a little bit about the pros and cons of private debt?
Jim: Sure. I think that on the cons side, we have some of the drawbacks of private equity, but it’s not nearly as significant. The first thing in the fund that we’re allocating capital to, it has monthly buy-ins, so we don’t have this three or four year cycle to get invested where there’s capital calls.
The second is, there is some liquidity constraints, but there’s far more liquidity. Within the fund we use, it has a 12 month soft lock. After 12 months, we have quarterly liquidity subject to a five percent gate. What this means to you as the investor is, you can get out quarterly, but there’s some constraints. If a lot of people want to get out in that same quarter, well you might only get a portion of your redemption met that quarter.
Now, what I meant by soft lock is, you could still get out prior to 12 months, but it comes with a two percent redemption fee. So those liquidity provisions are far more attractive than thinking about, “I’m locked up for 10, 12 years in, say, private equity, and I’m going to get money back in years, five, six, seven, eight, nine, 10, and I don’t have any control.” Here we have far more control, and we have access to the liquidity far faster.
John: And who’s eligible for this, Jim?
Jim: The investors eligible for it just need to have a million dollars of investible assets. So the scope of who can invest in something like this is far wider. There’s also a difference in the size of the investment required. For the private equity space, the typical minimum we’re looking at is 250,000, where within this it’s a hundred thousand. So far smaller purchase size for the actual investment, which opens it up to a broader client base.
One of the big drawbacks that we should be cognizant of is, within this holding, the income this is going to spin off… Because these are going to be loans, right? Debt is just a loan. The income that spins off is interest income, and interest income would be taxed at ordinary income rates. But the good news on this investment is, in the debt space, this investment is IRA eligible. So if we have an IRA account, we should give serious consideration of, where should that investment be held at? And our preference would be to hold this in the IRA.
Because not only is it ordinary income, but the expected income is going to be in that eight to 10 percent range. So if you’re asking, “Well, why would somebody consider this?” It’s because they’re looking for a higher income or expected return than what publicly traded bonds would provide. So think of private debt as the private equity side to the bond market. Instead of it being publicly traded debt, this is private debt.
This space looks and feels very different than the publicly traded bond market. The structure in the loans is typically five to seven year floating balloon payments. So five to seven years represents the term. When does that money need to be repaid? The interesting thing here is, most loans are refinanced prior to their maturity. So it’s not like it gets repaid on the very last day. It gets typically refinanced ahead of that.
One of the important things here, though, is the word floating. This is key in today’s cycle. Floating means that the income that gets paid to you, the investor, is going to move up and down with short term rates. Right now, this is tied to LIBOR. LIBOR’s not a hundred percent correlated, but it is highly correlated to what the Fed does with Fed funds rates. So as the Fed is raising rates, this provides a defensive mechanism that you don’t see in traditional bonds.
In traditional bonds, if interest rates go up, the value of that bond goes down. Whereas here, we don’t have what’s referred to as interest rate sensitivity, meaning that your bond price might fall. Here we have a situation where if interest rates go up, well this debt instrument, the income it’s paying you is moving right up alongside interest rates. And it seems fairly obvious that the Fed is likely going to continue to raise rates, and so this could be considered a defensive mechanism not only for a rising rate environment, but also for inflation. Because if inflation were to remain robust, we would expect the Fed to be more aggressive in their tightening cycle.
So when we think about this investment, we need to be cognizant of the lack of liquidity, that we’re basically locking the money up for a year’s time. But the driver here is, we’re looking for excess income, that eight to 10 percent income threshold, that we simply can’t achieve within the publicly traded bond market. And we’re picking up the floating rate aspect where we don’t have the sensitivity to interest rates. And at the same time, we should be cognizant of where do we own this investment? And if at all possible, put it within the IRA account.
John: I’m being joined by Creative Planning’s Chief Investment Officer Jim Williams, and for that eight percent, if you’re a retiree listening right now, you’re probably perked up, thinking eight to 10 percent’s pretty darn attractive even with rates having gone up. In this environment, obviously there are some drawbacks to consider that we discussed at length as well, but this is a really strong income opportunity in this environment.
Jim: Yeah, I think it’s very hard to meet that looking at the public markets. This here is the reason you ask at the beginning, “Why do people consider private investments?” Well, we’ve just answered the question in this sense. Why do people consider it? Because they’re not able to find this within the publicly traded markets.
The other investment within the credit markets that I’ll bring up is when we invest in a diversified credit option through Aries. This has a little bit different characteristics than the way that we do private debt. This is structured as what’s called a 40 act interval fund. Nobody needs to remember that, it just means that it looks and feels a lot like a mutual fund. The big difference between this and a traditional mutual fund is it only has quarterly liquidity, hence the word interval. So liquidity’s provided on an interval basis.
It still has that five percent gating mechanism, like we do within traditional private debt. Big difference here is, it’s more broadly diversified beyond loans to just private businesses. There’s also a component of real estate debt, high yield debt, but roughly half of it’s loans to private businesses. In the private debt space, typically a hundred percent of those loans are floating, here it’s roughly 90%. So we still have really good diversification against a rising rate environment.
Biggest difference between this fund and how we typically do private debt is we don’t have to meet the accredited guidelines that requires the million dollars. Basically we’re just looking at a $25,000 minimum investment, and anyone can allocate to it. So if you have 500,000, this can definitely be viewed as something that we could incorporate within the portfolio. So less constraints.
The interest rate on this right now, the interest income that’s kicking off, is roughly six percent. I would expect us that to continue to rise as we see the floating rate adjustments take place within the fund, and I’d give a target return here of somewhere in the six to seven percent range for income off that portfolio. Again, this is still significantly higher than what we’re seeing within the traditional bond market.
And so when we think about the alternative space, it wouldn’t make sense for anyone to go, “I’m going to put everything all in this fund or that fund or this space, or all of it in alternatives.” But these can be a key component or building block of the broader portfolio. So as we take a step back, the way I would think about portfolio construction would be, “Well, how much should be in my conservative bucket?” I.e. cash, bonds, CDs, things of that nature. “How much if anything should be in this private or alternative bucket? And then the remaining amount, I should focus on traditional growth, i.e. publicly traded stocks, REITs, and things of that nature.
So I don’t want to give the perception to anyone that they should put all their money in something like this, because they’re getting a higher yield than say the CD they have in the bank. But it can be a key component as far as diversifying the portfolio.
John: I’ve been speaking with Jim Williams, our Chief Investment Officer at Creative Planning. Thank you so much for joining us and sharing your insight and wisdom into alternative investments.
Jim: Hey, thanks for having me.
John: You heard that correctly. Floating interest rates at six percent are available as low as a $25,000 investment.
Announcer: At Creative Planning, we provide custom tailored solutions for all your money management needs. If you have any questions about what you’ve been hearing, visit creativeplanning.com and connect with a local advisor. Why not give your wealth a second look? Now, back to Rethink Your Money, presented by Creative Planning, with your host, John Hagensen.
John: In honor of the NFL opening weekend, one of my favorite times of the year, I wanted to provide you with a few really stupid football quotes that have been said over the years. George Rogers, former Saints running back said, “I want to rush for a thousand or 1500 yards, whichever comes first.” Former Houston Oilers head coach Bill Peterson famously said, “You guys line up alphabetically by height.”
How about the Fridge? William “Refrigerator” Perry, the famous former Bears defensive tackle, said, “I’ve been big ever since I was little.” And beloved current Fox broadcaster, and of course former Steelers quarterback, Terry Bradshaw said, “I may be dumb, but I’m not stupid.” And last but not least, the second greatest receiver of all time in my opinion outside of Jerry Rice is Randy Moss. And the great Randy Moss once said, “When you’re rich, you don’t write checks. Straight cash, homie.”
Which brings me to something that’s always bothered me. Why have we all heard from a parent or our grandparents or all of them the saying that cash is king? It’s probably one of the least accurate statements of all time, especially right now. Inflation’s at seven to eight percent, a 40 year high, and money market rates are averaging less than a half percent. So every extra dollar in cash is losing you right now around seven percent.
Cash is not king. Think about putting a hundred grand in and having the person on the other side of the counter say, “This is going to be so great for you.” Here’s what’s going to happen. In 12 months, your hundred thousand’s going to be at $93,000. Remember, this is exactly what’s happening. What you don’t see can hurt you just as much as the things you see. If inflation’s at zero and you lose seven grand in a hundred thousand dollar account, you know it’s bad, because you see right there on your statement $7,000 less than you started with. But it’s the exact same thing if inflation’s at eight percent and you make one percent. There’s no difference. It’s just the optics. The financial impact is identical. And so I say again, what you don’t see still can hurt.
Sticking with our football analogy. Previous Most Valuable Player and crazy athletic Baltimore Ravens quarterback Lamar Jackson is trying to negotiate a new contract, but he didn’t want to hire an agent. He’s going to be his own agent with his mom’s help, because I’m guessing he’d like to try to save the three to four percent commission cost that an agent will charge. But this is how it so often plays out. He’ll get a contract for $200 million, and he’ll look at his mom and the rest of his family and go, “I’m a genius, because we just saved six to eight million that we would have had to pay an agent.”
Well, what he’ll never know, and none of us will, is what if he hired an agent and would have ended up with a $250 million contract instead of 200? Would that agent have been well worth the nine million dollars that they made in commissions so that he still nets $241 million instead of 200?
Well, of course. But again, hypothetically, he’ll be walking around after signing a $200 million contract, high fiving the amount that he saved on an agent. And by the way, same thing happens with a great financial advisor or attorney or CPA. The fixed costs are obvious, and they’re assessed and we do the mental accounting, but the unseen often is the value. And if that value’s substantially higher than the fixed costs, you still come out ahead.
But I want to go a different direction than that for today. And it pertains to cash. Why are so many people I’m talking with right now carrying a ton of cash? Well, because they’re worried about losing money in the market. I get it, I don’t want to lose money in the market. Nobody does. But remember, stocks and bonds are both already down 15 to 25 percent. And so my question often for people in my office asking me this is, when do you plan to get back in? Because no one’s going to shoot flares in the air signaling the coast is clear. Time to invest.
And Walt Nockett, who’s a CFA and a CFP here at Creative Planning, wrote for our clients an article on why cash is not an investment strategy. I’ll post this to the radio page on our website at creativeplanning.com/radio if you’d like to read it in detail, but in the piece, Walt has a fantastic chart that shows the odds of cash outperforming the S&P 500 since 1928. Over a one year period, you win by being in cash 30% of the time. Over a seven year period, 16% of the time. And if going out 20 years, your odds of winning by being in cash over the S&P 500 is less than one percent. So the conclusion here is obvious. You should have all short term expense needs in cash, and about three to six months of living expenses in cash, and absolutely nothing else should be in cash.
I want to change pace a bit. So here are some quick hitter questions, I’m going to go rapid fire, that I’ve received over the last month, so that hopefully you can gain clarity through others’ questions that you might have as well. Number one, “Should I invest in foreign markets?” The answer is yes. If you’re wondering, the performance of US and foreign stocks swing over periods of time. Sometimes US outperforms, sometimes international does. But they tend to average similar long term returns, and you’re better diversified. Think about a Japanese investor putting everything in the Japanese markets the past 30 years. Don’t get sucked into the home team bias.
Number two. “How much, John, should I be saving?” 10% at a minimum, 20% or more if you want to fast track your retirement goals. Conversely, the follow up question to this is, if you’re in retirement and you’re not saving and you’re spending, “How much can I spend?” Let me start by saying the answer to that depends a lot on your legacy goals. Do you want to leave a bunch to charities or your family, or do you want the check to the morgue to bounce? But in general, about four percent of the total balance is a healthy and sustainable drawdown rate under most market conditions.
Next question. “What’s the best way to save money?” Automate it. You’re highly unlikely to save unless it’s on autopilot each and every pay period. Next question. “Should I buy active funds or passive?” If the active ones have a good track record or a five star rating, the answer is passive. Mathematically, there’s no more likelihood that a five star fund will outperform over the next decade. Morningstar did their own study on this relative to previously rated five star funds, and their future performance provided no correlation to better expected outcomes. Instead, just focus on your asset allocation and make sure it’s synthesized with your financial plan as a whole, and then go low cost.
Next question. “Why not just buy dividend stocks if I need income?” Well, there are plenty of books and newsletter subscription services that prop this idea of, “Which dividend paying stock should I buy?” And if you’re unaware, dividends are checks that companies send to their shareholders. Typically they come every quarter, but economists, generally speaking, mostly think this is dumb, and I do too by the way. You don’t need to wait for them to send you a check, just sell some of your shares and use the proceeds to finance your expenditures.
I am neutral on my preference of stocks that pay dividends versus stocks that don’t pay dividends, because theoretically, if stock A and stock B are the exact same, but stock A chooses to pay dividends and stock B doesn’t, stock B should increase by the exact amount additionally of the dividend that was paid by stock A. It’s a complete wash. Oh, and by the way, the stock that pays dividends is going to put a bigger tax burden on you as well, all else being equal, then a stock that doesn’t pay dividends. I’ve seen plenty of people in a dividend heavy portfolio reinvesting all the dividends, even though it’s completely tax inefficient. And so don’t chase dividends which can often lead to a less efficient overall portfolio.
Three more questions. “Should I pay off my mortgage early?” And the answer that you’re already aware of if you listen to the show is no. Beyond the fact that there are no pre-payment penalties if you change your mind, you would only want to pay it off early if you think that you can’t earn more than three or four percent, whatever your current mortgage rate is, over the next 30 years.
Next question. “How much should I spend on a house?” Been getting this question a lot as the housing market went through the roof the last couple of years. The short answer is, 36% of your gross income should go to total debt and about 28% max toward a mortgage. And so if you make 10,000 a month, your mortgage payment shouldn’t be more than about 2,500 to 3000 a month, and your total debt shouldn’t be over 3,600 a month.
That includes car payments, student loans, mortgage, and hopefully not credit cards, but may include credit cards. And if you go over that, you may be able to get approved for the loan, but I’ve seen plenty of clients just ridiculously stressed out by being house poor. And don’t bank on your income increasing either and over extend, hoping you make more money a few years down the road. Because you may, but you may not.
And my last quick hitter question, “How much should I allocate to stocks within my portfolio?” The answer is anything you don’t intend to spend within the next seven years or longer. It won’t always come out ahead, but you’re giving yourself the highest probability of success given the history of markets.
If you have questions like this, you can visit us at creativeplanning.com to get those questions answered. And I’d like to close today’s show with a pivot from what I spoke of recently regarding speaking to your children about money. Instead, let’s take a moment to discuss the importance of speaking with your parents about money.
I often encounter financial planning meetings with baby boomers, and the impact of whether they will inherit money, get nothing from their parents, or that possibility that they might need to pay money for their parents’ care or move houses to accommodate and have one of their parents live with them as they age, can be the difference between that boomer’s retirement plan working or not. On whether maybe you can retire a few years earlier or whether you’ll need to work a few years later. The problem is, I often find that that conversation has never taken place. So let me share with you just a few tips that I’ve advised my clients on regarding having these conversations with your aging parents.
Just remember that timing and wording should be carefully chosen, and feel free to acknowledge that the conversation’s kind of a sensitive topic. Be considerate and try to avoid busy holidays and family gatherings, which might already have a lot going on and may be more stressful. And if you have siblings or other family members that are also directly involved in your parents’ finances, maybe appoint the family member that seems to have the most open relationship with them. And remember, don’t go in as a group because oftentimes that can feel aggressive and might make your parents defensive.
Another tip I have is, remind your parents that you want to understand their wishes. Framing the entire conversation around, “We want to know what you want. We want your wishes to be upheld” often will empower them to give you more of a full picture of their finances. Because you really want to get clear on wills, powers of attorney, healthcare proxies, overall balance sheet. And that’s the final tip I have for you, is to get a team around that can help support and facilitate those discussions. At Creative Planning or a similar firm like us, we have estate attorneys and elder law attorneys and tax attorneys, who work with your wealth manager to ensure that all of this is simple, it’s organized, and it’s coordinated.
And for one unrelated bonus tip, that by the way has nothing to do with having conversations with aging parents around your finances? Well, this one relates to if you are, like me, attending a football game this weekend. Here is some tailgating tips of how to survive this inflationary environment. And just like everything else, iconic tailgating food and drinks have jumped in price. Beer’s up 4.6% since last July. Overall grocery prices have jumped 13.1%.
So here’s what you need to do. Opt for hot dogs at your tailgate if you’re trying to be frugal. They’re only up 5.3%, while chicken? Chicken’s up 17.6% and ground beef is up 10%. Oh, if you want to go real high society, do it right. Pork ribs, they’ve only increased a mere 1.6%.
So there you go. There is your useless tip to end today’s show. And whether you’re planning a lazy stay at home or an adventurous one out and about, I hope you enjoy the rest of your weekend, and remember that we are the wealthiest society in the history of planet earth. Let’s make our money matter.
Disclaimer: The preceding program is furnished by Creative Planning, an SEC registered investment advisory firm that manages or advises on $225 billion in assets. John Hagensen works for Creative Planning, and all opinions expressed by John or his guests are solely their own and do not represent the opinion of Creative Planning.
This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels. Clients of Creative Planning may maintain positions in the securities discussed on this show.
For individual guidance, please speak with an attorney, CPA, or financial planner directly for customized legal, tax, or financial advice that accounts for your personal risk tolerance, objectives, and suitability. If you would like our help, request to speak to an advisor by going to creativeplanning.com. Creative Planning tax and legal are separate entities that must be engaged independently.