Advanced Money School Lesson 4: Advanced Asset Allocation

Written by: David Weliver

Welcome back!

As promised, it’s time to turn our attention from planning and budgeting to investing.

Before we dive in, I’m going to ask you to revisit Lesson One and the picture you painted of You, Inc. Recall how we discussed why businesses must take calculated risks to survive and grow.

No risk, no reward.

This motto is taken for granted in the business world. Yet, many – perhaps most – individuals aim to eliminate risk from their lives – especially financial risk!

Unfortunately, here’s what happens if you avoid financial risk entirely: on a long enough timeline, you are guaranteed to go broke at the hands of inflation.

Now, if you have so much cash under your mattress that you can spend more and more each year and never run out before you die, I concede that you can afford to eschew any kind of risk.

But just how much money is that?

Asset allocation example unpacked

Let’s assume you’re 30 years old and spend $50,000 a year. Let’s also assume that inflation will average 3% per year, that you will live to be 95, and that you will spend the equivalent of $50,000 in today’s dollars every single year.

In this case, you’ll need about $10 million. Put another way, assuming 3% inflation and a 65-year lifespan, you’ll need about 200x your annual expenses.

Now, compare this to the common rule of thumb in financial planning that says if you save 25x your annual expenses, you can live on your savings indefinitely. This works, regardless of how old you are now.

It also works forever (as in, for the rest of your life and beyond).

So here’s my question to you: would you rather save 25x your annual spending or 200x?

In this lesson, you’ll begin to learn how to become a smarter investor by:

  1. Understanding the simple math between this – the “4% rule” – as well as its applications and shortcomings.
  2. Why it’s nearly impossible to retire without risk.
  3. The importance of a truly diversified investment portfolio and why most investing advice falls short of explaining how to properly diversify.
  4. How to begin determining your ideal asset allocation.

The magic of “The 4% Rule”

For the uninitiated, the 4% Rule is a simplification of a 1988 research paper (the so-called Trinity Study) by three professors of finance at Trinity University. The paper examined safe withdrawal rates in retirement. A safe withdrawal rate is the maximum amount of money one can spend each year from an investment portfolio without ever running out of money (in good times and bad).

Obviously, safe withdrawal rates vary widely based on a number of variables. The reason we’re still talking about the Trinity Study today – all these years later – is that the authors demonstrated that a properly-designed portfolio should be able to sustain annual withdrawals of up to 4% indefinitely (regardless of market conditions, which are always uncertain).

This seemed somewhat amazing at the time. And, indeed, it still does today.

Using this simple rule, it’s easy to calculate the amount of money you conceivably need to retire. Simply multiply your annual expenses by 25, the inverse of 4%. If you want to be more conservative (and there’s good reason to, which I’ll get to in a minute), simply replace 4% with 3% and multiply your expenses by 33.

Before we get into the pros and cons of the 4% rule, let’s brush up on why investing is necessary in the first place. Cause if you’re not 100% onboard with the fact that there’s no alternative to investing in the first place, nobody is going to be able to convince you to do these advanced allocation strategies in this lesson.

So bear with me – I want to be sure you’re really convinced.

A financial strategy with no risk is guaranteed to lose

It all comes back to risk and reward. The first rule of wealth building is:

Risk is necessary to avoid the inflationary erosion of purchasing power.

As you know, buying an investment is not the same as depositing money in the bank.

When you deposit money in a bank account, the bank agrees to keep your money safe. Depending on the kind of account, the bank may use your funds to make loans and pay you interest. Even though the bank is taking risks with your money, a certain amount of your money is insured by the government. Short of buying gold bricks and building your own Fort Knox, money in a U.S. bank account is about as safe as it can be.

The downside, however, is that the interest banks pay is rarely enough to outpace inflation.

  • For one, the banks are only paying you a fraction of the interest they earn for loaning out your money.
  • Second, the interest rate banks pay is based upon the prime index rate set by the Federal Reserve. This rate goes up and down over time based upon multiple economic factors. There is a complex relationship between inflation and interest rates. Occasionally, interest rates are higher than the inflation rate, as was the case between 2005 and 2007. Other times, inflation is higher than interest rates, as has been the case for the last decade.

What’s nearly certain, however, is that inflation outpaces deposit interest rates in the long run. If you deposit $10,000 and earn 2% annual interest while inflation is 3%, you are losing money. There’s no other way to spin it so be sure you understand the math and how the value of each dollar is declining. Because the balance in your account will continue to increase, but the purchasing power of each dollar is at once declining.

Now I realize you are familiar with inflation and that I’m not telling you anything you don’t know. Nevertheless, I am astounded by how often I see investment scenarios that fail to mention inflation.

How many times have you read articles with headlines like “This is how much you need to save to retire with $1 million”? And how many of those articles then give you the sobering news of how much $1 million will be actually worth in 30 years? The answer, assuming 3% inflation, is about $412,000.

Assuming 3% inflation, if you want to retire in 30 years with the equivalent of $1 million today, you’ll actually need to save $2,427,260. Yup, you need close to 2.5 million dollars.

Sorry! Don’t shoot the messenger!

To solidify the importance of inflation in your Wealth Map and investment plan, I encourage you to play with some scenarios yourself. Because you’ve got to really digest the numbers firsthand.

There are many good inflation calculators, but this one gives you the best three on one page.  You can calculate actual historical inflation using real data or model future inflation given an estimated flat inflation rate.

How does the 4% Rule work despite inflation?

Going back to the 4% rule, you might be wondering: “If inflation is so insidious and averages around 3%, how can someone withdraw 4% of their savings every year and never run out of money? Isn’t inflation chipping away at that money in addition to their withdrawals?”

Yes, it is. The thing about the 4% rule is that it assumes at least a 7% average annual return. At 7%, you can withdraw 4% each year and endure a 3% average annual inflation without ever losing purchasing power. If your long-term returns exceed 7%, you start to make money. If they dip below 7%, the real value of your portfolio begins to decline.

The math of the 4% rule is simple and irrefutable. It works.

So definitely pause for a moment to digest this rule because once you get it, we can surge forward.

But also remember, the real world is not a spreadsheet. Inflation is not fixed and investment returns are not fixed. The reason people are still so enthralled with the Trinity Study is that the authors outline how the 4% works in nearly every historical investing period.

The golden rule for this lesson: just because something worked in the past does not mean it will work in the future. But we learn and therefore understand a heck of a lot from what’s happened – especially in the financial thunderdome.

Additionally, although the study examined all the various historical market performance period, it was still a study. And no study can account for irrational human behavior.

The real shortcomings of the 4% Rule

When it comes to investing, we are often our portfolio’s worst enemy. We get nervous when the market is tanking and sell investments when we shouldn’t. We get caught up in the exuberance of a bull market and buy investments when they’re expensive. We bet too much that some new stock with lots of buzz is a fast track to millions only to watch it fizzle.

Even if you can resist all of the above scenarios, there’s one more than almost everyone will face at least once: Something unexpected will come up and require you to either save less or withdraw more than you planned.

Now, depending on how the markets do that year, such an unexpected variance could be a non-event. If it occurs during a particularly dismal market yet, it could totally break the 4% rule. At the very least, it will be a significant setback you’ll have to overcome.

This brings us to two more rules of wealth building:

  • Your assumptions are everything. Be accurate, and be conservative.
  • The success of your plan depends upon your ability to make mid-course corrections.

Nobody can predict with any degree of certainty future inflation rates or stock market returns. The best we can do is rely upon historical data and assume that future results won’t be radically different.

You can play with historical average annual returns of the S&P 500 here:

For example, you can find the average annual returns for different time periods. Without adjusting for inflation and assuming dividends are reinvested, the S&P 500 returned an average of 9.2% over the last 10 years, 9.2% over the last 20 years, 9.4% over the last 30 years, and 9.4% over the last 40 years.

That’s surprisingly consistent, isn’t it?

While actual returns will vary based on the beginning and end date of each period, what you’ll find is that the longer the investment period, the more predictable the result.

The average annual returns of the S&P article, for example, shows that, out of all possible historical periods in the S&P 500, 99.8% of 15-year investment periods and 94.6% of 10-year periods resulted in a positive return. Those figures drop to 87.4% of 5-year periods and 74.7% of 1-year periods.

Put another way, if you invest in the stock market for 15 years, you have only a 0.2% chance of losing money. But, if you invest for only one year, the chance of losing principal increased to 25%!

Yes, digest this fully. And re-read this section again. It’s the most important principle in advanced asset allocation

Smart investing is all about probability

This brings us back to one of the most important concepts in managing the risk of investing: Probability of returns.

In Lesson One, I introduced the concept of expectancy with a casino example.

Making bets on casino games is always a losing proposition because the games are rigged so that the player’s expected payout for any given bet is always just less than fair.

A “fair” bet would be winning even money for every flip of a coin. You could do this millions of times and expect to end up with the exact same amount of money as you started. If, however, bet a dollar on each flip but only won 0.99 cents when you won, you’d actually go broke fairly quickly. This is how casinos make money when the odds of a game are exactly 50/50. They simply pay you slightly less than is “fair.”

We can look at investing the same way. The math gets far more complicated when you consider the numerous possible combinations of annual returns. However, hopefully, you can see how – with a 25% chance of losing money investing for just one year, you would need to expect the possibility of a wildly outsized return.

To make those odds worthwhile, you’d need to expect a 33.3% return just to break even. This is why investing in the stock market with money you need soon (for example, to buy a house) is not a good idea. In this case, the lower rate of return and security of a bank account is attractive.

Compare this to investing for 15 years, however, in which time you have a 99.8% of coming out ahead. In this case, the odds are so good that you’d be silly not to take the bet. Yes, there is still risk involved. The 0.2% chance that you could lose money. But, the probability of returns is sky-high.

This is how you want to think about investing and risk. Take the risk when the probability of positive returns is highest and avoid risks when the probability of positive returns isn’t there.

This should be one of the main takeaways you go back to over and over again in this lesson so I’ll repeat myself here for emphasis:  Take the risk when the probability of positive returns is highest and avoid risks when the probability of positive returns isn’t there.

As you can see by the historical average annual returns of the S&P 500, the risk is quite tolerable on a long enough timeline.

One major reason for this is that the S&P is a basket of 500 large stocks. It’s a diversified index. Over time, the index grows even if certain included stocks collapse.

This is the next rule of investing.

Diversification is the largest lever you can pull to adjust the risk/reward equation.

Less diversification creates more risk, although potentially higher reward. If you bet your life savings on Bitcoin in 2010, as some did, you would have become a fast multimillionaire. Then again, if you had instead invested your money in a friends’ start-up that failed to launch, you’d be broke.

If, however, you split your investments between the two, you’d still have done well with Bitcoin, more than making up for the money lost on your friend’s failed business. As it’s easy to imagine something as new and speculative as Bitcoin not succeeding, you might have opted to split your investment into thirds: a third in Bitcoin, a third in your friend’s company, and a third in a stock index fund.

This further diversification again reduces your eventual return but dramatically reduces your risk of going broke.

(For the record, I’m not advocating for or against cryptocurrency investments, which remain a high-risk bet. But it’s a stellar example of a very high-risk bet that paid off, at least on the right timeline. Let’s not forget anyone who bought in as the value approached $20,000 only to see the price fall to around $6,000 as of the time I’m writing this.)

If calculating investment returns and ROI probabilities are the science of investing, diversification is the art.

There are infinite ways to allocate your investments, and every possible combination will have a different result. Just as there is no one way to paint, there’s no one way to invest. But there are key techniques.

Index funds and diversification

Index funds have been transforming how we invest over the past 20 years.

Generating investment returns that beat the S&P 500 index over long periods of time (several decades) is not impossible – but so few people succeed, it might as well be.

One study found that only one in 20 actively-managed mutual funds beat an S&P 500 index fund over a recent 15-year period. That is to say, if you were to invest in a random actively-managed mutual fund, you have a 95% chance of doing worse than if you just parked your money in an inexpensive index fund.

Speaking of expectations, as we did earlier, that is not a good one.

And, if only 5% of professional money managers beat the market over 15 years or more, do you really think the average investor has a shot? I don’t for a second believe I could pick stocks better than someone who has done it all day, every day for 20 years.

When you hear stories about friends who quadrupled their money on an obscure stock, remember that sometimes, even a blind squirrel finds a nut.

When you get pitches from publishers trying to sell you “can’t lose” stock picks, ask yourself: If these stock picks were so foolproof, why would they be in the business of selling newsletter subscriptions?

This is the reason more and more investors are trusting their savings to index funds. Smart investors know how difficult it is to beat the market. They’re also tired paying someone 1% of their assets every year to try, only to perform worse than the market as a whole.

Index funds provide built-in diversification. While no single index fund provides all the diversification you need, buying a single index fund is akin to buying shares in hundreds, if not thousands of individual securities.

In fact, it’s possible to create a properly diversified investment portfolio with just a handful of index funds.

A review of traditional asset allocation

In the world of investing, asset allocation refers to how you divide up your money among different types of investments, known as asset classes.

Most often, you will read about four high-level asset classes: cash, bonds, stocks, and “alternatives.”


Of these four asset classes, cash is the easy one. Whether you have money in a savings account, a checking account, or under your mattress, cash is cash.

Stocks and bonds

Within the stock and bond asset classes, there are numerous ways to further classify investments. Some kinds of classifications include:

  • Size: Large, medium, and small-cap stocks.
  • Type: Government, municipal, or corporate bonds.
  • Quality: Growth vs value stocks or investment-grade vs junk bonds.
  • Sector: Healthcare, technology, financials, utilities, etc.
  • Geography: Domestic, foreign, emerging markets, developed markets.

Alternative investments

There is also an enormous number of different kinds of alternative investments, which may include:

One thing that I want to make sure you take away from Advanced Money School is this:

Do not ignore the importance of asset allocation nor the variety of asset types in which you can invest.

It’s quite common to read an investment article or even use a retirement calculator that purports to help you choose an asset allocation but only talks about stocks, bonds, and cash. And the truth is, many investors never know anything different.

Can you make money and enjoy retirement with this kind of asset allocation? Sure, and millions of people have.

However, you can discover a lot of advantages when you broaden your horizons a bit.

Looking beyond “paper assets”

Stocks, bonds, and cash are all “paper assets.” Of course, today, they’re more like virtual assets. But you get the idea. When you possess a bond, a share of stock, or a $100 bill, the thing you own is simply a piece of data (or piece of paper) that symbolizes its value.

When you reflect on that for a minute, it gets a bit scary to imagine accumulating hundreds of thousands or even millions of dollars in such assets!

And yet, that’s exactly how most of save and invest.

Now, I happen to trust our financial system. I am not about to put on my tinfoil hat and tell you to put all of your money in gold bars and bury them in your backyard.

But I am going to encourage you to think beyond paper assets as you plan your own asset allocation and wealth map.

Specifically, I want you to think about two kinds of assets in particular: real estate and business.

Real estate

It’s true that some investors, wary of the stock market, bury gold in their backyards. But most investors who are wary of the stock market invest in real estate. And there are a lot more of these investors out there than you might realize.

Like many who lived through the Great Depression, my wife’s grandfather was one. He managed to accumulate some amount of wealth in his lifetime through his work as a physician, a frugal lifestyle, and a portfolio of a dozen or more rental properties.

The real estate portfolio provided ample cash flow in retirement even before he sold some of the properties.

Done correctly, owning real estate can be an invaluable part of your investment strategy. Or, in some cases, the entire strategy.

**We’ll get into real estate investing in more detail in a future lesson.

For now, remember the following points:

  1. Real estate is an important “alternative” asset class.
  2. Although it’s possible to invest in real estate without actually buying property (through real estate investment trusts aka REITs and other structures), these are still paper assets.
  3. Properties you live in yourself are not investments and should not be counted as part of your investment portfolio.


As an alternative asset class that’s not based upon a piece of paper, real estate gets a fair amount of play. I’m sure this is not the first time you’ve heard real estate investing mentioned or perhaps consider. Perhaps you already own an income property.

But there’s one more asset class that I want to talk about that’s often overlooked: a business of one’s own.

Although owning a business offers no guarantees, I have seen studies claiming at least half of American millionaires are small business owners. And that figure rises when you start looking beyond people with $1 or $2 million and looking at people with more than $5 million, $10 million and so on.

This only makes sense.

There are only so many heiresses, richly-paid corporate executives, and professional athletes out there. But there are plenty of business owners.

If you’ve ever considered entrepreneurship — whether it’s going all-in on a radical idea or just finally getting around to that side hustle, let me give you a little nudge.

Owning a business offers lots of benefits that we’ll get into in further detail in Lesson 7.

Choosing your ideal asset allocation

Whether you stick with traditional paper assets, venture into real estate and business ownership, or desire a mix of everything, determining how to divide up your money among various asset classes is as important as the assets you eventually buy.

Contrary to what you may have read elsewhere, there is no one-size-fits-all answer. Even if you and I are the same age and have the same amount of money to invest, we will likely have different asset allocation targets based upon our individual tolerance for risk and, of course, our goals.

“100 minus your age” is outdated

A formula that I’ve seen described as “the oldest asset allocation rule” suggests you should subtract your age from 100 and the resulting number is the percentage of stocks you should own. For example, I’m 38 years old, so the formula suggests I should own 62%stocks. If you were 25, it would be 75% stocks. If you were 80, it would be 20% stocks.

To be clear, this formula is outdated: we are living longer and need to work longer in order to afford retirement. As a result, young people, I think, should be more aggressive investors for longer periods of time. This formula would never recommend a 100% stock allocation. And yet, I think that 100% stock allocation could be appropriate for 20-somethings and even some 30-somethings with a high tolerance for risk.

What this formula offers, however, is a frame reference; a jumping-off point. Keep it in mind as you complete the exercise at the end of this lesson.

Lesson 4 wrap up – asset classes work together to manage risk

When it comes to paper assets, stocks represent the highest-risk but highest-rewards asset class. Bonds are typically thought of as lower-return but less volatile investments. And cash is your security blanket: low risk, but low return.

This Risk Tolerance and Suggested Asset Allocation Worksheet will help you determine your ideal asset allocation. In it, you will choose how much (if any) of your money you want to use to invest in alternative investments like business or real estate. If you can’t quite figure out how those asset classes play into your wealth plan right now, that’s OK. I provide an option to calculate a simple asset allocation using only stocks, bonds, and cash.

When it comes to asset allocation, there’s no right or wrong answer, only right for you or wrong for you.

In the upcoming lessons, we’ll take a closer look at investing in individual asset classes. First, we’ll talk about stocks and bonds and how to understand what you’re buying. Next, we’ll talk about real estate investments. Finally, we’ll talk about entrepreneurship and business ownership and the various ways you can incorporate this powerful asset class into your wealth plan if you so choose.