Designing an investment portfolio can be a complex process at any age. It requires consideration of various variables such as risk tolerance, time horizon, and financial goals; however, there is one rule that always holds true for investors:
**Rule** Never put yourself in a position where you MUST sell assets when they are down to meet a cash flow need.
Over the past few weeks, we saw this dynamic play out with the downfall of several US regional banks, and the concept also applies at the personal level. However, you can avoid this painful mistake with prudent budgeting, asset allocation, and internal asset class management! See below for details:
Secure Short-Term Cash Need
One of the most important steps in avoiding a forced sale of assets is having a sufficient amount of safe and liquid assets to meet a cash flow need. This is particularly important to retirees as they rely on their portfolio to supplement income from pensions, social security, etc., to maintain their lifestyle. Recommendation: At least six months of liquid cash/cash equivalents or short-term debt instruments, with little to no risk built into your portfolio’s bond/fixed income portion. While this approach sacrifices some upside potential offered by riskier bond instruments, there is an unquantifiable value in knowing where your cash flow is coming from in the short run.
Rebalance/Maintain Asset Class Diversification
Establishing a well-thought-out and disciplined rebalancing approach is key when designing and implementing an investment strategy. Rebalancing is a discipline that attempts to remove the emotion from the buy/sell dynamic and helps investors maintain the appropriate mix of stocks, bonds, and cash. The act of rebalancing can be based on a pre-determined schedule or be more event driven. Regardless of your criteria for rebalancing, the most important thing is to execute it. Recommendation: If you are in retirement, and have an ongoing cash need from your portfolio, make cash raises a priority in each rebalance.
Ensure Diversification within Asset Classes
Lastly, in addition to rebalancing and asset class diversification, you must also maintain internal asset class diversification. For example, within the stock portion of your portfolio have exposure to as many sectors of the economy as possible as sectors tend to respond differently in various market environments. On the bond side, ensure you have a mix of short-duration bonds (Money lent for short periods) and longer-duration bonds (Money lent for longer periods). Additionally, ensure you maintain a bias towards lending money to borrowers with high credit quality, such as the US government, or instruments backed up by the full faith and credit of the US government. While you may want to maintain some exposure to borrow with a lesser credit quality, it should be limited, particularly if you have a cash flow need from your portfolio. Recommendation: With short-term interest rates currently at multi-year highs, a larger allocation to instruments such as money market mutual funds should be considered as they offer respectable yields without the loss of liquidity.
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Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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