I’m going to give you another portfolio landmine from my new book, in a continued attempt to teach you how to identify potential hidden dangers in the way you invest, before the next crash hits and hurts you like it did in the year 2000 and much worse like it did in 2008.
As you know, if you are a regular follower of this blog, landmines are hidden investments or practices that you don’t know are dangerous until you step on them. So, a big part of success in investing is not so much knocking the ball out of the park and making a killing, it more about not blowing yourself up when things go wrong. So let’s talk about landmine #11 “Putting All of Your Eggs in ONE SYSTEM”.
Now, when you think about the typical way that Wall Street peddles their goods, which are mostly mutual funds or what I like to call public swimming pools of money, you think about diversification, asset allocation, pie charts and graphs, allocating your money between stocks and bonds and spreading your risk between things that are not supposed to move in unison with each other. Most of the time, just like your broker claims, that works just fine…UNTIL it doesn’t, like in 2008 when the credit markets froze, the real estate market went into a free fall and stocks lost an average of about 50% of their value in a very short period of months. So, in that scenario, you could have followed Wall Street’s beloved MPT and still have been damaged beyond repair, especially if you were older and didn’t have 20 years to recover before retirement.
So today, I want to introduce you to the theory of system diversification, which is a whole different level of protection that the super wealthy have been using for years.
When you think about stocks and bonds, and now even real estate, although they are all very different types of investments, they are all part of the same system which is supported by Wall Street. Until about the year 2000, in all fairness, most people did not consider real estate to be part of Wall Street, but something happened to make real estate just as risky as stocks and bonds that changed the system forever. Wall Street figured out a way to create securities made out of residential mortgages, package them up into a nice little pool, and sell them to investors all over the world. Remember the old days when the bank that gave you the mortgage actually kept it and serviced you for 30 years? Well, Wall Street changed all of that. Now, at first banks thought it was pretty cool to lend a bunch of money, collect all kinds of closing fees, and then, 30 days later, sell the loan to Wall Street and do it all over again. The problem arose when Wall Street started hiding sub-prime loans inside of relatively clean pools, which is ultimately what corrupted the system. When everyone suddenly realized that the pool had some mortgages under the surface that would never pay off, they panicked and started to dump everything.
As a result, in 2008, the credit markets froze, which took real estate into a free fall, because if banks are not willing to lend money to people, real estate can’t work. Especially if the loans that banks already have made are in question of default, it becomes a free fall. Well, that same issue affects another part of the system, the stock market. If banks are not able to lend to corporations to fund their short and long term cash flow needs, the stocks of those companies will plummet. If that happens, people will start to question the long term viability of the company, and their bonds will start to react over the fear of default.
These are just a few of the details of 2008, but the big surprise for many is that all of these supposedly different investments were all part of the same system. So, how can you diversify some of your risk away from this system? The answer is that you need to have some of your assets in other systems. There are several types of investments that my team and I use in my wealth management practice that are not directly part of the Wall Street machine, but the one I want to share with you today has been around for about 200 years and is the safest system this country has ever seen. This system has survived through every imaginable crisis, and it is still the most stable system anywhere. I’m talking about insurance companies and specifically having a portion of your assets inside of specially designed policies that allow your money to remain liquid, safe, earning a good rate of return and if designed properly, can be accessed 100% tax free. This “other” system has the longest track record of safety of any investment in our history, and the great thing about using it as part of your investment strategy is if you die while you are accumulating your fortune, your family gets a big chunk of money to go on without you. That is in no way similar to the stock or bond or real estate industry.
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photo credit: Luke Hayfield Photography via photopin cc