MONEY Master the Game: 7 Simple Steps to Financial Freedom (47 page)

So let’s take a look at what this is all about, starting with the first and perhaps the most important place to put a portion of your money: the
Security/Peace of Mind Bucket.
What assets would you want to put in here? Remember, this bucket is the slow but steady contender, like the turtle in the race to financial freedom. Because the turtle often wins! And you have to treat it like your sacred temple of savings and investments—because what goes in here doesn’t come out.

And before you go on, bear in mind that the beginning of this chapter has some fundamentals: the blocking and tackling of asset allocation. If you’re a sophisticated investor, you can scan through the list of investment options because you probably already know what they are, and you can save yourself some time. But I didn’t want to leave out anyone. Besides, you might find a distinction or two that you’ll find valuable.

So let’s dive in.

1. 
Cash/Cash Equivalents.
At some time in our lives, every one of us will need a cushion to cover our needs in case of an emergency or a sudden loss of income. No matter your income level, you need some liquidity—or instant access to cash. Is it possible to be rich in assets and feel poor because you don’t have cash or liquidity? A lot of people were caught short in 2008 when the banks froze up and stopped lending (even to one another), and real estate seemed impossible to sell. In fact, according to a 2011 study,
half
of all Americans would struggle to come up with $2,000 in a crisis such as an unexpected medical bill, legal cost, or home or car repair. So you need some cash to make sure that doesn’t happen to you. Think about it: it wouldn’t take a lot of focus or a lot of savings for you to be better off than more than half of America!

But once you’ve decided how much cash you need to have on hand, where do you keep it? Most of us choose bank accounts that are insured by the FDIC for balances of up to $250,000. Unfortunately, brick-and-mortar banks pay almost no interest these days—the last time I checked, some were as low as 0.01%!—while online banks have been offering slightly higher rates. Maybe not ideal, but at least we know the money is safe and available. You
also may want to keep some of that cash in a safe place or for safety near your home—you know, “under your mattress”—in a hidden safe in case there’s an earthquake or hurricane or some other kind of emergency, and the ATMs stop working.

Other tools for cash equivalents include
money market funds
—there are three types, and if you want to learn more, see the box for details.

For larger amounts of money that we need to keep safe and liquid,
you can buy into ultra-short-term investments called
cash equivalents.
The most well-known are good old money market funds.
You may even already own one. These are basically mutual funds made up of low-risk, extremely short-term bonds and other kinds of debt (which you’ll learn more about in a moment). They can be great because you get a somewhat higher rate of return than a boring old bank account, but you still get immediate access to your cash 24 hours a day—and there are some that even let you write checks.

By the way, most banks offer
money market deposit accounts,
which are
not
the same as money market funds. These are like savings accounts where the
banks
are allowed to invest your money in short-term debt, and they pay you a slightly better interest rate in return. There’s usually a minimum deposit required or other restrictions, low rates, and penalties if your balance falls too low. But they are insured by the FDIC, which is a good thing. And that sets them apart from money market
funds,
which are
not
guaranteed and could potentially drop in value.

But if you want to keep your money safe, liquid, and earning interest, one option is a
US Treasury money market fund with checking privileges.
True, these funds aren’t insured by the FDIC, but because they are tied only to US government debt and not to any corporations or banks that might default, the only way you can lose your money is if the government fails to pay its short-term obligations. If that happens, there is no US government, and all bets are off anyway!

2. 
Bonds.
We all know what a bond is, right? When I give you my bond, I give you my word. My promise. When I buy a bond, you give me your word—your promise—to return my money with a specific rate of interest after
X
period of time (the maturity date). That’s why bonds are called “
fixed-income investments.
” The income—or return—you’ll get from them is fixed at the time you buy them, depending on the length of time you agree to hold them. And sometimes you can use those regular interest payments (dividends) as income while the bond matures. So it’s like a simple IOU with benefits, right? But there are zillions of bonds and bond funds out there; not all but many are rated by various agencies according to their levels of risk. A
t the end of this chapter, you’ll find a quick bond briefing
to find out when they can be hazardous to your financial health, and when they can be useful—even great!—investments.

Bonds can also be kind of confusing. Like a seesaw, they
increase in value
when interest rates go
down,
and
decrease in value
when rates go
up.

After all, who wants to buy an old low-interest-rate bond when a shiny new bond with a higher interest rate comes on the market? But one way to avoid worrying so much about price fluctuations in bonds is to diversify and buy into a low-cost bond index fund.

And just remember, not all bonds are equal. Greece’s bonds are not going to be as strong as Germany’s. Detroit’s municipal bonds are not going to be as strong as the US Treasury’s. In fact, some investment advisors say the only completely safe bond is one backed by the full faith and credit of the United States. And you can actually buy US bonds called
Treasury inflation-protected securities,
or TIPS, that rise in value to keep up with inflation through the consumer price index. Again, we’ll cover all of this in the bond briefing. And later I’ll be showing you an amazing portfolio that uses bond funds in a totally unique way. But meanwhile, let’s consider another fixed-income investment that might belong in your Security Bucket.

3. 
CDs.
Remember them? With certificates of deposit,
you’re
the one loaning the money to the bank. It takes your cash for a fixed rate of interest, and then returns it—along with your earnings—after a set amount of time. Because CDs are insured by the FDIC, they’re as safe as savings accounts, and—at the time of this writing—just about as exciting. But I wrote this book for every season, and seasons keep changing. I don’t know what season you’re in now, but I can tell you this story: in 1981, when I was 21 years old, you could buy
a six-month CD for . . . wait for it . . . 17% interest! But you don’t have to go that far back to see how some types of CDs, in the right environment, can give you quality returns. Remember the story of how my Stronghold advisor
got a small fixed rate on a CD in 2009,
but it was a
market-linked CD,
which was attached to the growth of the stock market, and
he
averaged 8% interest over time
!
That was an unusually good deal, but there are still ways to get more bang for your buck (without risking your principal) by investing in these
market-linked CDs.
(You can go back to chapter 2.8 for a recap about how they work.)

So how’s our team of assets doing so far? CDs, cash, money market funds, and bonds would be obvious players for your Security Bucket. But when do you put them in the game? Some players will do well in some environments and poorly in others. What’s the advantage of the cash player? The cash
player can jump into the game any time. You can keep your money safe and ready to deploy when the right investment comes along. On the other hand, if you hold too much money in cash, your spending power is not growing. In fact, it’s shrinking due to inflation each year. But in deflationary times, like 2008, your cash will buy you more. If you had cash in 2008 and had the stomach to do it, you could have bought a home for almost 40% less than that same house cost the year before. (By the way, that’s what many hedge funds did. They bought tens of thousands of homes during the down time, fixed them up and rented them, and then sold them between 2011 and 2014 for a big profit.) Many stocks could be bought at a similar or even greater discount in 2008.

What’s the advantage of the bond player? Depending on the type of bond, you’ve got a guaranteed rate of return that gives you security when other asset class prices might be dropping. Regular CDs, as I’m writing this in 2014, probably don’t interest you at all, and they don’t interest me either. But that player can do well in high-interest-rate environments. And while market-linked CDs excel when the stock indexes are hot, they’re rock solid in every environment because you don’t lose principal. Here is the downside of bonds: if you want to sell bonds before their maturity date (when you receive your full investment plus interest), and interest rates have risen significantly and new bonds provide a higher rate of return, you will have to unload them at a discount.

If all this seems incredibly complex, here’s the good news. Ray Dalio has created a strategy called All Seasons, which will show you how to succeed with the right mix of bonds, equities, commodities, and gold in any economic season. We’ll learn more about that later.

First, understand that because secure bonds offer a promised or stated rate of return and a return of principal, they are more secure than investments that do not guarantee either the rate of return or the principal. But the promise is only as good as the bond issuer. The point here is that you need the right player for the right season in the right proportions and at the right time.

Now let’s take a look at a few other assets for your Security Bucket team you might not have thought of:

4. 
Your home
goes in here, too. Why? Because it’s a sacred sanctuary. We shouldn’t be “spending our home”! Americans have learned a hard lesson in
recent years about the dangers of house flipping and using their homes like ATMs. A home, if it’s your primary residence, shouldn’t be seen as an investment to leverage, and it shouldn’t be counted on to produce a gigantic return. But wait, haven’t we always been told that your home is your best investment because it always goes up in value?

In my search for answers, I sat down with the
Nobel Prize–winning economist Robert Shiller,
the leading expert on real estate markets, and creator of the Case-Shiller home price index of housing prices. His breakthrough insights were used to create the following chart. Shiller found that when he adjusted for inflation, US housing prices have been nearly flat for a century! He exploded one of the biggest myths of our time: that home prices keep going up and up. “Unless there’s a bubble,” he told me. And we all know what eventually happens to bubbles.

On the other hand, owning your home with a fixed-rate mortgage is a hedge against inflation, and there’s a tax advantage. What’s more, if you own a home outright, and you rent out all or part of it, it can be a safe way to earn some income. Also, as you’ll soon learn, there are some great ways to invest in real estate—like
first trust deeds,
REITs (real estate investment trusts), senior housing, income-producing properties, and so on. So nobody’s suggesting that you give up on real estate investments if that’s what you like to do! But it’s probably a good rule of thumb to put them in the next bucket we’re going to talk about: the Risk/Growth Bucket.

Meanwhile, what other assets might belong in Security?