(00:03:08):

So to kick things off today, I would like to have you start off by talking about your investment philosophy that you use with a lot of your clients called the Bucket Plan.

Dave Alison (00:03:18):

Yeah, absolutely. And to the point of being prepared, at the end of the day, that’s what having a plan is all about. And those of us that have a plan can take advantage of opportunities when things go south. Recessions are somewhat inevitable. Market downturns are a natural part of investing.

(00:03:36):

And so the most important thing for us when we think about investing is ensuring people are prepared. And so the Bucket Plan is really our behavioral framework of how we should all think about segmenting our money. And it almost comes off as common sense, but so many people miss it that we really feel like everyone should have essentially three buckets of money, if you will.

(00:04:04):

The first bucket of money, what we would call the now bucket is really your safe and your liquid money. We’ve heard cash is king, you should have X amount of cash on hand to get through any uncertainty. With that now bucket of money, we typically recommend to have maybe up to 12 months worth of living expenses or income in the form of cash.

(00:04:32):

We expect or advise our clients to have some sort of an emergency fund, a rainy day or a sunny day type of fund. And then last but not least, any major planned expenses that they know they’re going to have on the short term time horizon in the next six to 12 months, like if they were going to go take that $10,000 European vacation.

(00:04:54):

And really that now bucket is off the table from investing in volatile markets because essentially you might need it and it gives you peace of mind to lay your head on the pillow at night knowing it’s just there safe and liquid.

(00:05:09):

The second bucket is what we would call the soon bucket. So we have the now bucket is our money in the bank generally. Our soon bucket is going to be any money that we may need or will need to access sooner rather than later.

(00:05:24):

And so as we all know, markets are very volatile in the short run, we’re experiencing that right now. But statistically, if you look over a longer period of time, five, seven, 10 years, that volatility starts to smooth out because of a longer time horizon. And so really think about that soon bucket as that area that you would go to if you needed to access your money sooner rather than later.

(00:05:52):

So it’s invested for growth to help offset inflation because we all know the money in the now bucket down at the bank isn’t even keeping up with inflation in a normal environment, let alone the skyrocketing inflation we’re seeing now.

(00:06:05):

That soon bucket is invested for growth to help offset inflation. It’s just invested more conservatively so that if there was a big downturn in the market like we’re experiencing right now and you needed to access some of that money, you would have the ability to do so without having to sell into a major down market.

(00:06:24):

And so for a lot of my clients, not only is that the money that they may need or will need sooner rather than later, it can also serve as more of an opportunity fund also, because we all know in many cases the best time to buy assets are in distressed markets. It’s when they’re going down in value. And so think about that soon bucket as a place maybe you have some dry gun powder to be able to go shopping as real estate values are falling or stock prices are falling.

(00:06:55):

And then last but not least, the third bucket, Rebecca, is the later bucket. And so this is where we’ve essentially bought a time horizon with the now bucket and the soon bucket and can have the confidence to make those longer term investments knowing that markets are going to go up and down, we’re going to go through different economic cycles, but there’s certain asset classes that assuming you hold them for the right period, have a very high probability at rewarding those that supply capital, i.e., investors like all of us.

(00:07:27):

And so we try to think about it in terms of what needs to be in your now bucket, what needs and should be in your soon bucket, and then last but not least, the majority of your assets in many cases are out in that later bucket really for long term growth without having to worry about the day to day, week to week, month to month market volatility.

Rebecca Hotsko (00:07:46):

I really like that framework of thinking about how to manage or financially plan your money at the forefront because that really helps us think about what to prioritize first. So I have a few questions on each of the buckets.

(00:08:01):

Starting with the now bucket, you mentioned having 12 months of income in that now bucket. So my question is what if a millennial doesn’t have that amount in their savings right now? They have that amount of money, but maybe they’ve invested some. Would you recommend always having that 12 months of income set aside in cash before even investing?

Dave Alison (00:08:26):

The key with that, and I want to clarify, I generally advise up to 12 months, and so it’s not a hard fast number of 12 months for everyone. I’ll give you my personal example. I keep three months of living expenses in cash. I’m maybe a little bit more aggressive. I would rather have more of that money invested, having a better rate of return hopefully than what cash would provide.

(00:08:49):

I have many other clients who maybe don’t share the same sentiment of being a little bit more aggressive. Maybe they’re a little more conservative or adverse to risk and they really want to keep 12 months.

(00:09:01):

And then the third component of that is job stability. If you’re uncertain of your job, if you’re starting to hear about layoffs at your company and you know there might be a bumpy road ahead of you, you might want to expand that time horizon to 12 months.

(00:09:16):

I have many clients that are business owners and they like to keep more cash on hand because they know if things go sideways, they’re the last person that’s going to get paid. I think everybody’s situation and aversion to risk helps dictate what that number is, whether it’s a month, three months, six months, 12 months. 12 months is on the high end though once you’ve got that amount of cash set aside.

Rebecca Hotsko (00:09:42):

And then for the soon bucket, for that one you mentioned that is for purchases that we plan to make in the near future or something. So what does that mean in terms of asset allocation? Because the now bucket, that’s clear, that’s cash, that’s not in an investment, but then what are we investing in for that soon bucket?

Dave Alison (00:10:03):

The soon bucket, it’s a challenging one and it’s even in this market been incredibly challenging because if you think about going back to the academic side of investing or asset allocation 101, it was like there’s three main assets, there’s cash, there’s bonds or fixed income, and then there’s stocks.

(00:10:20):

And historically bonds have served as a pretty good ballast in a portfolio to provide some downside protection and some uncorrelated exposure to the stock market. If the stock market goes down, hopefully bonds go up. If bonds go up, the stock market’s going down.

(00:10:36):

Well, we’re in this unique situation that many at least millennial investors haven’t experienced in their lifetime. We’re starting to go into a rising interest rate environment. We’ve been in a declining interest rate environment since the really early ’80s at this point. And essentially what happens is when you go into a rising interest rate environment, the principal value of bonds falls.

(00:10:59):

And so if you were to say, “Well, from a textbook perspective, maybe a 50-50 balanced portfolio would be a really good option in that soon bucket because it would provide some stability to the volatile times in the stock market,” well, that really hasn’t held up and we’ve seen that writing on the wall. It’s nothing new to the academic world that when interest rates go up, principal value of bonds go down.

(00:11:25):

And if you look at the longer the duration of the bond, the harder it’s fallen. For example, a 30 year bond right now is down about 30%, almost the same as the NASDAQ is down for the year. But the shorter the duration and the higher the credit quality of the bond, the more stable it is or the less impacted it is by a rising interest rate environment.

(00:11:51):

One area to focus on from a bond perspective in a rising interest rate environment is going more towards short duration, high credit quality, two years, three years, four years. I was just looking at the numbers and the 2-Year Treasury for example, which is a really good risk-free rate of return, is paying almost a 4% yield right now. That could be an option to blend a balanced portfolio of shorter duration, higher quality bonds with stable sound equities on the stock side to provide some stability.

(00:12:26):

The other thing that we see outside of just a traditional balanced portfolio approach is some alternative asset classes that could fit inside of that soon bucket that help provide downside protection or mitigate risk. Some of those products could be insurance products. If you invest in permanent or cash value type of insurance, you at least have some downside protection on the market going down. It could be a good source of stability in somebody’s plan.

(00:12:56):

Or you could use some of the different types of options strategies out there or collared risk strategies. There’s some great ETFs that are in the market now, these defined outcome ETFs that essentially provide you exposure to the S&P 500 on the upside up to a cap or a participation rate, but they protect a certain buffer on the downside, like 20 or 30%.

(00:13:22):

Those are just a couple of very high level examples, whether it’s more towards a balanced portfolio using high quality bonds with equities in a certain allocation depending on what your risk or volatility target is, whether it’s outsourcing or shifting some of the risk or liability to an insurance company, or whether it is using some of these newer hybrid type of products that provide more collaring or option type of protection on the downside.

Rebecca Hotsko (00:13:51):

So then for that bucket, are these ones just subjective then? In terms of how millennials should think about allocating their overall available capital between these three buckets, is the soon bucket subjective to what they might need along with the later bucket versus the now bucket, it’s this is money that you should have because that’s what you need to live?

Dave Alison (00:14:15):

Exactly. So I think that when I’m talking to clients about their soon bucket, there’s really two primary questions that I’m asking. The first is, do you have any known planned expenses or goals that you would like to achieve in the next five, seven, eight years?

(00:14:34):

I’ll use a couple of examples of my own personal financial life. A few years back, we were living in Ohio and my wife was like, she wanted to move down South. And so I knew at some point I was going to be making a second home purchase and I didn’t want to have to be forced to sell my primary home before I could make that second home purchase.

(00:14:57):

So in my mind, I needed enough capital in my soon bucket to be able to substantiate the down payment on that second home so that if we found our dream home, a couple years ago, it was a really quick moving market, we had to show up and make a deal quickly if we wanted that home. Well that was money that I allocated into my soon bucket so that the day we found the home I put an offer in it, didn’t even think twice about it.

(00:15:24):

That was an example of I knew there was this projected goal at some point in the future. I would even say if anyone has children that are approaching high school, getting ready for college age, that might be another soon bucket number. I’ve had many clients who have maybe a 14 year old or a 15 year old and they’re three, four, five years away from college and they want to be able to have a bucket of money to help with college funding.

(00:15:53):

Or a client recently that I was talking to just had another child, both spouses are working, they’re going to need about $25,000 a year of healthcare. Or not healthcare, excuse me, child care. And so they wanted to allocate about four or five years of childcare expenses in their soon bucket.

(00:16:15):

And so those are all just different examples where you look at what the goals are that you might have and you start to quantify backwards how much you need in that soon bucket to achieve those goals.

(00:16:27):

And that’s a great way to think about saving too for short term goals because one of the things that I know I’ve talked about with many of my clients is a big reason that they save and they invest money is so that ultimately one day they could have the financial freedom to be able to retire or stop working.

(00:16:43):

But for many of us, I know at least for me, my only goal in life isn’t to be able to retire one day, it’s to have all these other things along the way. If I have a four year goal to do X, Y, and Z, now I can start implementing a savings and accumulation plan over the next four years in my soon bucket to get to the point where my balance meets my goal now and I can really track my financial progress.

(00:17:10):

There’s one avenue that’s purely goals based, the second one is very non-scientific. The second one is a simple question that I ask my clients, is there a certain amount of money you just want invested more defensively or conservatively so that if we do experience a big downturn in the market, this portion of your portfolio is not going to fall like the rest of the market potentially does.

(00:17:39):

And I found everybody has that magic number, whether it’s 50 grand, a 100 grand or a million dollars. People have that number that it’s like their safety net. They want it invested because they don’t want it sitting in the bank earning zero, but they don’t want it in a full equity portfolio that’s going to be very volatile. They can’t stomach that volatility.

(00:18:00):

And what’s fantastic about that design is that going into this market downturn for all of those clients that we had properly funded a soon bucket for, now they have the opportunity to go on a shopping spree. There’s a lot of good companies out there that have severely depressed stock prices. And so we’re able to take some of that soon bucket money and think about reallocating it towards the later bucket and go and buy really good companies that we can now hold onto for five or 10 years.

(00:18:35):

And we saw the same exact thing in 2020 where the market fell 30, 35% really quickly when the pandemic erupted. And our clients who had soon buckets established were able to go on a buying spree of some of, particularly, those tech companies that really skyrocketed and had that V-shaped recovery.

(00:18:56):

That’s just an idea of getting to that dollar amount in the soon bucket. It’s much more of a gut feeling with a millennial or somebody of a younger age. When you get into retirement, it becomes really easy. We typically recommend five to 10 years worth of retirement income in that soon bucket.And so if I was trying to project out how much I would need to have in order to retire, I would want to make sure I could have about five to 10 years worth in that soon bucket and then a bigger pile of money out in that later bucket that’s going to replenish my income bucket over time and throughout the latter half of my life.

Rebecca Hotsko (00:19:34):

And now I want to touch on the later bucket because I’m just wondering for your clients, do you figure out how much they need in the future and then reverse engineer what kind of return rate you would need to get there by that date? I’m just trying to help millennials think about how to create this long-term financial plan.

Dave Alison (00:19:56):

I think that’s a great way to potentially do it. And that gets to the heart of, again, goals-based financial planning is number one, we start with what are some of your goals. I always share with my clients that are of a younger age, it’s really hard to think out 20 or 30 years into the future. If you ask me where my life is going to be in 30 years, I’d have a really hard time answering that question.

(00:20:21):

And I always just say, “Well, let’s put a bogey out there because if we have no goal, we’re just going to be throwing our arms up in the air, and it’s better to have a goal and at least try to continue to get to there.” And so if you were to tell me, my goal is I want to try to be able to retire by 62, and then I would say, “What type of standard of living do you want? How much do you make right now? Are you comfortable living off of the amount? Do you feel like in retirement you might need more or less?”

(00:20:48):

Hopefully you’re going to continue to go into peak earning years as you earn more, your lifestyle is going to probably continue to improve. And I don’t meet many 60 or 65 year olds that want to take a step back in lifestyle once they retire.

(00:21:03):

And so we start to get to some of these core targets to your point, and if somebody told me, well, I want to be able to retire with $10,000 a month in today’s dollars in terms of an income stream, well then we start to get to some of these other financial concepts that we call, one example would be an income gap that said, okay, if you need $10,000 a month of income in retirement, well what sources of income do we know you’re going to get outside of your own savings?

(00:21:33):

And for many millennials, hopefully it’s going to be social security depending on the outcome of social security over the next 20 or 30 years. But we can all see our statements and know what some projected benefits are going to be. If somebody came in and said, “Well, my social security benefit is projected to be 40,000,” that means we need about $80,000 of our own money per year to make up to get to that 120,000 in today’s dollars of spendable retirement income.

(00:22:03):

And so from there we would start to reverse engineer the numbers of, okay, if I need 80,000 of spendable income, how much do I need to accumulate by the time I’m 62 to make that happen? And then if I can save X amount of dollars every month, what type of rate of return would I need based on that savings trajectory? And so this is all stuff that you could mathematically model out of course, and I always find that just having a target or having a goal is incredibly helpful.

(00:22:33):

It’s amazing to see, I always call it milestones. Five years at a time we check in and say, “All right, how are we doing on this milestone? Are we off? Are we ahead of schedule?” kind of where we’re at and why with our clients and they find that to be somewhat helpful and just making sure they’re on track to meet some of their goals, both long term like retirement and short term like some of the other things that we spoke about.

Rebecca Hotsko (00:22:56):

I really love how you touched on all of that because I think we often get caught up on beating the market, but at the end of the day, maybe you would have enough for retirement by having the market return. You just have to backtrack your goal, like you said, figure out what return that is. Maybe it’s only 7% or 6. Obviously a better return means more money for you later, but that would eliminate some of the decisions we make from buying and selling different assets because we want to get that extra return when really that might be hurting us in the long term.

Dave Alison (00:23:27):

It is. And you know what’s really interesting? I mean that whole concept of beating the market. I think that takes our focus away from what truly matters. We manage a lot of money at our firm. We’re over I think 1.75 billion or so of client assets that we manage and I co-chair our investment committee.

(00:23:44):

Would I love to always beat the market? Of course. Have I ever met a client that wouldn’t want to? Of course. Everybody wants to make as much money as possible and earn the highest rate of return they possibly can, but it’s insanely difficult to consistently beat the market over a 30 year time period. I mean Warren Buffet and others have exhibited that in some of the research and data out there.

(00:24:06):

And so I always challenge people to reframe the conversation and rethink the approach and the philosophy behind what you’re trying to accomplish, because for me, and one of the things I explain to all my clients is the money is just a means to achieve the goals and objectives that we have in life.

(00:24:22):

And so let’s start with outlining what all those goals and objectives that you have in life are. And they’re going to change over your life. What mine were 10 years ago before I had three kids are much different than what they are today, now that I have three kids under six.

(00:24:35):

We really try to start with goals and objectives and then to your point, reverse engineer the lifestyle and the math backwards because at the end of the day, if you look back over a 80, 90 year life and you were able to achieve all of your goals and objectives, but you underperformed the market by 1 or 2%, I don’t think you would be that disappointed with your life.

(00:24:58):

But if you were expecting to beat the market by 1 or 2%, but then you look back at your life and you only actually were able to achieve 40, 50, 60, 70% of the true goals and objectives you had in life, you might be a little bit disappointed. I think everything needs to start and reshift with what are those goals, what’s the purpose of the money.

(00:25:19):

I have a specialization where we work with very high net worth clients, mostly in Silicon Valley and in tech. And I can tell you most of these clients, although they love earning and making money, their biggest concerns aren’t beating the market. Their biggest concerns are, can I live my life to the fullest and achieve what I want to achieve with what I have, without taking on too much risk?

(00:25:41):

And it’s more, again about accumulating wealth in the right way because once you get into your 50s or 60s, if you make a few wrong moves, it’s very hard to ever make that wealth back again. And so I don’t know, I just always challenge people with their thinking on that term of beating the market, not that we all don’t want to get great returns whenever we can.

Rebecca Hotsko (00:26:02):

Yeah, I’m definitely glad we touched on that because I just think especially in today’s environment, investors could be making some mistakes by buying and selling maybe unnecessarily and adding maybe extra risk to their portfolio that they wouldn’t otherwise. And so I guess I’m just wondering, can you talk a bit about that emotional aspect and some of the biggest mistakes that you see your clients or investors make when a recession or bad times fall?

Dave Alison (00:26:31):

I just want to start, there’s an empathetic side of things that nobody in the world likes seeing their account balances go down. You could have the most amount of money and the greatest financial plan and at the end of the day you see your account balances go down and it never feels great.

(00:26:48):

And there’s actually some great research and studies done on risk aversion and loss behavior that people actually hate losing more than they like gaining. Some of the greatest athletes in the world subscribe to this. Michael Jordan hated losing a game more than he ever liked winning a game. And I feel like that transcends into the investment world. We all hate losing much more than we like winning.

(00:27:13):

So these downturns, while they are generally short in nature, if you look at the time of a bear market, it’s maybe 18, 20, 24 months. Of course, we’ve seen these really horrible ones like 2008, 2009 that lasted a few years. They have a sharp fall and then generally a full recovery.

(00:27:33):

And so I think some of the biggest mistakes that people make from an investment standpoint is very common, it’s they buy high and they sell low. They looked at what was happening in the stock market over the last couple years and they were chasing trends instead of actually having a sound discipline principle and philosophy.

(00:27:54):

Maybe going into last year, and I can’t tell you how many portfolios I saw that were massively overweight, technology as an example, they might have been 80% of their portfolio tech. And prudence would tell us that’s not great diversification even though those are some wonderful companies. And again, look at what’s happened this year. This year we’ve seen an incredible value premium over growth, growth stocks are way down, value premiums have remained somewhat stable.

(00:28:24):

They make decisions based on trend following or emotions, sometimes what they’re hearing in the media of hyping up these hot stocks or funds that maybe have already experienced their run up. Take a look at some of the ETFs like ARKK that we’ve seen out there, gained so much popularity and by the time a lot of investors got in, it tanked.

(00:28:46):

And so I think the timing of your investments, chasing returns, cashing out of the market at times like this right now, I think what people really need to be thinking about is you need to be an opportunistic investor right now, not a cautious investor. The time to make life changing wealth in the market is in these times where there’s so much fear and uncertainty.

(00:29:11):

And it’s not that you have to take insane risks. I’m not saying go dump all your money in cryptocurrency or something like that, but being a buyer of financial assets, as prices are falling, it seems contrarian, why would I want to put my money in as the knife is falling? But the reality of it is we all know that capitalism works to a certain extent and all of these companies that make up the stock market are in business to produce money and we’re going to ride out this short term storm.

(00:29:40):

I think ensuring people are not essentially getting out of the market when, and in fact, they should be still turning up their savings during this time period and trying to buy more assets. They’re acquiring more shares and by acquiring more shares when the markets do rebound, they’ll have greater wealth because of it. Those are a couple, of course the big ones.

(00:30:03):

I mean I don’t think it’s any surprise to people, but it’s very much harder to do in practice, especially when you’re managing your own money because you’re so much more emotionally devoted and connected to it that again, for some of our biggest clients, they just want to outsource it and not have to look at it because, even though they have the knowledge to know what they should be doing, they don’t have the discipline to actually transact on their own to be able to execute. Those are a couple of the big things, Rebecca.

Rebecca Hotsko (00:30:36):

Yeah, I think that’s the biggest struggle being an investor that manages your own money, like you said, it’s just you might know exactly what to do, but the emotion can sometimes get the best of you. So I’m wondering, does the Bucket Plan in your opinion, help investors maybe manage some of those risks or that bad behavior?

Dave Alison (00:30:57):

It does completely. And it’s really interesting, this year we’ve obviously seen the first three quarters, one of the worst starts to stock market history and we don’t have clients reaching out or calling in a negative way at all. I haven’t had one call since the market has gone down.

(00:31:15):

And the reason for that is they know that they have their now bucket. They have their soon bucket, if things were to continue to get really crazy and this recession becomes a deeper recession or things get worse economically. And then they know in their later bucket, they have a prudent strategic strategy to how that portfolio is designed for long-term growth.

(00:31:40):

They also know that if they, and where we’ve been getting more of our calls from clients, I just got one right before I got on this podcast with you, is I sent out a quick little economic and market intel report through the first three quarters to our clients and they were like, “Hey, I actually have a pile of excess cash in my now bucket. Can we move it over to our later bucket? What do you think about some buying opportunities right now?”

(00:32:04):

I think that is the Bucket Plan gives us and our clients, number one, common language, number two, they start to know, hey, my now bucket’s getting a little bit too filled up. I need to start reallocating that. They know they have a soon bucket so that they can weather the short term volatility of these ups and downs that the market is facing and have that time horizon out in the later bucket. That’s really important.

(00:32:30):

I think another thing that coincides with it, and it’s not as much investment related as it is, in my opinion, one of the best ways to build wealth is thinking about tax planning during these market downturns because inside of the Bucket Plan, we’re also looking at what assets you’re holding and what account types you’re holding them in.

(00:32:49):

We’re doing an awful lot of Roth conversion planning right now where we’re taking pre-tax dollars that are now maybe down 20, 30, 40% depending on the stocks that they were holding, and we’re paying tax on the value now and converting it to Roth money out in the later bucket and essentially eliminating the government forever from the future earnings in the Roth.

(00:33:11):

And so don’t just look at the stocks and the bonds and the mutual funds and the ETFs that you’re holding, look at the tax diversification that you have because now is an unbelievable time to start doing strategic tax planning on top of your investments.

Rebecca Hotsko (00:33:28):

I’m sure that we could have a whole episode just talking about those tax efficiencies and the most tax optimal way to position yourself. But on a high level I guess, do you have any tips for millennials on how to allocate their investments in the most tax optimal way? Say for, let’s use the last bucket, their long term bucket, do you have any tips for that one?

Dave Alison (00:33:51):

I do totally. I actually just got back from two days in Austin, Texas. I was teaching a group of CPAs and financial advisors this whole tax management journey concept of really helping them accumulate and protect their wealth from income taxation. Actually on my YouTube page, I have a video, it’s about a seven minute video where I go through steps to build a tax efficient savings and accumulation plan.

(00:34:15):

But there’s some really, really quick tips. The first thing is if you’re just getting started as an investor, the first place I generally would recommend putting money into is a Roth. Even using that Roth IRA as your emergency fund in your now bucket, because many people don’t realize that with a Roth IRA, if you were to need that money, you could get back your contributions tax and penalty free. It’s only earnings that would face some sort of tax or pre 59 and a half penalty.

(00:34:48):

If somebody ever came to me and they said, “Dave, I just got my first job, I’m about to start saving. I heard I should save an emergency fund down at the bank.” I’d say, “No, no, not at the bank necessarily. Set up a Roth IRA, get $6,000 into there each and every year, use that as your emergency fund and then any additional savings over that 6,000 start building up your reserves outside of the Roth account.” That’s a really important account.

(00:35:18):

I think there’s great accounts. Health savings accounts, they’re one of the best accounts for any high income earner because they’re the only account in the IRS tax code that is triple tax exempt. You get a deduction for putting money in, it grows tax deferred. You could take the money out income tax free using it for medical expenses.

(00:35:38):

The biggest mistake that I see millennials make with HSAs, they put the money in through their employer deduction, but then they take it right out and use it for medical expenses. That is an account that should almost always sit in your later bucket because you get to take advantage of compounding tax deferred growth and then tax free for retirement later on. That’s an idea of the right account in the right bucket can make massive impact to building wealth.

Rebecca Hotsko (00:36:06):

So then on the later bucket, would you recommend if millennials have mostly equities, would you say that they should all be in the Roth or a Roth IRA account or do you think about that differently?

Dave Alison (00:36:21):

I think about it a little bit differently. I mean most of them I believe should be to the extent possible. Any asset that you’re going to hold in the Roth account should be where you feel like you’re going to generate the highest expected return in your portfolio.

(00:36:35):

It pains me sometimes when I see millennials holding bonds in their Roth account, for example. Bonds have a low expected return, you want your highest growth asset. It’s how Peter Thiel made like $6 billion in his Roth account. He put all of his PayPal stock in it when it was startup company stock and now he’s got the biggest Roth in the world, which is a little bit questionable, but that’s an example of how people should be thinking about the investments inside of their Roth specifically.

(00:37:01):

I think that as you think about these different account types, I mean of course a big limitation we have with Roth is for a millennial you can only put $6,000 a year into there. It might not be a big part of their overall savings.

(00:37:14):

There’s obviously opportunities where you could get more in Roth through a Roth conversion process, but I think it’s a great starting point to think about where they might want to hold some of their assets that have higher expected return.

Rebecca Hotsko (00:37:27):

I also want to talk to you about money cycle. I read this on your website and so I was hoping that you could just talk a bit about this and explain to our listeners what this is.

Dave Alison (00:37:38):

Yeah, so the money cycle is a function that we all go through in our lifetime. I’m going through it, you’re going through it, my mother’s going through it, everybody goes through it. And there’s essentially three phases to the money cycle.

(00:37:53):

There’s the phase where pretty much probably all of our listeners are today, which is the accumulation phase. It’s when you’re younger, you’re working, you’re saving, you’re accumulating, you are trying to build up your nest egg.

(00:38:06):

Now when you’re younger, when you’re working, when you have a steady job and you have a long time horizon before you’re going to retire, you could afford to take on more risk or volatility. You could make bets with your money, you can throw some money in different cryptocurrencies or you could throw your money in different individual stocks and make bets on whether that’s going to pay off or not.

(00:38:29):

Because at the end of the day, if you lose that portion of your money, it’s not going to totally disrupt your lifestyle. You still have a steady paycheck, you still have a good job, you’re still a long ways out for retirement.

(00:38:42):

But then as people get to about five to 10 years out from retirement, they start to enter what we call the preservation phase of the money cycle. At this point, they’ve built their nest egg, they’re financially sound, or they’re on the road to retirement.

(00:38:58):

It’s right around the corner and they don’t have as much time or capacity to take unnecessary or big risks with their money because they’re preparing for the third and final phase, which is distribution, distribution to themselves in and through retirement and distribution to their family amongst their passing.

(00:39:20):

And so this money cycle is this evolution that we think about from cradle to grave as we all are building wealth, investing, saving, accumulating, and then ultimately climbing down the backside of Mount Everest, which is distribution and retirement.

(00:39:36):

When we think about the money cycle, there’s really big mistakes or consequences people could make along the way in each of those phases. There’s many in the retirement phase, there’s some in the preservation phase, but specifically here in the accumulation phase, it gets into some of that topic, Rebecca, you and I were just talking about.

(00:39:56):

I think the biggest mistake I start to see people make in the accumulation phase is they do not think about the tax sensitive nature of the accounts that they’re holding. I for one feel taxes are going to continue to be one of the biggest threats to us building wealth. We have an incredible amount of national debt right now. It’s continuing to get bigger. Somebody’s going to have to pay some of this off and it’s going to come at the hands of higher taxes in the future.

(00:40:23):

I think for millennials as they’re investing, in my opinion, the tax diversification that you have is not as important, but it’s up there with what types of investments you’re actually buying because there’s certain investments you should always buy in a Roth and certain investments you should never buy in a Roth and certain investments you should buy in an after tax account and certain investments that aren’t as efficient in an after tax account.

(00:40:47):

And so that’s how we think about the money cycle and it helps us really target in on helping our clients avoid particular mistakes that they could make in each of those incredibly important phases of their investing life.

Rebecca Hotsko (00:41:01):

That was really helpful. And the third concept that I read on your website that helps us think about financial planning is the pyramid of risk. Can you talk a bit about this and how our listeners can use this to help inform their investment decisions?

Dave Alison (00:41:20):

This is kind of a visualization concept. I mean imagine if you have a piece of paper in front of you, you draw the shape of a pyramid and then divide it into three sub segments. When I explain the pyramid of risk to my clients, I essentially say that of course most of us know that risk and expected return are related. The higher the risk we take, the higher the expected return we should hopefully be rewarded with.

(00:41:47):

But what else happens with things that are high risk? They could lose everything. They could totally go out of business, they could lose all of their value. And so there’s some trade offs that we have to navigate. And what I like to do is from a bigger asset class picture, categorize things and how they fall in that pyramid of risk.

(00:42:08):

So for example, at the top part of the pyramid, I really classify three main categories. The first is alternative assets. So alternatives could be a spectrum of things. They could be cryptocurrencies, they could be oil wells, oil and gas drilling, really anything that’s massively speculative and could lack broad liquidity.

(00:42:33):

Because again, if I put a bunch of my money into a speculative hedge fund, I might have to keep it there for 10 years, for example, and so it lacks liquidity. Those types of investments would sit in that top part of the pyramid.

(00:42:46):

The other types of investments that would fit into the top part of the pyramid are highly concentrated individual stocks or highly concentrated individual bond positions. These are a lot of my clients out in Silicon Valley who have made a lot of wealth in their company stock. They own 80% of their net worth in Meta or Apple or Google or whatever it is. And obviously the higher the concentration, the riskier it is because that company could do what some of these companies have done.

(00:43:14):

I was just looking at Meta this morning, I think it’s down 67%, 65% year to date. That’s a big risk for people who have that level of concentration. I always joke and say, it’s a cheesy financial advisor line, but concentration gets you rich and diversification keeps you rich, as we think about that pyramid of risk.

(00:43:33):

And people might say, “Well, bonds, how are highly concentrated individual bonds at the top part of it?” And I go back and look at 2008, 2009, look at anyone who maybe had high concentrated positions in Lehman Brothers bonds, they still lost their money. Again, these companies that either issue debt via bonds or equity via stocks could go out of business. I never say you shouldn’t have money up there. You should in many cases because you could potentially hit some grand slams, but you might strike out a lot with those types of investments also.

(00:44:05):

In the middle part of the pyramid, these would be investments that I would consider to be volatile but not risky. Volatile but not risky, meaning they’re going to go up and down in a big way, but the chance of them going to zero is slim to none. And so things like that would be mutual funds, stock funds, bond funds, index funds, ETFs.

(00:44:30):

These carry one massive characteristic in that they’re very diversified. They’re owning hundreds if not thousands of individual stocks. I mean, could you imagine if the S&P 500 index went to zero? It would mean all 500 of the largest companies in the United States would go out of business simultaneously. And at that point, I’m not worried about my investment portfolio, it’s probably a zombie apocalypse.

(00:44:54):

Those are all things that are going to have massive fluctuation to them, like in ’08, ’09, it lost 55%, in COVID it lost 30, 35%, today it’s down about 25%, but if you have the right holding period, you should be rewarded. But again, it’s going to zig and zag a lot, a lot of squiggly lines on that chart going upwards.

(00:45:16):

And then down at the base of the pyramid is the boring stuff. It’s like when you look at my house, if you came over here today, nobody would be very excited to see the foundation of my house, but the foundation of the house is what keeps all the nice stuff held up.

(00:45:30):

And so this is where we would look at things like insurance driven vehicles. There’s permanent cash value life insurance and annuities. There’s government bonds which again are becoming very much more attractive. There’s cash, savings, CDs, money market accounts, things that again would be more preservation versus growth oriented, but provide total stability.

(00:45:55):

As I map this out in an exercise I would encourage all of your listeners to do is look at those three components and write down a percentage of your liquid investible assets that you’re comfortable with in each.

(00:46:10):

For example, maybe you have a bigger appetite for risk and you want to have a range of 10 to 20% of your assets in the top of the pyramid, maybe 50 to 60% in the middle, and then the rest in the bottom. And as you experience ebbs and flows in market value, that starts to allow you to say, “Hey, you know what? I put $30,000 in this cryptocurrency and over five years it’s quadrupled in money. Maybe I should take some gains and reallocate it towards the middle or the bottom of my pyramid.”

(00:46:43):

So it starts to create a rules-based methodology for how you build wealth, because without that, we become behaviorally anchored into the positions that we hold. And how many times, Rebecca, have you heard people that bought an asset, it did really well, it made them a whole bunch of money, but then what happened? They didn’t sell and it came crashing down, right?

Rebecca Hotsko (00:47:06):

That is so fascinating. I’m so glad that you brought that up because I love how this approach can help you become a rules-based investor so you don’t make those mistakes. And I think financial planning is often overlooked. We spend a lot of time picking assets and picking what we should buy next without thinking of the overarching goals that will help us become better investors in the long run and keep more of our money.

Dave Alison (00:47:32):

So I think the keys of what we’ve spoke about so far is if you establish goals to help you realize the importance of the money and why you’re accumulating and then you establish rules that you’re going to abide to that help you eliminate unnecessary mistakes, just those two things alone, I think you’re going to start to see a lot more success in your long term strategy and probably reduce some anxiety that you might be facing.

(00:47:58):

Because again, I’ve had so many people that come in and they say, “Hey, I made all this money in this stock and I just don’t know what to do with it now. Should I sell? I don’t want to pay tax,” this and that. And at the end of the day, the tax means you made a bunch of money and think about the people that made a bunch of money last year in stocks, but they didn’t sell because they didn’t want to pay the tax and now they’re sitting at 40%, 50% of their values. And so set those rules-based systems.

(00:48:23):

Tax is another one. I talk to clients about establishing what I would call a capital gains budget, a certain budget that you are going to leverage each year if you need to, to harvest capital gains so that you can sell those positions and not be anchored in from a tax perspective.

Rebecca Hotsko (00:48:42):

Just touching on that further, that is something that I struggle with is selling winners because I think I have a long-term mindset. So in my view I’m like, I’m holding this for 10, 15 years anyways. Why would I sell now? But can you touch on that a bit more and how we should actually think about reallocating and maybe selling a portion of our winners, when it would be time to do so?

Dave Alison (00:49:05):

Your philosophy and mindset is a hundred percent right. I tell people when you go to buy a stock, unless you’re a flipper, like buying real estate to flip it, it’s very hard to make calculated money on the short term on stocks unless there’s some anomaly of a situation in market prices like COVID, when we saw this steep downturn and then steep upturn.

(00:49:27):

But I think to answer your question is if you have a stock that you like for the long haul, then what you have to ask yourself is tie a percentage of your liquid investible assets to that stock. Let’s say I love Amazon. I shop on Amazon. I think Amazon’s a great stock, I want to continue to own it. I want to own it for the next 10 years. I think Bezos is going to continue to do big things.

(00:49:50):

Well, if today Amazon represents 10% of my net worth, at what level would I start to get a little bit uneasy? Is it 15%? Is it 20%? Is it 25%? And so Rebecca, going back to that concept of establishing some rules or parameters around that. And what I would do is if I said, “Okay, well it’s 10% and 10 percent’s about all I want in one company stock,” that’s a pretty good exposure to one company.

(00:50:19):

Now what I would start to look at is anytime my exposure got above and beyond that, if it gets up to 12%, I might sell 2% to get myself back to 10 and I take that 2% and I invest it in other areas that I think could provide some asymmetrical risk or some higher expected return to the portfolio.

(00:50:38):

And that’s simple rebalancing in the broad scheme of things. But again, if you don’t have a rule about what percentage of your liquid investible assets you’re comfortable with in that stock, then you’re just leaving it up to your own emotion and how you’re feeling and what the news is telling you. And I think that that’s where it becomes a little bit more challenging to moderate.

Rebecca Hotsko (00:51:03):

That was so helpful, that explanation. And now that I’m thinking about it, that same logic can be applied between assets, so a single stock and also regional diversification. That’s something I do in my portfolio. When my US equities get above 40%, I notch those down. I buy more emerging markets or I’m from Canada, so Canada. And then also I guess that could be applied to stocks and bonds. When you see one above the allotted percentage you want, you rebalance.

Dave Alison (00:51:32):

I think there’s a couple different areas. It’s individual stocks, it’s asset classes, it’s sectors, to your point, it’s geography, and the other thing, again, just people don’t think about this, it’s also taxes. There’s essentially what we call three funnels of money, three places we can funnel our money into. There’s pre-tax, our IRAs, our 401ks, our 403bs. There’s tax advantaged, our Roth accounts, our HSAs, college 529 plans, permanent cash value life insurance, all carry tax deferment and then tax free later on. And then the middle funnel is post-tax.

(00:52:07):

And what I would typically do with my clients as well is analyze, if you have a million dollars of investible assets, how much is in each one of those funnels, because at one point we might not want the pre-tax funnel to get substantially larger than some of the other ones because that could create a big problem in retirement because now you might be forced to take a lot more money out of your accounts via required minimum distributions, and it could push you into a really high unnecessary tax rate in retirement.

(00:52:38):

So just like in investing, rebalancing is important in the portfolio, there’s ways to look at where you’re actually accumulating your money into to make sure one’s not getting off balance. Because if there was the biggest piece of tax advice I had for millennial investors right now, it’s that if I look at my 65 year old clients and I said, what’s the one thing I wish I could go in a time machine and help them fix, is so many of them have the biggest portion of their net worth tied up in pre-tax accounts, IRAs, 401ks, and 403bs.

(00:53:10):

They don’t have the ability to diversify and create what I would call a tax efficient retirement income distribution plan because every dollar that they take out of those accounts is taxed as ordinary income. It’s like they’re a W-2 employee for the rest of their life.

(00:53:26):

Whereas, if they had tax diversification and they had a good amount of money in Roth IRAs as well as traditional IRAs, we could blend out the ordinary income at lower tax rates and then take money out of the Roth account at the higher brackets to get them the most tax advantageous retirement income stream we could develop, reduce taxation of social security benefit, lower their Medicare costs.

(00:53:50):

And the challenging thing is, in my opinion, nobody’s out educating younger generations that this is also stuff you need to be thinking about because it’s not just accumulating a big bucket of money, it’s accumulating the right types of money so that when you retire, you’ve got ultimate flexibility in how you design your income stream in and through retirement.

Rebecca Hotsko (00:54:12):

That was super helpful as a reminder. We actually had a guest on recently helping us talk about when we should allocate to a Roth versus Roth IRA versus traditional. And there’s obviously so many different reasons why you would maybe want to choose one over the other.

(00:54:27):

But in terms of what you just talked about, where the biggest mistakes you see for people in retirement and where you wish they could go back, would you say that a useful tool then for millennials would be to split their contribution room to both today?

Dave Alison (00:54:43):

So it really is independent. I’ll give you a couple guiding things that I would try to look for. Number one is if I’m starting off and saving and investing, maybe I’m in early stage of my career, maybe don’t have incredibly high income or earnings yet, so I’m in the lower tax brackets.

(00:54:59):

Then what I would always recommend is participate in the 401k up to your match. That in today’s tax environment is always going to get allocated to the pre-tax side of the 401k and you’re going to get some free money from your employer on top of that via the match.

(00:55:15):

Then what I would do is I would really focus all of the rest of your contribution to the Roth component because you don’t want to defer tax today at a low tax rate of, let’s say 12%, build up this wealth, 30 years later have to take a bunch of income out, and now you’re actually taxed at a higher rate, like 20, 22, 24 if tax rates continue to go up. Don’t take the deductions today.

(00:55:44):

It’s like a gamble, and I always share, every time you make a decision on your retirement accounts, you’re gambling. If you’re taking the pre-tax contributions today, that means you think your tax rates are going to be lower later on in life, and that just doesn’t happen for many people, especially with the amount of spending the United States has.

(00:56:02):

But once you start escalating in your career, now maybe you’re in a higher marginal rate, maybe you’re a high income earner, you’re in the 32, 35, 37% bracket, you might want to max out as much money as you can on the pre-tax side, the 20,500 for example, this year in the 401k, use that to continue to get the deductions at those higher marginal rates today, but still do whatever you can through maybe strategies like a backdoor Roth conversion to build Roth money at the same time. So it’s never an all or nothing decision, it really is individualized based on where your income and earnings are and then where we project your wealth to be in the future.

(00:56:45):

Now, one of the challenges on pre-tax side, we have some clients that have been fortunate enough to accumulate a pretty substantial amount of net worth, and what people don’t realize is if they accumulate all this money in IRAs, pre-tax retirement accounts and their net worth is so high, they never really need that money, number one, at age 72, the government forces you to start taking it out and paying a high tax rate on it.

(00:57:11):

But if you passed away, a retirement account is the worst savings vehicle to leave behind to your beneficiary. And the reason is you have to drain that account over a small 10 year period, if not in some circumstances, even shorter, and it’s all taxed at income rates. And if for some of these high, high net worth clients, they might also be impacted by the estate tax. And in some cases you could lose like 70% of your account value to income taxes between an estate tax and an income tax. You don’t want to accumulate too much money in a pre-tax retirement account. There’s really an optimal balance of what you should have as you age into retirement.

Rebecca Hotsko (00:57:52):

That was so helpful to hear your perspective on that. I know I assume when I’m retired I’ll have a lower tax bracket or I won’t be working, I might as well put more money into that account. But like you mentioned, tax rates just are likely to go up given how much debt we have. So it’s just more of that macro factor that could really impact it versus if I’m working or not and my personal tax rate’s lower.

Dave Alison (00:58:18):

Yeah, there’s two components. There’s the macro. Many economists today say that our tax rates have to double in order to pay and service the debt we have, even the interest on the debt. I mean, think about that today. If you’re thinking you might be in a 12% bracket later on in life and now you’re in a 24% bracket, that’s a big deal.

(00:58:37):

The other thing that people don’t realize … So again, by background, I’m an enrolled agent admitted to practice before the IRS, which is the highest credentialing the IRS awards, so we do a lot of strategic tax planning.

(00:58:48):

And today as a younger person, when I look at my taxes, I have a lot of deductions. I have home mortgage interest, I have childcare, I have all this stuff. When you retire, most of that stuff goes away. Even if you have lower income and even if tax rates stayed the same, you might pay more in tax because you have less deductions.

(00:59:08):

And the last thing that I’ll share in that point is we know tax rates are going up in 2026. In 2017, when Donald Trump passed the Tax Cuts and Jobs Act, it lowered taxes for almost everybody. Not only did the brackets lower, but they got compressed, meaning you could make a lot more money and still be in a lower bracket. That’s known as a sun-setting provision.

(00:59:32):

On December 31st of 2025, that tax cut sunsets and we revert back to the previous tax code, which was higher brackets and the compression is gone. So for less income, you now are in a higher bracket.

(00:59:49):

And so for the next two years or so, we have a tax planning opportunity of a lifetime to try to figure out how we can structure our assets to potentially capitalize on this historically low income tax environment that we sit in today.

Rebecca Hotsko (01:00:04):

That is so interesting. We’re almost out of time here, and I didn’t even get through half my questions with you. Just one more thing for our listeners. We’ve talked a lot about the holistic financial approach that they can take. I guess I’m just wondering, given this high inflation, rising interest rate environment, what is a piece of advice you’d like to give our listeners on how they can better manage their portfolio or what they can do to prepare for this if things get worse in 2023?

Dave Alison (01:00:37):

I think the first thing is don’t necessarily panic at some of the headlines. I think one of the greatest indicators of future is history. And we find oftentimes that history doesn’t repeat itself, but many times it does rhyme or it does look similar. We’ve all heard that story before.

(01:00:53):

And a rising interest rate environment doesn’t always mean horrific things for the stock market. If you look back into the decade of 1970 to 1980, we saw huge interest rates and high rates of inflation, but we did not just see total chaos across the stock market. Actually, we saw real rates of return net after inflation and interest rates over that decade time period, albeit they weren’t quite like we saw over the last decade where interest rates were really low.

(01:01:23):

It just doesn’t automatically mean things are going to go bad. Don’t take knee-jerk reactions to your investment approach just on some of these headlines that we’re seeing. There’s certainly a lot of headlines right now. I mean, this jobs number is going to be a big component of it, how far the Fed is actually going to go. Are they truly going to tip us into a massive recession or are we going to potentially see a moderate recession that right now a lot of the analysts that I follow are saying …

(01:01:52):

I saw a number just yesterday that at least of the big financials, JPMorgan, Goldman, some of those different firms, about 47% of their analysts are saying we are going to head into a recession, which the glass is half full. That means more than half of them say we’re not going to be in a recession.

(01:02:08):

But what was interesting is, of the ones that said we were going to go into a recession, they said the average time was going to be seven months, seven months. And typically what we see in the stock market is a stock market bottoms many, many, many months before a recession is actually declared. See, because the stock market is pricing in future information and discounting it back to today.

(01:02:31):

When I talk about a great opportunity to make money, you want to look for investments that provide asymmetrical risk to the upside, meaning in simple terms, we’re probably closer to the bottom than we are to the next stock market high. If you have dry gun powder, now is a great time to get in the market.

(01:02:48):

Don’t try to time the bottom. Timing the bottom is impossible. Now is a great time to potentially start getting in. Could we go down further from here? Yes, we could, of course we could. Will we? Probably. There’s going to be an incredible amount of volatility, particularly leading up to the midterm elections here in the US.

(01:03:06):

But we’ve also seen, and if you look at data on markets, historically, there’s been a pretty good rally in the stock market after midterm elections. If you look at the data from the day the polls close to the end of the year, historically, we’ve delivered double the return that we’ve historically seen in non midterm years. So there’s some things to be optimistic about as we close out this year, even though it’s been an incredibly rough start.

Rebecca Hotsko (01:03:31):

That was great advice to leave us with today. Thank you so much for joining me today, Dave. Before I let you go, where can our listeners go to learn more about you and your work and everything that you do?

Dave Alison (01:03:44):

Yeah, so we have two companies. Prosperity Capital Advisors is an RIA that I am the president and founded about 11 years ago. We have offices and advisors all around the country that we teach and train and support on this holistic approach to advising. I also have more of a boutique tax and wealth management firm out of Silicon Valley, Alison Wealth.

(01:04:04):

So prosperitycapitaladvisors.com, if you are interested in learning more about this holistic approach and maybe an advisor in your area, or alisonwealth.com, which is where we serve clients directly through our holistic approach to tax investment management, financial planning, estate planning, and all of the family’s financial needs.

Rebecca Hotsko (01:04:25):

Awesome. Thank you so much, Dave.

Dave Alison (01:04:27):

Thank you. Thanks for having me. It was fun.

Rebecca Hotsko (01:04:31):

All right. I hope you enjoyed today’s episode. Make sure to subscribe to the show on your favorite podcast app so that you never miss a new episode. And if you’ve been enjoying the podcast, I’d really appreciate it if you left us a rating or review. This really helps support us and is the best way to help new people discover the show.

(01:04:50):

And if you haven’t already, be sure to check out our website, theinvestorspodcast.com. There’s a ton of useful educational resources on there, as well as our TIP Finance tool, which is a great tool to help you manage your own stock portfolio. And with that, I will see you again next time.

Outro (01:05:08):

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(01:05:29):

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