We know that if you want to make at least $100,000 a year, all you’ve got to do is find enough work that will pay you at least $50/hour for 40 hours a week for 52 weeks. I’m personally always gunning for $100/hour because San Francisco is expensive.
But what about maximizing your investment returns in a risk-adjusted manner? Given we know how to optimize our hourly income, all we have to do is apply the same principles to investing. By slicing portions of our investment capital up, we’re better able to allocate our capital for potentially higher returns. This is The Samurai Method to investing.
The biggest deterrent to investing is laziness. Many people are too lazy to spend the due diligence necessary to get educated about investing. They’d much rather spend hours reviewing the latest iPhone features than read company research reports. As a result, they just dump their entire portfolio into several expensive mutual funds or index ETFs, regardless of platform risk or better investment opportunities elsewhere.
You should see yourself as the portfolio manager of your entire net worth. You’ve got various pieces that all fit together to achieve your financial objectives e.g. real estate, cash, CDs, fine art, stocks, and bonds. It’s important to follow some sort of net worth allocation framework so you don’t blow yourself up when things turn sour.
For the investing portion of our net worth, I think we can do a better job optimizing returns by allocating our money through various channels, including building your own portfolio.
Another consideration to think about is farming out some of your investable assets to an algorithmic advisor like Wealthfront, which charges nothing for the first $10,000 – $15,000 managed. They’ve grown to roughly $3B in assets under management because they’ve been able to perform while minimizing costs. If time is valuable, and ETFs and portfolio construction are a commodity, then having someone invest for you at a low cost is a good move if your time is better spent making money elsewhere. I plan to allocate new capital with Wealthfront and compare the performance soon.
Farming out capital across various platforms is exactly what multi-billion dollar college endowments and wealthy family offices do. There’s no reason why you and I shouldn’t do the same, especially since access and fees are so low thanks to the rise of financial technology companies.
Let me share the three pillars to my investing methodology.
1) Know your base case return scenario. In other words, what investment can you make where you are guaranteed to get the stated return and principal back. The main risk-free investment is the 10-year government bond yield, which is currently yielding ~2%. The US government isn’t going to default. If it does, the world is coming to an end due to a zombie apocalypse and money will be the last of your worries.
The other risk-free rate of return is a long-term CD guaranteed by the FDIC up to $250,000 for individuals and $500,000 for married couples. A 7 – 10 year CD so happens to yield roughly 2% – 2.3%, which goes to show you that the market is efficient.
2) Decide on your desired rate of return. You can choose the risk-free rate of return, but that’s only if you’ve amassed a large amount of capital where the risk fee rate of return provides enough for you to live a comfortable life. For example, if you’ve accumulated $5 million by age 60, perhaps you can comfortably live off $100,000 a year in retirement if you have been regularly spending less than $150,000 gross a year. You’ve likely only got 40 more years left to live, so the math works out fine.
But if you’re like most people still looking to amass their fortune, you require a higher rate of return than the risk-free rate. With inflation running at close to 2%, if you just invest in a 10-year bond, you’ll end up just running in place. If you’re younger, you’ve got more time and earnings power to overcome possible losses, which over the short-term are inevitable.
At my current stage in life, I’ve accumulated enough so that a 2% return on my financial nut will support a decent lifestyle. However, for me, it’s not quite enough to feel absolutely worry free. I need $10 million in investable assets to generate my ideal $200,000 annual income risk-free. Unfortunately, I’m not there yet, which is why I take risk to generate a greater than 2% rate of return. My target return is 2X – 3X the risk-free rate, or a 4% – 6% annual return. For those of you in your 40s and 50s, I suggest following this similar mantra of singles and doubles instead of home runs.
3) Allocate your investable capital like a Samurai. Once you’ve decided on your desired rate of return based off your risk tolerance, it’s time to allocate capital in the most efficient way possible. Instead of just dumping everything into an asset allocation split based on ETFs and index funds, consider narrowing down each investment and pressing when the risk-adjusted returns are much higher than your desired rate of return. Your goal is to beat your annual bogey by as much as possible without taking more risk.
I’ve already explained in a previous post how everyone needs to come up with an investing game plan to better deploy their capital. You’ve got to measure your cash flow, liquidity, and risk tolerance as you follow a methodical dollar cost averaging strategy.
The reason why it’s important to always have cash on hand is because there are ALWAYS investment opportunities that come up (the same goes with real estate). One such opportunity finally came up in a Netflix structured note offered by my wealth manager at Citibank. With the bull market getting long in the tooth, I’m hesitant to put fresh capital to work without protection.
The offering is as follows:
Two-Year Callable Coupon Note on Netflix Inc. (NFLX) – 13% per annum contingent coupon paid quarterly. Coupon barrier is 65% of initial level (observed quarterly). Downside barrier is 65% of initial level (observed at maturity). 100% Auto-call observed quarterly after one year of issuance if NFLX is above the strike price.
Here’s an example that explains the various scenarios.
Each valuation date is equal to one quarter paying a 3.25% coupon (13% a year). In order to make money on this Netflix investment, I’ve got to be positive enough to believe Netflix will NOT close down more than 35% before each valuation date to get a 3.25% quarterly coupon. If Netflix closes up higher than -35% in each quarter, I will see a 26% total return after two years (8 quarters X 3.25%). I do not get to participate in the actual upside if it goes above the strike price. If Netflix closes down more than 35%, then I’m stuck with that exact percentage loss.
I’ve been following Netflix ever since Reed Hasting, the founder and CEO spoke at my Haas School of Business commencement back in 2006. I’m a user, and an existing shareholder in my current after-tax portfolio. In other words, I’m bullish enough to be naked long (no downside protection). I just don’t have a very big position.
The bear case for Netflix is that its growth rate is slowing in the US with already 40 million+ subscribers, it’s terribly free cash flow negative, it probably has to raise capital, it’s expensive, and it’s losing money overseas as it tries to land grab.
The bull case is that Netflix already missed its 3Q results, is down ~20% from its highs, has price elasticity if it wants to raise its subscription price by 10-30% a month, and will eventually make money off international subscribers after it spends money gaining market share. Their ability to create successful homegrown shows such as OITNB and Narcos should create a very sticky user experience.
A 13% return with a 35% barrier is asymmetric and very attractive to me. 13% is also 6.5X the risk-free rate of return, and 2-3X greater than my desired rate of return of 4% – 6% a year. Given I’m willing to invest in this Netflix note with a 13% return if I received only 15% downside protection, I’m making a larger investment due to the 35% downside barrier.
Even though my current Netflix position is only $227.84, I’ve spent enough time following the company where I feel comfortable making a bigger investment. I’ve now carved out $40,000 in new capital (5.8% position in my “Unemployment Fund” started in 2012 after receiving a severance) in a Netflix note that I believe has a high chance of returning 13% a year for at least the first year. Always start small and work your way up to a larger position.
The point of this article is not to debate the investment merits of Netflix. It is to encourage investors to optimize limited capital for maximum risk-adjusted returns. Slicing up your capital in order to optimize returns is the same strategy as figuring out how to make the most per hour with your limited number of hours you desire to work a week. It’s the same strategy Henry Ford used in 1913 to create the assembly line for the mass production of an entire automobile. His innovation reduced the time it took to build a car from more than 12 hours to two hours and 30 minutes.
Don’t let laziness or ignorance prevent you from allocating capital in an optimal way. Put your money to work either by yourself or with the help of an automated investing service. There’s always a place for cash. But if you’re just holding cash because you haven’t bothered to do any research or optimize your deployment of capital, then decades from now you’ll have much less wealth than you really should have.
Track Your Net Worth Easily For Free: In order to optimize your finances, you’ve first got to track your finances. I recommend signing up for Personal Capital’s free financial tools so you can track your net worth, analyze your investment portfolios for excessive fees, and run your financials through their amazing Retirement Planning Calculator. Those who come up with a financial plan build much greater wealth over the longer term than those who don’t!