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What should be in the “perfect portfolio?”

Posted by John Reed on

Today’s WSJ has a review of a new book In Pursuit of the Perfect Portfolio—a survey of all the major academic experts on such things—although I was surprised to not see Burton Malkiel mentioned.
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But the review and the book piss me off as I have been pissed off before for assuming that “portfolio” refers only to stuff you can buy from a securities broker. Actually, if the review was comprehensive regarding the nature of the book’s contents, it is not even that broad. It is only about broadly-traded common stocks, no mention of bonds.
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This is outrageous. For one thing, such investments have a transaction cost going in and coming out and when they are profitable, a tax cost coming out.
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How about we start with the TYPICAL investor’s portfolio and point out what’s right and what’s wrong?
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The main thing in most senior Americans’ portfolio is their principal residence residence equity. Good. My recent book on the superiority of principal residences devotes its second chapter to the two dozen or so advantages that no other investment asset has including rental properties which are also real estate and may even have the same value as the principal residence.
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A salient one is USE VALUE. You cannot use any other investment to live in. You cannot eat gold. You cannot live in an index fund. But you can live in a principal residence and you can also work in a non-residential real property that you own.
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The academic experts need to acknowledge that, They also need to take note of the risks eliminated by such a deed with your name on it asset compared to securities. If you own a common stock or a bunch of them, you are exposed to fidelity risk (employee embezzlement or laziness), credit risk (corporation lends money or assets to third parties and does not get fully paid back), exchange risk (misbehavior or cessation of the exchange where you trade the asset), national market risk (when a would-be assassin shot President Reagan, stocks fell in price, but not homes).
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There is an agricultural saying I love: “The best fertilizer is the shadow of the farmer.” Your principal residence IS under your shadow. Fidelity, credit, and exchange risk do not exist in your principal residence.
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For seniors who have a 401(k), that is usually their biggest asset, with their home equity second.
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Individuals should also own and TAKE DELIVERY of COMMODITIES. The securities brokers think of commodities only as options. They would not deign to get their hands dirty with an actual piece of metal or other type of commodity.
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I have inherited gold and silver bullion coins and nickels and pennies which are worth their weight in the metal they contain. I also have inventory (books that I wrote and published and distribute). Many businesses have raw material that they turn into finished products. Standard best practice used to be to hold down inventory of finished products or raw materials. Nowadays with looming inflation danger, I deliberately buy more inventory than I used to, for inflation hedge purposes. You should consider doing the same with inventory, spare parts, and raw materials.
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Mormons advocate having a year’s supply of long shelf-life food. They sell such dry-pack foods items. You can also buy freeze-dried foods from camping stores. This is considered kooky by many, but no one can refute the logic that we all need a certain amount of food daily and that, in various emergency situations in the past around the world, such food was a life saver. It can also be bartered.
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You really ought to buy everything you need for the rest of your life now as a hedge against inflation. That is an exaggeration as a practical matter. Remember that it is better to own what you need than to rely on traditional investments that you have to sell in order to buy what you need. Cut out the middleman.
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Think outside the securities box. Instead of buying gold then selling that to pay taxes and transaction costs then buying heating fuel, how about buying a home in a mild climate area where you have little need to buy heating fuel. That is an investment in mild climate. Mild climate should be in the “perfect portfolio.”
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Foreign currency is an asset category that is a hedge against USD inflation. It is probably not in the thinking of the professors, but it is very important in a hyperinflation. But it better be in your “perfect portfolio.”
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Then there is liquidity. Liquidity is not an asset per se, but some of your assets had better be liquid. If you need cash, but for whatever reason, cannot turn a particular asset into cash as fast as you need, it could cost you a substantial part of your net worth in the form of quick-sale value discount or need to pay to borrow money or foreclosure costs.
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So to prevent a small need for cash from turning into a big loss of net worth, you need an appropriate amount of liquid assets to handle those rainy-day possibilities. What sort of events? Need for a large replacements like roof, furnace, medical expenses, condenser. What assets are liquid? Foreign currency. Gold, silver, nickels, pennies. A HELOC on your principal residence.
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Your state BANKRUPTCY EXEMPTIONS list items ought to be in your portfolio. Every state but NJ has an exemption for home equity and in all states including NJ you can choose the federal home equity exemption. State lists also have items like pensions, workman’s tools, some jewelry, clothing, life insurance, household items, heirlooms, health aids, burial plot, vehicle, fuel, sewing machines, domestic animals, food, furniture, appliances, crops, musical instruments, health aids, prepaid higher education funds, professional books, and other things depending upon the state.
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If you have a state program that lets you prepay for a child’s future post-high school education, you should probably put money into it. As stated just above, it may be exempt in bankruptcy in your state. And it may just be an excellent investment and hedge against inflation.
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Roughly speaking, you should OWN everything that is exempt in your state in your “portfolio” because it has zero bankruptcy risk. The state lists vary dramatically so you may even want to move to a better state. Notably, seven states and DC have an unlimited dollar homestead (principal residence) exemption. Many have moved to those states to take advantage of that. This is not just for persons with shaky finances, indeed, such people moving would raise fraudulent transfer questions. EVERYONE should own all the exempt assets that they can keep in bankruptcy. Simple logic, albeit not simple enough for the professors.
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The “perfect portfolio” ignores tax ramifications. For your principal residence, they are ignoring IRC§ 121, the $250,000 per spouse exemption from gains taxes. Kind of a big deal. Also, real estate can be exchanged tax-free; securities cannot. (IRC §1031) Seems like you load up on tax advantaged investments before you start buying those with no advantages or which are taxed worse than ordinary income.
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This is typical ivory tower BS. To make their calculations simpler, they assume no taxes or transaction costs, no use value, no risk profile, no hedging of risks. The intelligent portfolio and the real world portfolio, let alone the “Perfect portfolio,” must take into account all the issues that the ivory tower refuses to bother their pretty little heads about.
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If you only consider common stocks in your “perfect portfolio,” what about depression risk? In the Great Depression, the stock market fell 90%. Should the “perfect portfolio” leave you with more than 10% of your life savings?
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In hyperinflation, dollar-denominated assets are wiped out. True, the “perfect portfolio” has no bonds—based on the book review anyway. I submit that the perfect portfolio must NOT leave you penniless. The US has not had a hyperinflation since the Civil War, so I cannot predict the actual details of what is enhanced or destroyed or preserved in various asset categories in that situation.
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Leverage is key especially in inflation. You make a profit if you own a non-dollar-denominated mortgaged asset. And you can get far more leverage on better terms in real estate than any other asset. So these are important considerations if you are looking for the “perfect portfolio.”
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Life estates and RAMs are assets that resemble annuities, which are great for hedging the risk that you will die earlier or later than expected. But annuities are worthless in high inflation because traditionally what you receive is a fixed dollar-denominated cash amount that will have lost purchasing power. However, the life estate and RAM are a non-dollar-denominated annuity. You do not receive cash each month. You get the right to live in the house, which, by definition, automatically adjusts for any level of dollar inflation.
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What assets you own affects your eligibility for government-related long-term care, Medicaid, and college financing. These are important, significant, real world concerns about which asset categories should be in your “perfect portfolio.”
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Anyway, a “perfect portfolio” needs to be holistic, not just common stocks. And it must take into account ALL of the possible risks. It must not be just a bet on one or more asset categories and a prayer that the others do not happen. It must leave you with as much of your net worth as possible no matter which negative or positive events occur.

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