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CHAPTER 7

SLAY THE BEAR

How to Navigate Crashes and Corrections to Accelerate Your Financial Freedom

I learned that courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear.

—NELSON MANDELA

THE PATH TO FEARLESSNESS

When I was 31 years old, I visited a doctor for my annual physical—a routine checkup that was required for me to renew my license as a helicopter pilot. In the days that followed, the doctor left several messages asking me to call him. I was running around like crazy and didn’t have time to speak with him. Then, one evening, I got home after midnight and found a note that my assistant had taped to my bedroom door: “You must call the doctor. He says it’s an emergency.” You can imagine how my mind began to race. I was extremely disciplined about my health, and I’d never felt fitter. So what could possibly be wrong? The mind tends to go crazy in times like this. I began to wonder: “I travel a lot, so maybe it’s related to the radiation on airplanes. Could I have cancer? Could I be dying?” Surely not.

I pulled myself together and managed to get some sleep. But when I woke up the next morning, I was filled with fear and dread. I phoned the doctor, and he told me: “You need surgery. You have a tumor in your brain.”

I was stunned. “What are you talking about? How could you know that?” The doctor, a combative guy with no bedside manner, said he’d done some extra blood tests because he believed that I had an enormous amount of growth hormone in my body. It didn’t take a genius to figure that out, given that I’m six foot seven and had shot up 10 inches in a single year when I was 17. But he was convinced that this explosive growth was the result of a tumor in the pituitary gland at the base of my brain. He wanted me to come in immediately and have the tumor cut out.

I was scheduled to fly to the South of France the next day to teach a Date with Destiny seminar. But I was now supposed to drop everything and undergo emergency surgery? So much for destiny! I went ahead and taught the seminar anyway, and then traveled to Italy, where I stayed in a beautiful fishing village called Portofino. But it was there that I started freaking out. I felt like a different human being, getting angry and frustrated at little things. What was wrong with me?

Growing up, I’d lived in a world with no certainty. When my mom was on drugs and angry, she’d sometimes lose control over little things. If she thought I was lying about something she might pour soap in my mouth until I threw up—or smash my head against a wall. Since then, I’d spent a lifetime training and conditioning myself to find certainty in an uncertain world. But I’d allowed this doctor’s comments to suddenly plunge me into the deepest level of uncertainty. Out of nowhere, my world had been turned upside down, and the life I’d built was crumbling. After all, how can you be certain about anything when you’re uncertain about the most basic question: “Am I going to live or die?” Sitting in a church in Portofino, I prayed for dear life. Then I decided to go home and deal head-on with this situation. The next few days were surreal. I remember coming out of the MRI machine and seeing the grim look on the lab technician’s face. He said there was definitely a mass there, but he wouldn’t give me any details until the doctor had interpreted the scan. The doctor was busy, so I had to wait another 24 hours. Now I knew for sure that I had a problem, but I still had no idea whether or not it was fatal.

Finally, the doctor met with me to explain my test results. The scan confirmed that I had a tumor, but also showed that it had miraculously shrunk by 60% over the years. I had no negative symptoms, and I hadn’t grown since I was 17. So why did I need surgery? The doctor warned me that excessive growth hormone could trigger an array of health problems, including heart failure. “You’re in denial,” he said. “We have to operate immediately.” But what about the side effects? Beyond the danger of dying under the knife, the biggest risk was that the operation would damage my endocrine system, so that I’d never again have the same level of energy. This was a price I wasn’t prepared to pay. My mission of helping people to transform their lives requires tremendous energy and passion. I kept wondering, what if the surgery left me unable to do my life’s work? To give you an idea, my average weekend event today has 10,000 people in attendance and goes for 50 hours over 4 days. In today’s world, most people won’t sit through a 3-hour movie that someone spent $300 million to make! So without enormous energy, there is no way I could deliver an experience where people from 40 different countries are not only totally engaged, but feel like they’ve completely transformed their lives.

The doctor was furious with me: “Without surgery, you can’t be sure that you’ll live.” I wanted a second opinion, but he refused to recommend another doctor.

Through friends, I eventually found my way to a legendary endocrinologist in Boston. He scanned my brain again and then sat me down to review the results. He was a wonderful man, full of compassion, and his attitude was entirely different. He said I didn’t need surgery; the risks were too great. Instead, he suggested that I fly to Switzerland twice a year for an injection of an experimental drug that hadn’t yet been approved in the United States. He was certain this drug would stop my tumor from expanding and prevent the growth hormone from causing dangerous heart problems.

When I told him about the doctor who wanted to cut into my brain, he laughed and said: “The butcher wants to butcher, the baker wants to bake, the surgeon wants to cut, and I want to drug you!” It was true. We all like to do whatever we know best in order to achieve certainty. The problem was, this drug was also likely to have a profound effect on my energy level. The endocrinologist could see why this troubled me so deeply. “You’re like Samson,” he said. “You’re afraid that you’ll lose your power if we cut your hair!” I asked him what would happen if I did nothing—no surgery, no drugs. “I don’t know,” he replied. “Nobody knows.”

“So why should I take this drug?”

“If you don’t take it,” he said, “you can’t be certain that you’ll survive.”

But by now, I no longer felt uncertain. There was no evidence that my health had deteriorated in 14 years. So why should I roll the dice by having high-risk surgery or being injected with an experimental drug? I went to see a series of additional doctors until I found one who told me, “Tony, it’s true, you have an enormous amount of growth hormone in your bloodstream. But it hasn’t had any negative side effects. In fact, it may be helping your body to recover more quickly. I know body builders who would have to spend $1,200 a month to get what you’re getting for free!” In the end, I decided to do nothing more than get myself tested every few years to see if my condition had worsened. I didn’t realize it then, but I’d just dodged a lethal bullet: the US Food and Drug Administration later outlawed that drug, based on studies showing that it caused cancer. Despite his best intentions, my big-hearted endocrinologist’s flawed advice could have ruined my life.

And you know what? Twenty-five years later, I still have that tumor. In the meantime, I’ve had an amazing life, and I’ve been blessed with the opportunity to help millions of people along the way. This was possible only because I made myself unshakeable in the face of uncertainty. If I’d overreacted or followed unquestioningly the advice of either doctor without considering all of my options, I’d be missing a part of my brain, or I’d have cancer, or perhaps I’d be dead. If I’d relied on them for my certainty, it would have been catastrophic. Instead, I found certainty within myself, even though nothing in my external circumstances had changed.

Could I die tomorrow because of my brain tumor? Yes. I could also get hit by a truck as I cross the street. Still, I don’t live in fear of what’s going to happen. I shut that off. You can be unshakeable, too, but this is a gift that only you can give yourself. When it comes to the areas of your life that matter most—your family, your faith, your health, your finances—you can’t rely on anybody else to tell you what to do. It’s great to get coaching from experts in the field, but you can’t outsource the final decision. You can’t give another person control over your destiny, no matter how sincere or skilled he or she may be.

Why am I telling you this story of life and death in a book about money and investing? Because it’s important to understand that there’s never absolute certainty in life. If you want to be certain that you’ll never lose money in the financial markets, you can keep your savings in cash—but then you’ll never stand a chance of achieving financial freedom. As Warren Buffett says, “We pay a high price for certainty.” Even so, many people avoid financial risk because uncertainty terrifies them. In 2008 the US stock market plunged by 37% (and it crashed more than 50% from peak to trough). Five years later, a survey by Prudential Financial found that 44% of Americans still vowed never to invest in stocks again because they were so scarred by their memories of the financial crisis. In 2015 another survey discovered that nearly 60% of millennials distrusted financial markets, having lived through the crash of 2008–09. According to State Street Corporation’s Center for Applied Research, many millennials keep 40% of their savings in cash!

I’m heartbroken to see that so many millennials aren’t investing. Because let me tell you: if you live in fear, you’ve lost the game before it even begins. How can you achieve anything if you’re too scared to take a risk? As Shakespeare wrote four centuries ago, “Cowards die many times before their deaths; the valiant never taste of death but once.”

Let me be clear with you: I’m not suggesting that you take reckless risks! When it came to my health, I met with multiple experts, explored all the options, and let the facts guide me—not somebody else’s emotions or professional biases. I then made an informed decision for myself that put the probabilities on my side. This process allowed me to move from uncertainty to unshakeable certainty.

It’s the same with investing. You can never know what the stock market will do. But that uncertainty isn’t an excuse for inaction. You can take control by educating yourself, studying the market’s long-term patterns, modeling the best investors, and making rational decisions based on an understanding of what’s worked for them over decades. As Warren Buffett says, “Risk comes from not knowing what you’re doing.” There’s one thing we do know for sure: there will be market crashes in the future, just as there were in the past. But does it make sense to be paralyzed with fear merely because there’s a risk of getting hurt? Believe me, it wasn’t easy to find out that I had a brain tumor. But I’ve flourished for the past 25 years because I learned to live fearlessly. Does being fearless mean having no fear? No! It means fearing less. When the next bear market comes and others are overwhelmed with fear, I want you to have the knowledge and fortitude to fear less. This fearlessness in the face of uncertainty will bring you tremendous financial rewards.

In fact, while others live in terror of bear markets, you’ll discover in this chapter that they are the single greatest opportunity for building wealth in your lifetime. Why? Because that’s when everything goes on sale! Imagine longing to own a Ferrari and discovering that you can buy one for half price. Would you be downhearted? No way! Yet when the stock market goes on sale, most people react as if it’s a disaster! You need to understand that bear markets are here to serve you. If you keep your cool, they will actually accelerate your journey to financial freedom. If you find internal certainty, you’ll actually be excited when the market crashes.

I’m now going to pass the baton to my friend and partner Peter Mallouk, who will explain how he and his firm, Creative Planning, navigated through the last great bear market back in 2008–09. Peter doesn’t like to boast about his phenomenal results. But let me tell you, he handled the crisis so masterfully that his firm’s assets under management rose from $500 million in 2008 to more than $1.8 billion in 2010, with hardly any advertising or marketing—and he now oversees $22 billion and counting. What’s more, Creative Planning is the only company ever named by Barron’s as the top independent financial advisor three years in a row.

Peter will show you how to prepare for and profit from a bear market. As he’ll explain, it all starts with building a diversified portfolio that can prosper through thick and thin. He’ll give you invaluable advice on the art of asset allocation. Armed with this knowledge, you’ll have nothing to fear from market mayhem. While others flee, you’ll stand your ground and slay the bear!

PREPARE FOR THE BEAR

By Peter Mallouk

A simple rule dictates my buying: be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread.

—WARREN BUFFETT IN OCTOBER 2008, explaining why he was buying stocks as the market crashed

The Eye of the Storm

On September 29, 2008, the Dow Jones Industrial Average plunged 777 points. It was the biggest one-day drop ever, obliterating $1.2 trillion in wealth. That same day, the VIX index, a barometer of fear among investors, hit its highest level in history. By March 5, 2009, the market had tumbled more than 50%, devastated by the worst financial crisis since the Great Depression.

This was the perfect storm. Banks collapsed. High-flying funds blew up and crashed to the ground. Some of Wall Street’s most renowned investors saw their reputations shattered. Yet I look back on that tumultuous time as one of the highlights of my career—a time when my wealth management firm, Creative Planning, guided its clients to safety, positioning them so they not only survived the crash but also benefited enormously from the rebound that followed.

Tony has asked me to share this story with you because it embodies a central lesson of this book: bear markets are either the best of times or the worst of times, depending on your decisions. If you make the wrong decisions, as most people did in 2008 and 2009, it can be financially catastrophic, setting you back years or even decades. But if you make the right decisions, as my firm and its clients did, then you have nothing to fear. You’ll even learn to welcome bear markets because of the unparalleled opportunities they create for coolheaded bargain hunters.

How did our ship survive the storm while many others sank to the bottom of the sea? First of all, we were in a better ship! Long before the bear market occurred, we prepared for it in the knowledge that blue skies never last, that hurricanes are inevitable. None of us knows when a bear market will come, how bad it will be, or how long it will last. But as you learned in chapter 2, they’ve occurred, on average, every 3 years over the last 115 years. That’s not a reason to hide in terror. It’s a reason to ensure that your vessel is safe and seaworthy, regardless of the conditions.

As we’ll discuss in detail in this chapter, there are two primary ways to prepare for market turmoil. First, you need the right asset allocation—a fancy term for the proportion of your portfolio that’s invested in different types of assets, including stocks, bonds, real estate, and alternative investments. Second, you need to be positioned conservatively enough (with some income set aside for a very rainy day), so that you won’t be forced to sell while stocks are down. It’s the financial equivalent of making sure you’re equipped with safety harnesses, life vests, and sufficient food before heading out to sea. As I see it, 90% of surviving a bear market comes down to preparation.

What’s the other 10%? That’s all about how you react emotionally in the midst of the storm. Many people believe they’ll have ice in their veins. But as you may have experienced yourself, it’s psychologically intense when the market is melting down and panic is in the air. That’s one reason why having a battle-hardened financial advisor can be helpful. It provides an emotional ballast, helping you remain calm so you don’t waver at the worst moment and jump overboard!

One advantage our clients had is that we’d gone to great lengths to educate them in advance, so they wouldn’t be in shock when a crash occurred. They understood why they owned what they owned, and they knew how these investments were likely to perform in a crash. It’s like being warned by your doctor that a medication might make you dizzy and nauseous; you’re not thrilled when this risk becomes a reality, but you’ll cope much better than if it were a total surprise!

Even so, some clients needed a lot of reassurance. “Shouldn’t we get out of stocks now and go to cash?” they’d ask. “Doesn’t this crash feel different?” This reminded me of Sir John Templeton’s famous remark: “The four most expensive words in investing are ‘This time it’s different.’ ” In the midst of a market meltdown, people always think this time is different! Battered by all the bad news in the media each day, they begin to wonder if the market will ever recover—or if something has fundamentally broken that can’t be fixed.

I kept reminding my clients that every bear market in US history has eventually become a bull market, regardless of how bleak the news seemed at the time. Just think of the many calamities and crises of the twentieth century: the 1918 flu pandemic, which killed as many as 50 million people worldwide; the Wall Street crash of 1929, followed by the Great Depression; two world wars; many other bloody conflicts, from Vietnam to the Gulf; the Watergate scandal that brought about the resignation of President Nixon; plus countless economic recessions and market panics. So how did the stock market fare in that chaos-filled century? The Dow Jones Industrial Average rose inexorably from 66 to 11,497.

Here’s what you have to remember, based on more than a century of history: the short-term outlook may look dire, but the stock market always rebounds. Why would you ever bet against this long-term pattern of resilience and recovery? This historical perspective gives me unshakeable peace of mind, and I hope it will help you to keep your eyes on the prize, regardless of the corrections and crashes we encounter in the years and decades to come.

The best investors know that the gloom never lasts. For example, Templeton made his first fortune by investing in dirt-cheap US stocks during the dark days of World War II. He later explained that he liked to invest at “the point of maximum pessimism,” when bargains were everywhere. Likewise, Warren Buffett invested aggressively in 1974 when markets were slammed by the Arab oil embargo and Watergate. While others were filled with despair, he was exuberantly bullish, telling Forbes: “Now is the time to invest and get rich.” Psychologically, it’s not easy to buy when pessimism is rampant. But the rewards often come spectacularly fast. The S&P 500 hit rock bottom in October 1974 and then jumped 38% in the next 12 months. In August 1982, with inflation out of control and interest rates at almost 20%, the S&P 500 bottomed out again—and then soared 59% in 12 months. Can you imagine how investors felt if they’d panicked and sold during those bear markets? They not only made the disastrous mistake of locking in their losses but missed out on those massive gains as the market revived. That’s the price of fear.

When the bear struck again in 2008, I was determined to make the most of this opportunity. I had no idea when the market would recover, but I was certain it would recover. At the height of the crisis, I wrote to our clients: “There is simply no precedent, ever in history, of the market staying at a valuation level this low. . . . There are only two potential outcomes: the end of America as we know it or a recovery. Every time investors have bet on the former, they have lost.” Throughout the crash, we continued to invest heavily in the stock market on behalf of our clients. We took profits from strong asset classes such as bonds and invested the proceeds in weak asset classes such as US small-cap and large-cap stocks, international stocks, and emerging-market stocks. Instead of betting on individual companies, we bought index funds, which gave us instant diversification (at a low cost) across these massively undervalued markets.

How did this work out? Well, after bottoming out in March 2009, the S&P 500 shot up by 69.5% in just 12 months. Over 5 years, the index rose 178%, vindicating our belief that bear markets are the ultimate gift for opportunistic investors with a long-term perspective. As I write this, the market has risen 266% since the 2009 low.

As you can imagine, our clients were ecstatic. I’m proud to say that our clients held firm during the crash and hardly any abandoned ship. As a result, they profited handsomely from the recovery. Only two clients that left stand out in my memory. One of the two who abandoned our strategy was a new client who’d come to us shortly before the crisis with a portfolio loaded with real estate. We helped him diversify, which saved him a fortune when the property market crashed. But he couldn’t cope with the volatility of the stock market. He panicked and put all his money in cash.

I called him a year later to see how he was doing. By then, the market had rallied dramatically. But he was still waiting on the sidelines, too nervous to invest. For all I know, he’s still waiting and has missed the entire bull market of the last seven years. As Tony mentioned, you pay a high price for certainty.

The other client who left Creative Planning during that time was overwhelmed by the barrage of alarmist news in the media. He’d hear a pundit claiming that the market would fall 90%, or the dollar would collapse, or the United States would declare bankruptcy, and these warnings terrified him. To make matters worse, his daughter fed these fears. She worked at Goldman Sachs, where she had no shortage of brilliant colleagues. But one colleague convinced her that the financial system would collapse and that gold was the only safe haven. Her father listened, cashed out of stocks at the worst moment, and lost a fortune in gold. When I spoke with him months later, stocks were skyrocketing, but he feared it was too late for him to get back in. He was utterly dejected.

It saddens me to say this, but these two former clients have both suffered permanent financial damage because of rash decisions they made during the bear market. The reason? Their emotions got the better of them. In the next chapter, we’ll look at how to avoid some of the most common psychological mistakes that trip up investors. But first, let’s focus on an equally critical subject: how to prepare for the next bear market by constructing a diversified portfolio that reduces your risks and enhances your returns. This will help you to generate increasing wealth in any environment and allow you to sleep soundly at night!

The Ingredients of Success

Harry Markowitz, the Nobel Prize–winning economist, famously declared that diversification is the “only free lunch” in investing. If so, what are the ingredients? We’ll run through them quickly here, looking at stocks, bonds, and alternative investments. Then we’ll discuss how to mix these together to create a well-diversified portfolio. But before we get to that, it’s worth clarifying why a portfolio should include multiple asset classes.

Let’s start with a simple thought experiment. Imagine that I have a bunch of guests in my house. I offer them $1 each to walk across the street. As it happens, I live on a quiet suburban road with little traffic. So my offer feels like free money. But let’s say I repeat the offer, and this time I give them two choices: either they can cross my street for $1, or they can cross a four-lane highway for $1. Nobody will take me up on this offer to cross the highway. But what if I offer $1,000 or $10,000? At some point, I’ll arrive at a figure that entices someone to cross that highway!

What I’ve just illustrated is the relationship between risk and reward. There’s a risk of injury in both scenarios—and, as that risk increases, the reward must rise in order for this to be perceived as a fair deal. The additional reward you receive for taking that additional risk is called a risk premium. When experts determine your asset allocation, they evaluate the risk premium for each asset. The riskier an asset seems to be, the greater the rate of return an investor will demand.

As a financial advisor, I construct a client’s portfolio by combining asset classes, each with different risk characteristics and different rates of return. The goal? To balance the return you need to achieve with the risk you’re comfortable taking. The beauty of diversification is that it can allow you to achieve a higher return without exposing yourself to greater risk. How come? Because different asset classes don’t usually move in tandem. In 2008 the S&P 500 fell 38%, whereas investment grade bonds rose 5.24%.I If you owned stocks and bonds, you took less risk—and achieved better returns—than if you owned only stocks.

Now let’s look at the major asset classes we can combine to help you reach the promised land!

Stocks

When you buy a stock, you’re not buying a lottery ticket. You’re becoming a part owner of a real operating business. The value of your shares will rise or fall based on the company’s perceived fortunes. Many stocks also pay dividends, which are quarterly distributions of profits back to the shareholders. By investing in a stock, you’re making the shift from being a consumer to being an owner. If you buy an iPhone, you’re a consumer of Apple products; if you buy Apple stock, you’re an owner of the company—and are entitled to a percentage of its future earnings.

What can you expect to earn as an investor in stocks? It’s impossible to predict, but we can use the past as a (very) rough guide. Historically, the stock market has returned an average of 9% to 10% a year over more than a century. But these figures are deceptive because stocks can be wildly volatile along the way. It’s not unusual for the market to fall 20% to 50% every few years. On average, the market is down about one in every four years. You need to recognize this reality so you won’t be shocked when stocks tumble—and so you’ll avoid excessive risks. At the same time, it’s useful to recognize that the market has made money three out of every four years.

In the short term, the stock market is entirely unpredictable, despite the claims of “experts” who pretend to know what’s going on! In January 2016, the S&P 500 suddenly sank 11%; then it made a U-turn and rose nearly as rapidly.

Why? Howard Marks, one of America’s most respected investors, candidly told Tony, “There was no good reason for the decline. Equally, there was no good reason for the recovery.”

But in the long run, nothing reflects economic expansion better than the stock market. Over time the economy and the population grow, and workers become more productive. This rising economic tide makes businesses more profitable, which drives up stock prices. That explains why the market soared over the course of the twentieth century, despite all those wars, crashes, and crises. Now do you see why it pays to invest in the stock market for the long term?

Nobody understands this better than Warren Buffett. In October 2008 he wrote an article for the New York Times encouraging people to buy US stocks while they were on sale, even though the financial world was “a mess” and the “headlines will continue to be scary.” He wrote: “Think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long term, the stock market news will be good.” I suggest you commit that line to memory: “Over the long term, the stock market news will be good.” If you truly understand this, it will help you to be patient, unshakeable, and ultimately rich.

So where do stocks fit within your portfolio? If you believe that the economy and businesses will be doing better 10 years from now, it makes sense to allocate a good portion of your investments to the stock market. Over a 10-year period, the market almost always rises. Still, there are no guarantees. A study by asset management company BlackRock showed that the market averaged -1% per year from 1929 to 1938. The good news? BlackRock noted that this 10-year losing streak was followed by two consecutive 10-year periods of robust gains as the market resumed its upward trajectory.

Of course, the challenge is to stay in the market long enough to enjoy these gains. The last thing you want is to be a forced seller during a prolonged bear market. How do you avoid that fate? For a start, don’t live beyond your means or saddle yourself with too much debt—both reliable ways to put yourself in a vulnerable position. As much as possible, try to keep a financial cushion, so you’ll never have to raise cash by selling stocks when the market is crashing. One way to build and maintain that cushion is to invest in bonds.

Bonds

When you buy a bond, you’re making a loan to a government, a company, or some other entity. The financial services industry loves to make this stuff seem complex, but it’s pretty simple. Bonds are loans. When you lend money to the federal government, it’s called a Treasury bond. When you lend money to a city, state, or county, it’s a municipal bond. When you lend money to a company such as Microsoft, it’s a corporate bond. And when you lend money to a less dependable company, it’s called a high-yield bond or a junk bond. Voilà! You’ve now completed Bonds 101.

How much can you earn as a money lender? It depends. Loaning money to the US government won’t earn you much because there’s little risk that it’ll renege on its debts. Loaning money to the government of Venezuela (where inflation may hit 700% this year) is way riskier, so the interest rates need to be much higher. Again, it’s all a trade-off between risk and reward. The US government is asking you to cross a traffic-free rural road on a sunny day; the Venezuelan government is asking you to cross a busy highway on a stormy night while wearing a blindfold.

The odds that a company will go bust and fail to repay its bondholders are higher than the odds that the US government will default on its loans. So the company has to pay a higher rate of return. Similarly, a young tech firm that wants to borrow money must pay a higher rate than a blue-chip giant such as Microsoft. Rating agencies like Moody’s use terms such as “Aaa” and “Baa3” to grade these credit risks.

The other critical factor is the duration of the loan. The US government will currently pay you about 1.8% a year for a 10-year loan. If you lend the government that money for 30 years, you’ll earn about 2.4% a year. There’s a simple reason why you receive a higher rate for lending the money over a longer period: it’s riskier.

Why do people want to own bonds? For a start, they’re much safer than stocks. That’s because the borrower is legally required to repay you. If you hold a bond to maturity, you’ll receive all of your original loan back, plus the interest payments—unless the bond issuer goes bankrupt. As an asset class, bonds deliver positive calendar-year returns approximately 85% of the time.

So where do bonds make sense in your portfolio? Conservative investors who are retired or can’t tolerate the volatility of stocks might choose to invest a large percentage of their assets in bonds. Less conservative investors might put a smaller portion of their assets in high-quality bonds to meet any financial needs that could arise over the next two to seven years. More aggressive investors might keep a portion of their money in bonds to provide them with “dry powder” that they can use when the stock market goes on sale. This is exactly what Creative Planning did during the financial crisis: we sold some of our clients’ bonds and invested the proceeds in the stock market, snapping up once-in-a-lifetime bargains.

There’s just one problem: it’s hard to be enthusiastic about bonds in today’s weird economic environment. Yields are abysmally low, so you earn a paltry return for the risk you’re taking. It seems particularly unappealing to invest in US Treasuries, which recently offered their lowest yields ever. Overseas, the situation gets even wilder: the Italian government recently sold a 50-year bond with a 2.8% interest rate. That’s right! If you loan your money for a half century, you might be “lucky” enough to make 2.8% a year—if this economically vulnerable country doesn’t run into trouble. It’s one of the worst bets I’ve ever seen.

The challenge is that you earn nothing these days if you keep your money in cash. In fact, after inflation, you’re losing money by holding cash. At least bonds provide some income. As I see it, bonds are now the cleanest dirty clothing in the laundry pile.

Alternative Investments

Any investments other than stocks, bonds, and cash are defined as alternatives. That includes exotic assets such as your Pablo Picasso collection, your cellar full of rare wines, the vintage cars in your air-conditioned garage, your priceless jewels, and your 100,000-acre ranch. But we’ll focus here on a few of the most popular alternatives, which are likely to be relevant to a broader audience.

First, a word of warning: many alternatives are illiquid (in other words, hard to sell), tax inefficient, and laden with high expenses. That said, they have two attractive attributes: they can (sometimes) generate superior returns; and they may be uncorrelated to the stock and bond markets, which means they can help to diversify your portfolio and reduce overall risk. For example, if the stock market drops 50%, you don’t suffer a 50% drop in your net worth, because all your eggs aren’t in one basket. Any challenge you face is much smaller.

Let’s look at five alternatives, starting with three that I like, followed by two that I don’t:

• Real Estate Investment Trusts. I’m sure you know people who’ve done well by investing directly in residential property. But most of us can’t afford to diversify by owning a slew of houses or apartments. That’s one reason why I like to invest in publicly traded real estate investment trusts (REITs). They provide a no-hassle, low-cost way to diversify broadly, both geographically and across different types of property. For example, you can own a small slice of a REIT that invests in assets such as apartment buildings, office towers, senior housing facilities, medical offices, or shopping malls. You get to benefit from any appreciation in the price of the underlying property, while also receiving a healthy stream of current income.

• Private Equity Funds. Private equity firms use pooled money to buy all or part of an operating company. They can then add value by, say, restructuring the business, cutting costs, and minimizing taxes. Ultimately, they attempt to resell the company for a much higher price. The upside: a private equity fund that’s run with true expertise can make outsized profits while also adding diversification to your portfolio by operating in the private market. The downside: these funds are illiquid, risky, and charge high fees. At Creative Planning, we’re able to leverage our relationships, and $22 billion in assets, in order to gain access to funds managed by one of the country’s top-10 private equity companies. Their minimum investment is usually $10 million, but our clients can invest with a minimum of $1 million. As you can see, this isn’t for everyone, but the best funds may well earn their high fees.

• Master Limited Partnerships. I’m a big fan of MLPs, which are publicly traded partnerships that typically invest in energy infrastructure, including oil and gas pipelines. What’s the appeal? As Tony mentioned in the last chapter, we sometimes recommend MLPs because they pay out a lot of income in a tax-efficient way. They don’t make sense for many investors (especially if you’re young or have your money in an IRA), but they can be great for an investor who is over 50 and has a large, taxable account.

• Gold. Some people have an almost religious belief that gold is the perfect hedge against economic chaos. They argue that it’ll be the one true currency if the economy falls apart, inflation soars, or the dollar collapses. My view? Gold produces no income and is not a critical resource. As Warren Buffett said once, “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again, and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.” Even so, gold prices soar occasionally, and everyone piles in! Every time—without exception—the price has ultimately collapsed. Historically, stocks, bonds, energy commodities, and real estate have outperformed gold. So count me out.

• Hedge Funds. At Creative Planning, we have no place for hedge funds in our portfolios. Why not? A few of these private partnerships have performed brilliantly over many years, but it’s a minuscule minority—and the very best of them tend to be closed to new investors. The problem is, hedge funds start with a huge disadvantage in every major category: fees, taxes, risk management, transparency, and liquidity. Most charge 2% a year, no matter what, plus 20% of their investors’ profits. What do you get in return? Well, from 2009 to 2015, the average hedge fund lagged the S&P 500 for 6 years in a row. In 2014 the nation’s largest pension fund, CalPERS (the California Public Employees’ Retirement System), abandoned hedge funds entirely. As I see it, hedge funds are handmade for suckers or for speculators looking to roll the dice on a big bet. They’ll make someone rich, but it ain’t likely to be you or me.

A CUSTOMIZED APPROACH TO ASSET ALLOCATION

Now you know what ingredients you can use, but how should you combine them to create the perfect meal? The truth is, there’s no single method that’s right for everyone. Yet many advisors use a cookie-cutter approach to asset allocation, ignoring critical differences in their clients’ needs. That’s like serving steak to a vegetarian or kale salad to a carnivore.

One common—but misguided—approach involves using a person’s age to determine the percentage of bonds in his or her portfolio. For example, if you’re 55, you’d have 55% of your assets allocated to bonds. To me, that’s crazily simplistic. In reality, the type of assets you own should be matched to what you personally need to accomplish. After all, a 55-year-old single mom who is saving for her kid’s college tuition has different priorities than a 55-year-old entrepreneur who’s just sold her business for millions and wants to build a philanthropic legacy. It makes no sense to treat them as if their needs are the same just because they’re the same age!

Another common approach involves basing a person’s asset allocation on his or her tolerance for risk. As the client, you fill out a questionnaire to establish whether you’re an aggressive or conservative investor. You’re then sold a prepackaged model investment portfolio that supposedly matches this risk profile. To me, this approach is equally misguided because it ignores your needs. What if you’re risk averse but have no chance of retiring unless you invest heavily in stocks? Setting you up with a conservative portfolio loaded with bonds would just doom you to disappointment.

So how should you approach the challenge of asset allocation? As I see it, the real question that you and your financial advisor have to answer is this: What asset classes will give you the highest probability of getting from where you are today to where you need to be? In other words, the design of your portfolio must be based on your specific needs.

Your advisor should start by getting a clear picture of where you are today (your starting point), how much you’re willing and able to save, how much money you’ll need, and when you’ll need it (your ending point). Once these needs have been clearly identified, your advisor should provide a customized solution to help you achieve them. Can you figure all of this out yourself, without hiring a professional? Sure. But the stakes are high, and you don’t want to mess up. So it probably makes sense to get help, unless you’re particularly knowledgeable about these matters.

In any case, let’s say you need an average annual return of 7% over the next 15 years so you can retire. Your advisor might conclude that you ought to invest, say, 75% of your portfolio in stocks and 25% in bonds. It doesn’t matter if you’re 50 or 60 years old. Remember: your needs determine your asset allocation, not your age. Once your advisor has settled on the right allocation to meet those needs, you should discuss whether you can live with the volatility you’re likely to experience. If you can’t, then you can adjust your goal downward, and your advisor can create a more conservative allocation that allows you to achieve this scaled-back goal.

A sophisticated advisor will customize your portfolio to address whatever is unique about your financial situation. Let’s say you work for an oil company and have a hefty portion of your net worth in your employer’s stock. Your advisor would adjust your asset allocation accordingly to ensure that your other investments don’t expose you too heavily to the energy sector.

Another priority is to create a customized game plan that minimizes your tax liabilities. Let’s say you show an existing portfolio to a new advisor. Your asset allocation is clearly out of whack, so the advisor suggests a total overhaul. In a perfect world, he or she may be right. But what if your investments have done well, and selling them would saddle you with a big tax bill on all your capital gains? A sophisticated advisor would first assess the tax impact of selling these assets. As a result, you might end up taking a much slower approach—for example, using your additional monthly contributions to build more gradually toward your new allocation.

The point is, you want an advisor with the skills to tailor your portfolio to suit your specific needs. A one-size-fits-all approach to asset allocation can be disastrous. It would be like going to a doctor who tells you, “This drug I’m giving you is the best arthritis treatment in the world.” Your reply: “That’s great, Doc, but I don’t have arthritis! I’ve got a cold.” CORE AND EXPLORE

Before we wrap up this chapter, I want to leave you with a few key guidelines to keep in mind when you’re constructing (or reconstructing) your portfolio. These are principles we live by at Creative Planning, and I’m confident that they’ll serve you well through sunny days and storms!

1. Asset Allocation Drives Returns. Let’s start with the fundamental understanding that your asset allocation will be the biggest factor in determining your investment returns. So, deciding on the right balance of stocks, bonds, and alternatives is the most important investment decision you’ll ever make. Whatever mix you choose, make sure you diversify globally across multiple asset classes. Imagine being a Japanese investor with all your money in domestic stocks: Japan’s market is still down from the insane heights it reached in 1989. The moral: never bet your future on one country or one asset class.

2. Use Index Funds for the Core of Your Portfolio. At Creative Planning, we use an approach to asset allocation that we call “Core and Explore.” The core component of our clients’ portfolios is invested in US and international stocks. We use index funds because they give you broad diversification in a low-cost, tax-efficient way, and they beat almost all actively managed funds over the long run. For maximum diversification, we want exposure to stocks of all sizes: large-cap, midcap, small-cap, and microcap. By diversifying so broadly, you protect yourself against the risk that one part of the market (say, tech stocks or bank stocks) could get crushed. By indexing, you enjoy the long-term upward trajectory of the market without letting expenses and taxes corrode your returns. For other parts of your portfolio, there are more sophisticated options to consider, as we will discuss later.

3. Always Have a Cushion. You never want to be in a position where you’re forced to sell your stock market investments at the worst moment. So it makes sense to maintain a financial cushion, if at all possible. We make sure our clients have an appropriate amount of income-producing investments such as bonds, REITs, MLPs, and dividend-paying stocks. We also diversify broadly within these asset classes: for example, we invest in government bonds, muni bonds, and corporate bonds. If stocks crash, we can sell some of those income-producing investments (ideally bonds, since they are liquid) and use the proceeds to invest in the stock market at low prices. This puts us in a strong position where we can view the bear as a friend rather than a fearsome enemy.

4. The Rule of Seven. Ideally, we like our clients to have seven years of income set aside in income-producing investments such as bonds and MLPs. If stocks crash, we can tap these income-producing assets to meet our clients’ short-term needs. But what if you can’t afford to set aside years of income? Simply start with an achievable goal and keep raising the bar as you progress. For example, you might start with a goal of saving three or six months of income, and then work your way—over many years—toward the ultimate goal of setting aside seven years of income. If that sounds impossible, check out the wonderful story of Theodore Johnson, a UPS worker who never earned more than $14,000 a year. He saved 20% of every paycheck, plus every bonus, and invested in his company’s stock. By age 90, he’d accumulated $70 million! The lesson: never underestimate the awesome power of disciplined saving combined with long-term compounding.

5. Explore. The core of our clients’ portfolios is invested in index funds that simply match the market’s return. But at the margins, it can make sense to explore additional strategies that offer a reasonable chance of outperformance. For example, a wealthy investor might add a high-risk, high-return investment in a private equity fund. You might also decide that a particular investor like Warren Buffett has a specific advantage, which could justify putting a modest portion of your portfolio in shares of his company, Berkshire Hathaway.

6. Rebalance. I’m a big believer in “rebalancing,” which entails bringing your portfolio back to your original asset allocation on a regular basis—say, once a year. At Creative Planning, we take opportunities to buy as they happen, rather than waiting for the end of the year or quarter. Here is how it works: imagine you start with 60% in stocks and 40% in bonds; then the stock market plunges, so you find yourself with 45% in stocks and 55% in bonds. You’d rebalance by selling bonds and buying stocks. As Princeton professor Burton Malkiel told Tony, unsuccessful investors tend to “buy the thing that’s gone up and sell the thing that’s gone down.” One benefit of rebalancing, says Malkiel, is that it “makes you do the opposite,” forcing you to buy assets when they’re out of favor and undervalued. You’ll profit richly when they recover.

A FINAL WORD

If you follow the advice in this chapter, you’ll be able to ride out any storm. Sure, there’ll be turbulent times when the news is full of frightening headlines. But you’ll have the comfort of knowing that your portfolio is properly diversified, so it can withstand any market mayhem.

In chapter 2, you learned that there’s no need to fear market corrections, and I hope you see now that there’s no need to fear bear markets, either. In fact, they provide the best opportunity to buy the bargains of a lifetime, so you can leapfrog to a whole new level of wealth. The bear is your gift—one that comes, on average, once every three years! These aren’t just times to survive. These are times to thrive.

But as you and I both know, there’s a big difference between theory and practice. Just think of my former client who cashed out of the stock market and gambled everything on gold during the last bear market. Fear led him to jettison a carefully constructed plan that would have ensured him a future of total financial freedom. So how can you make sure that your own emotions won’t get out of hand and knock you off course?

The next chapter will focus on how to master the psychology of wealth so you won’t make the common—and entirely avoidable—financial mistakes we see again and again. As you’ll discover, there’s only one real barrier to financial success: you! Once you know how to silence the enemy within, nothing can stop you.