Many of you are familiar with the popular show “Narcos” which depicts the true story of the growth and spread of drug cartels across the globe. The main character, Pablo Escobar, is the notorious Columbian kingpin and creates a fortune from selling cocaine in a variety of markets. Before he gets into the cocaine market, Pablo is an expert smuggler. He was able to get a variety of products in and out of Columbia for years without facing any criminal charges. Although Pablo’s acts were criminal in nature, they can teach us a great lesson on what’s called asset allocation in the markets.
We have talked about the importance of diversification before. Essentially not having all of your eggs in one basket. In this article, I’m going to take that a step further as we talk about asset allocation and why it is so important. First let’s take a look at 4 asset classes:
When you begin to grow your account, stocks are going to only be one piece of the puzzle when it comes to being well-diversified (aka protecting yourself against downside risk). Asset allocation is essentially balancing risk and reward between these asset classes. Asset allocation is going to be your long-term approach to investing and will be what makes the bulk of your wealth.
To better explain asset allocation let’s think back to Narcos. When Pablo first started expanded his business in Miami, he used “The Lion” to transport cocaine to the states. This was one man, carrying kilos in his jacket pockets. As his business grew and the factories started to produce more cocaine he began to transport it in a variety of different ways. He used shipping containers, mattresses, even pregnant women’s stomachs! The main point is he spread out his risk so that if one method was found by the DEA, then it did not ruin his entire supply!
The same can be said of your portfolio. Remember the economy is cyclical. We are going to have up and down periods. During these times, certain asset classes will perform better than others. For example, typically when the stock market is underperforming, the bond market will be outperforming. Think of each asset class as being an insurance policy on the other. Working together, they can create successful returns for your account, no matter what kind of market we are experiencing. Some of you might be thinking, “well what if something like 2008 happens and the whole market collapses. Will I still have successful returns then?” To answer that question, I think we need to define success. In 2008 the S&P 500 lost 37% of its value. If you had a good asset allocation and only lost 4% that year would you consider that a success? I definitely would!
Pablo Escobar understood that he was likely to make better returns if he spread out his risk. When his cocaine was uncovered in mattresses he only lost a small portion of money because other cocaine was spread out in hiding places that were doing well for him at the time! This might be one case where I encourage you to think like a drug kingpin. Your portfolio is cocaine; you need to protect it to build an empire.
The point of investing is to make money while we sleep, not lose sleep while we try to make money. You don’t want to constantly stress about your investments and we want to leave emotion out like we have talked about before. As you grow your account you want to determine percentages for your asset allocation and put it on autopilot. These percentages will be mixed between stocks, bonds, commodities, and cash. Let me briefly explain what each one is so you have a better understanding.
So we all know what stocks are by now from previous lessons but let’s break them down into two different categories.
Large cap stocks are companies with a market capitalization of more than $5 billion. Basically what this means is that this is a BIG company. A company that has been around for years and has shown is one of the top dogs in its market. Think Apple or IBM. These companies are said to be safer because of their long standing history than our the next category, small-cap.
Small-Caps are companies with a market capitalization of less than $1 billion. Even though these companies do not have as long of a track record, they are thought of to have high growth potential. Small-caps could eventually turn into large-caps. Think Shake Shak or Weight Watchers.
A bond is a debt instrument in which you loan money to an entity like a company or the government for a defined period of time and you receive interest payments off the loan. Think of it just like a car loan that you would be taking out except this time you get to be the banker. For example, a typical bond could be issued by Sprint. You buy a $1000 dollar, 8 year bond at 5%. This means that you will get $50 dollars in interest payments every year for 8 years. Most bonds are said to be safer than stocks because of this locked-in interest payment that you receive.
Commodities encompass everything from gold, silver, oil, natural gas, lumber, corn, beef, and many more products. Commodities are anything that are grown or extracted from their nature state and are brought up to a minimum grade for sale in a marketplace. Some popularly traded commodities are gold and silver because they provide protection if we had a downturn in the equity positions.
Cash is simply….cash. Its not invested in anything and is usually part of your asset allocation as part of a “rainy day” fund. You need some funds to be liquid so that you can pull out that money immediately and use it in case of emergencies. This cash portion of your account could grow as you age.
What percentages should I put into each?
The percentages that you put into each asset class will vary depending on your time horizon and risk tolerance. If we are younger, we can afford to take more risk because we have a greater time horizon to grow our money. At the same token, how much risk you want to take on is ultimately up to you. Stocks will be your riskiest investment but also give you the chance for the highest returns. As you get older you will want to slowly shift your portfolio into investments with less risk such as bonds to protect your principal.
If you want to be a successful long-term investor and retire wealthy, then protect your cocaine! Pablo was a businessman and just like a keen businessman, he had a great risk management strategy. Even when he accumulated more cash than he could put on the books, he began to bury it all over Columbia, spreading out the risk of it being found. You need to have similar mindset as you acquire more wealth over your lifetime. Spreading your risk will give you great returns every year and not cause you to lose any sleep.
“Silver or lead. You choose” -Pablo Escobar
Homework: Think back to the risk tolerance questionare you took in article, “Being a Robot Could Save You Millions”. Think about what your asset allocation would look like right now if you had 100k to investment. Divide your percentage of your 100k according.