It sounds good on paper.  20% bonds, 60% stocks, 20% commodities/alternative investments.  Or if you would like to make it even more detailed:

15% investment grade bonds, 5% high yield bonds, 20% small cap growth stocks, 20% consumer goods and 20% industrial/cyclical stocks combined with 10% in REITs and 10% in a hedge fund.

Keep your investments spread out, and automatically re-balancing your portfolio will ensure your percentages stay spot on and correctly diversified right?

So the only slight issue is that you are ruining your returns.  We can just apply a bit of common sense and we will realize the issues with blind/automatic/frequent re-balancing.  We will not even need a chart or graph or table this time.  Think about what happens when you re-balance a portfolio.

Say you have a portfolio of 10 investments, each one with 10%.

In our first scenario, 5 of them go up 50%, 5 of them stay flat.  You re-balance all of them so that they stay at 10% each.  What you have just done is, take money out of an investment going up and reinvesting that money in a company that is going nowhere.

Scenario 2, 5 of them go down and 5 of them are flat.  You re-balance and dump more money into investments that are going down and taking it out of investments that are holding their value.

For scenario 3, worst case, 5 of them go up and 5 of them go down.  So you are taking money out of investments earning you a good return and dumping them into investments that are losing you money.

Not to mention, each time the portfolio is rebalanced, transaction fees may and probably will apply.

What would make more sense when selling and buying another investment, is if an investment has

• reached it’s estimated intrinsic value
• become impaired, either bad capital allocation, change of management, poor corporate governance, etc…
• lower potential return than another investment that has become known and actionable

This way, you are selectively selling investments that no longer have the potential for good returns and allocating the money to investments that will offer the ability to provide greater returns.

Most brokerages I have dealt with love automatic re-balancing and asset allocation.  Especially if it is done monthly.  With transaction fees on each buy and sell, having that done to every single client account for every single holding to make minor adjustments of 1-2% and then doing it 12 times a year?  Brokerages would love you for it.  While most only re-balance once a year, please keep in mind that automatic re-balancing may not be the best method for you.

One caveat is that it may work in some indexing situations, but when buying and selling individual investments, it can lead to mediocre and depressed returns.  More often than not you may be better off just leaving the investments alone.

There is a magic number for everyone.  It will not always be the same, but there is how to get a rough idea.

For  people who index, this is a moot point.  When you buy indexes, you have anywhere from hundreds to thousands of stocks in your portfolio.

Same situation for people who only hold mutual funds.

Now for self investors who buy individual stocks and advisors who purchase stocks on behalf of the clients.  The graph below shows the benefits of diversification.

On the vertical Y axis, it is referring to volatility of the investments.  How much and how often do the investments go up and down in value.  As you can see, around 10 you start having large diminishing returns for each additional stock you add to your portfolio.  As you get closer to 20, the change becomes very minuscule.  So for most investors of individual stocks, 10-20 stock holdings is probably what you would need to be adequately diversified, assuming they are not all 20 tech stocks, or 20 retail stocks or 20 iron miners or something of that nature.

Assuming you are doing your homework on each investment, it would not make sense to hold much more than that.  If I told you to think of 3 good business ideas, you could probably come up with something practical and plausible.  Now if I were to tell you to think of 100 good business ideas.  I’m sure about 90 of them would be worse than you top 3 ideas.

Same goes for investing.  If you have picked out 20 good investments, which is quite a bit in itself already.  If you find a better investment, why would you not swap one of the 20 out?  That and the chances are the investment will not be as good as you first 10 or 20 ideas.

So concentrating a portfolio may give better returns by investing in your best ideas and over diversifying may dilute the returns by having too many mediocre ideas.  If you have 3 great ideas, and 7 good ideas, would you not want to put more into the great ideas?  This line of thinking goes along with the issues of dollar cost averaging (in this post).  Why put money in many mediocre ideas over placing them into your few great ideas?

In the eggs and basket analogy, if you have a basket padded on the inside with the softest goose feathers and the outside is made of indestructible adamantium, then it may make sense to put more of your eggs into that basket, than into 10 baskets of woven grass.

Lastly, it also comes down to what lets you go to sleep at night.  I know of investors who invest in 4-6 stocks.  That is it.  Nothing more.  They drill down deep, do all their homework and double check their facts and the investment style suits their personality.  At Lodestone Capital Solutions LLC, we invest in a mixture of stocks, mutual funds and ETFs, but we limit our ideas to roughly 10-20 different investment positions.

But once you are close to the retirement age and have done all your saving, there needs to be a change in the mindset.  It is no longer save and  grow.  It is protect  and prolong the assets life to keep throwing off that money to pay for your daily needs.

Roughly 2/3s of bankruptcies are caused by medical bills, while not all of it is attributed to LTC, it is an indication of the severity and the lack of planning by most families.  With term life insurance, the majority of people never use it or receive a benefit from it, but with LTC, over 2/3s of the people who purchase a policy will end up needing it.  That is an extremely high probability.

Face it, there comes a time when you get to an age where you may need help getting changed, walking around, showering, eating, etc…, and there are 2 primary ways of dealing with it.

1. You hope your spouse or children are able to wait on you hand and foot.  While this would be a great show of devotion, most parents would not like to put such a burden on their children or spouse.
2. You pay someone to help take care of you.  Either at home or in a nursing home.  Keep in mind a good nursing home runs anywhere from 60k-80k a year if you want to live decently.

With that said, LTC is a good way to protect your assets and to avoid putting a large burden on your family.  Not to mention the mental aspect of it.  Most people would prefer their loved ones not see them in such a dependent/infirmed state.  With LTC, the skilled care helps provide you a modicum of independence and respect.

LTC policies are expensive, but not compared to the costs of providing skilled care to someone who is unable to live by themselves.  A monthly premium from 200-400, is much preferable to paying out 60,000-80,000 a year for nursing home care.

So one of the major difference is that with ETFs, you can trade them throughout the day.  Mutual funds reprice at the close and trade at that price.  So while it is slightly less liquid, it generally is not a huge issue unless you need the money that day and cannot wait 24 hours.

ETFs generally also have slightly lower fees, but low expense mutual funds are very competitive as well and can offer roughly the same expense ratios if you look hard enough.

We are believers in active management.  So we have a list of good managers/mutual funds we keep an eye on.  But for an indexer, ETFs may be a good supplement/alternative to purely mutual funds.

Instead of using a rent vs buy calculator, the best way to start is to think about why you want to buy.  Is it because you see everyone else buying?  Or because you can earn money through appreciation?  Or because you are tired of throwing away your money on rent?  Or do you need the space for a family, or want pride of ownership?

All these reasons may or may not be valid depending on your own circumstances.  I know that sounds like a cop out answer, it is, but it is also the truth.

Assuming you have decided to buy a home for your own reasons, then you can go ahead and use the rent vs buy calculators.  I went ahead and googled and test out 3 of them.  Many do not include the tax benefit from home buying.  Others do not account for the opportunity cost of placing the money for the home into an investment account, and others do not account for all the expenses associated with homeownership.  Granted these are free online tools, they give you an estimate as to if it is better for you to rent or buy.  Or better for them in any case as they are trying to sell you a home.

The biggest question that needs to be asked is if it is feasible.  Not just on paper through rent/buy calculators, but also from your own balance sheet and income statement capabilities.  Questions such as:  If you bought a home and you were laid off, would you be able to find another job to pay for the mortgage?  Do you have enough money saved up in case it takes you a bit longer to find that job?  Do you have any other major expenses that might be coming up?  If you’re married, do you both work, will one spouse pick up the slack if another is laid off, do you have a contingency plan if you are both laid off? 

The trick is fitting homebuying into your lifetime of cash flows (please see my  fish analogy) and looking at “the big picture”  Home buying is important, but it is not the only important thing in your life. 

When we think banks, we use to think Bank of America (BAC), Wells Fargo (WFC), JP Morgan Chase (JPM), and Citigroup (C).  The general sense is they are a commercial bank.  You put money in the bank, earn a slight rate of interest and you can go there to obtain a loan/mortgage.

On the flip side, when you thought of brokerage houses, you thought Charles Schwab, Fidelity, Vanguard, Barclays, Blackrock or even TradePMR.  They are places where you place money to invest in.  Buying and selling stock, bonds, commodities, options, etc..

What happened was the removal of the separation of commercial banking and securities activities, often referred to as Glass-Steagall.  You can read more about it here.  So with that removed, banks started offering investment advisory products and services and brokerage houses started offering banking services.

Now there is Bank of America with Merrill Lynch as their investment arm, Wells Fargo, JP Morgan and Citigroup all offering Traditional/Roth IRAs, investment accounts, and investment advisory services.  At Fidelity and Schwab, they have debit cards and bank accounts and check writing privileges on their accounts.  So with the blend, companies from both sides are combining and competing for the same resources.

With that said, we can now clarify how each part of the services work.

1. Banking services we have explained above
2. Brokerage services is creating/holding/trading the funds for clients and generally earning a fee per transaction, such as buying or selling a stock/mutual fund.  This would be opening a brokerage account, IRA, 401k, etc.. and then a fee per purchase/sale of an asset.
3. Investment Advisory services.  This is as it sounds.  Payment for investment advice.  Often this is a flat up front fee or a smaller ongoing monthly/annual fee.
4. Clearing house.  They earn money by routing/completing the transaction for the purchase/sale of an asset.  Remember, each time you buy or sell a stock, there is someone on the other side selling or buying in return.  So the sellers and buyers must be matched.

So for a few examples.  Fidelity Investments now offers banking services in addition to their brokerage services.  They also provide investment advisory services for clients who wish to engage them in that capacity.  Then, they clear through National Financial, their clearing arm.

Wells Fargo offers banking services and also offer brokerage services through IRAs, brokerage accounts and 401ks.  They also offer investment advisory services and they clear through First Clearing LLC.

We at Lodestone Capital Solutions LLC offer investment advisory services and financial planning, but the banking and brokerage services are provided for by TradePMR whom uses First Clearing LLC (same as Wells Fargo) to clear their trades.  For more details on what financial planning is click here.

People often ask, what is the difference between going with any of these firms?  Besides the supposed quality of service, not much.  They all perform the same functions.  All investment advisory accounts are covered by SIPC up to 500,000 and all bank accounts are covered by FDIC up to specific limits based on account ownership/titling.

That then leads to the next question, of will smaller firms go under compared to large firms like Merrill Lynch or ETrade.  Unless they dabbled in the derivatives markets, firms that strictly provided brokerage services, meaning only earning monies from trades and holding of assets, have nothing to impair their balance sheet and had very little risk of going under.  Same with investment advisory services.  I would go as far to say Lodestone Capital Solutions LLC and Trade PMR (I use our firms, but any smaller focused firm would be in the same position) are as solvent if not more solvent/safe than many of the big firms as the focus is on earning money from trading for TradePMR and at Lodestone Capital Solutions, it is from management and growth of assets.

With that, we can assumption of:

1. Maximum contributions into both retirement accounts
2. The maximum contribution increasing at 3%/year assumed for cost of living adjustments.
3. Estimates of 4%, 8% and 12% annual compounded returns
4. Starting age of 25, For someone of age 40, find the closest corresponding retirement savings you have and start from that year.  Ex:  45 year old has 350,000 in retirement, start counting from age 33 and stopping at age 53 (45 +20 =65)
5. Not including any company matching or profit sharing
6. Contributions are made at the end of each year
7. Rounded to the nearest dollar
8. To keep it simple, we are ignoring inflation, taxes and pre tax vs after tax versions of both accounts.

Below is a quick excel spreadsheet of if you maxxed out your two accounts from age 20.

As you can see, total contributions over the 40 years will total almost 1.7 million.  Total resulting account value will be 3.5, 8.7 and 24.3 million respectively with the powers of compounding.  Using the 8% return column, it leaves 8.7 million to use over the next 35 years of your life.  Not too shabby right?.

Assuming inflation doubles prices every 20 years, leaves you 2.175 million, then after taxes of 35%, leaves you 1.41 million in today’s dollars.  Then, assuming you wish to leave nothing to your heirs from these two accounts and a 4% return, will net you roughly 75,544/year after tax or 6300 cash to use a month.  While not great, most people would agree that it would provide for a comfortable lifestyle in retirement.

I found an infographic on Warren Buffet.  One of the greatest investors of all times and one we try to mimic here at Lodestone Capital Solutions.  It shows a quick snapshot of his philosophy, hobbies and life achievements.  For a larger version, please go here

1. Are you comfortable with the amount of money you have?  Is it enough?
2. When you think about your finances, do you feel peaceful and at ease?
3. Are you spending as much time with friends & family as you would like? (or have an idea of how much time you would like with a method of achieving that free time?)
4. Do you come home from your job feeling fulfilled?
5. Do you have time to participate in things you believe are worthwhile?
6. If you were laid off from your job, would you see it as at tragedy or an opportunity?
7. Do you have enough savings to support yourself through six months of living expenses?
8. If you were to pass away in the next few years, would you feel comfortable with your legacy to your children and family, and possibly to your community and the world?
9. Do you have a good balance between all aspects of your life?  Does your job, family, possessions, relationships, values all fit well together?

In here, we try to get a feel for a client’s position, not just financially, but concerning their goals, values, and perceptions towards people, lifestyle habits, family and events.  People may think that everyone who has money is a good fit for financial planning.  But that is not entirely correct.

One of the hardest lessons is that not all clients are a good client.  Looking at it from the company perspective, you want clients who have an understanding of what we are trying to achieve.  I will not lie that if a client is bringing in 5 million dollars of assets for us to manage, that I would be more amenable to accepting him or her as a client, but personality and values are a major aspect of it.

A client who has 1 million assets, earns 400,000 a year and has personality quirks of always being right, never making a mistake and never needing to plan for the future (and no we’re not referring to this man )

vs a client who has 500,000 in assets and earns 100,000 a year and is willing to work with us to put his/her 2 children through college without loans.  Between those two, it is easy to see who will be a good fit for our firm.  With long working relationships, it is much easier to change the amount of assets a client has over time, than it is to change their personality.

One bank we are interested in is Bank of America.  A close second is Wells Fargo, but in this post we will focus on the former.  Banks have been hated on and unloved for the past few years and rightly so.  Along with all the news headlines and the issues in Europe, many investors are fearful of investing in banks, especially with all the short term volatility.  With that said, we are very aware of the possible backlash from Europe but with our banks becoming profitable and well capitalized, we do not see it as a long term concern.  It may cause large short term volatility in the stock price, but will have little impact on the long term profitability of our banks.

The biggest concern is the fear of Bank of America going under.  That is the item we must address before we proceed.  We start by looking at the balance sheet.  Taking a look at a balance sheet gives you a quick overview of the assets, liabilties and equity in a company.  Remember, assets – liabilities = equity and the equation can be moved around, as assets = liabilities + equity. 

Currently Bank of America trades at around 7-8 dollars per share.  With 10.8 billion shares outstanding, that is a market capitalization of ~82 billion. 

Book value is a measure of how much the company is worth in tangible and intangible items.  Such as goodwill and brand names, etc..etc..   Book value per share, is somewhere between 18-20/share for Bank of America.  Tangible book value, meaning just physical/real assets that can be sold with a concrete value, is around 10-12 dollars a  share.  So assuming a worst case scenario where Bank of America becomes bankrupt and must liquidated, people would receive a minimum 10-12 dollars a share minus any litigation/debt outstanding, assuming all their intangible assets are worthless.

Bank of America currently trades at 7-8 dollars/share.  That is a 25-45% margin of safety. 

Home mortgages are generally bundled up, slapped with a coupon and then sold to the public.  So say a RMBS, has 1,000 home mortgages packed together and is offering a coupon/interest rate of 4% to investors.

Mortgages usually have a high burn rate for the first few years and taper off over time.  Meaning if we have a package (bond/RMBS) of 100,000 mortgages, we would have the majority of the defaults in the first few years and a drastically reduced amount in remaining life of the mortgages/bond.  This seasoning, is normally caused by people who can’t pay their mortgage, usually default after a few years.  People who can pay their mortgage, generally have no issues paying it for 30 years.   

In our current situation, take all the 3/1 or 5/1 or even 7/1 ARMS (adjustable rate mortgages) that were sold to homeowners, a housing crash and a bad economy with high unemployment rates and you have an idea as to how unprofitable it was for banks, especially with lax underwriting of these loans/portfolios.  But note that  ARMs are generally 3/1 and 5/1 ARMs (artificially fixed at a low interest rate for 3 year or 5 year , then annually updated based on current interest rates).  This means that over the course of 5 years, most of the defaults/refinances will occur.  For us, the bad loans were funded starting in 03 and 04 and peaking in 06-07.  It has been 5-7 years since then.  This means  that the majority of the defaults have already occured.

After the financial crisis, Bank of America and the industry as a whole, has become very strict in their lending practices.  More than is probably necessary.  But that is to be expected as a result of the financial crisis.  The new loans they are writing are in house only to ensure their quality.  This is leading to a profitable book of mortgages.

With all this said, chances of Bank of America going under are very slim.  If they do go under, there is the protection from the margin of safety.  If they do not go under, and continue to generate to repair their balance sheet and start earning 1-2 dollars a share profit in normalized profits, then you are looking at a 15-25% earnings per share for your 7-8 dollar stock price. 

With a possible and plausible normalized earnings of 1.50+,  trading at a P/E of 12-15 would net a stock price of 18-22.

The volatility of the stock works in our favor as a value investor.  Markets tend to overreact and combined with daytrading and high frequency traders, allows us to find very favorable pricing.

One event that comes to mind is when AIG raised a lawsuit against Bank of America for 10 billion dollars. The instant market reaction was a drop of 20 billion in market cap. Meaning, just based on the fact that there is a lawsuit, not taking into account the chance of winning/losing the suit, the market automatically assumed, that it would lose, and somehow lose twice what the lawsuit amount was for.  As we have faith in our analysis of the firm, the lower the price goes, the more we can buy and earn an even greater return.

In an efficient market.  What should have happened is.  10 billion dollar lawsuit, chance of losing lawsuit 75%, chance of winning 25%, therefore a reduction of 7.5 billion in market price/share price should occur.

Disclaimer: Long BAC and WFC