The 3 Portfolios

A framework for building wealth and managing risk



There are infinite ways to squander money but only a few ways to build sustainable wealth. Despite the lucrative self-help book industry and endless late-night commercials promising the secrets to “getting rich quick,” we strongly believe that there is no one “right way” to manage money and risk. No two households will—or should—protect and nourish their assets in the exact same way. Success is derived not by having the “best” ideas but by having good ideas that you actually implement. More important, you must have a consistent, disciplined perspective and the ability to navigate the noise.

In this article, I would like to share the basics of our perspectives on wealth creation and risk management. This framework is largely the result of working with a diverse array of clients, some successful and some not. Again, this is not a claim that our perspective is the “right” one, just that it is one logical methodology that could apply.


The Three Portfolios

Living in the Bay Area, I have the good fortune of cheering for a number of talented sports teams, including the San Francisco Giants, winners of three World Series in the past six years. Like in baseball, the goal of investing is to win—not all the time, but “enough” times to get to the next level.

Most of our clients’ wealth-generating activities can be classified into three “portfolios.” The “A” Portfolio is focused on hitting “home runs”—they will be few and far between, but when they come, they can change the game and our clients’ fate. The “B” Portfolio is about hitting singles and doubles—nothing too cute or exciting, but a necessary strategy for sustainable wins. The “C” Portfolio is analogous to playing in the backyard for fun—no expectations of winning a championship, but a hobby that lets you enjoy the game.

Each portfolio has its own unique objectives, risk profiles, and expected returns. Our role as advisors is primarily to help manage these portfolios to maximize returns per unit of risk.

What follows are brief descriptions of each portfolio and some real-life examples of how our clients have wisely invested in them.

The table below summarizes discussion

The “A” Portfolio
The “B” Portfolio
The “C” Portfolio

In Baseball Speak...

Focus on hitting home runs.

Swing for singles and doubles; stay consistent.

Play for fun; don't worry too much about winning.

Objectives

Concentrated bets, abnormal returns.

Diversification, normal returns.

Have fun, returns are secondary.

Winning Strategies

  • Pursue the right career / business venture.

  • Have a singular focus.

  • Build good relationships.
  • Mostly buy the market.

  • Focus on risk.

  • Manage systemic wealth destructors.
  • Limit investable assets, energy, and resources.

Our role as advisors:

  • Enable clients to have more time and energy to dedicate to their “A” Portfolio.
  • Minimize taxes, fees, and other systemic wealth detractors.

  • Design portfolios to meet specific risk targets

  • Mostly hit singles (market returns), and sometimes hit doubles with contrarian bets.
  • Help clients understand underlying risks in the investments.

  • Make sure clients don’t bet excessively on these ventures.

The “A” Portfolio

What is it?

Every person can be thought of as a wealth-creating machine, though some machines are more efficient than others. For example, engineers working in tech and MBA grads working as investment bankers are more efficient earners than farmworkers and shoe-shiners. I am not passing judgment—low-efficiency earners are no better or worse than high-efficiency earners, and I have worked on a farm and as a shoe-shiner myself. But in a capitalistic society, some folks will simply earn less than others per unit of time or energy spent. And if our objective is to create wealth, then the question is: how do we maximize efficiency?

The “A” Portfolio is made up of the investments where most of the wealth will be created or lost. Success in the A Portfolio is mostly based on the unique efforts and abilities of the investor in question. In market-theory speak, this is where the investor attempts to exploit inefficient markets. As an analogy, think of a doctor who specializes in some intricate and rare treatment. She is likely to be a very efficient earner because most members of society are not willing and/or able to invest so many years of schooling and training in such a technical field. Furthermore, this doctor’s success in generating wealth is largely due to her performance relative to her peers. Of course, luck is also an important factor—a plastic surgeon specializing in some augmentation that becomes outdated or unfashionable could find his practice bankrupted. To invest in an “A” Portfolio, you need to have dedication, self-confidence, and willingness to take on risk.

Investment and risk objectives:

Generate abnormal investment returns through one or a few concentrated bets

This portfolio is not about playing it safe. It’s about going deep into one area that the investor knows well (and hopefully enjoys) where there is premium market demand. In the book Outliers, author Malcolm Gladwell says that it takes roughly ten thousand hours of practice to achieve mastery in a field. Achieving mastery is only part of the requirement, however. Mastery in the right field is just as important. For example, entrepreneurship, technology, finance, and real estate are some of the areas where the odds of abnormal wealth creation are favorable.

Common strategies we’ve observed and advocate:

  • Pursuing the right career.Studying science, technology, engineering, math (STEM) increases the odds of financial success. Business careers, particularly finance, accounting, and anything “technical” are also good. Social work and teaching are necessary and noble careers, but if the objective is efficient wealth creation, the road is likely to be more challenging (though we know a few exceptions!).
  • Having a singular focus. Being well-rounded makes for a great business school application, but when the objective is making large sums of money, the more focused you are, the greater the odds of success. In our experience, successful people are rarely excellent in more than a few areas.
  • Building good relationships. Even in the age of Facebook and other impersonal social networks, personal relationships with resourceful and execution-driven people will continue to be one of the most important contributors to financial success. Yes, being born into powerful networks is an advantage, but it’s not an absolute requirement. Families that have achieved generational wealth are typically the product of one person who did not have a strong network initially.

Some client examples:

  • A founder and CEO of a tech company that is hoping to go IPO or get acquired in the next couple of years. He works seven days a week.
  • A couple that is building a residential rental portfolio. They buy one or more properties a year and have more than 90% of their net worth tied up in this asset class.
  • A corporate executive who receives lots of options and RSUs. His individual performance largely correlates with the fate of the company, and therefore the final market value of his equity.

Our role as advisors:

By taking on multiple financial tasks and projects, we enable clients to have more time and energy to dedicate to their “A” Portfolio.


The “B” Portfolio

What is it?
This is the portfolio designed to protect and manage the funds generated by the “A” Portfolio. Again, it’s about hitting singles and doubles. Attempting to hit a home run with this portfolio is likely to result in disappointment at best and complete wipe-out at worst. So much time and energy is (or should be) devoted to the “A” portfolio, making the “B” portfolio a part-time endeavor that’s unlikely to earn abnormal returns (someone’s “B” Portfolio is another’s “A” Portfolio, so the former investor is likely to be outworked—and out-earned by the latter).

The B Portfolio is about protecting and slowly growing what has been earned.

Investment and risk objectives:

Diversify investments and generate normal returns. Only take as much risk as you need to.

Common strategies we’ve observed and advocate:

  • Buy the market. As we’ve discussed in earlier articles, buying broad, market-based investments is a better strategy than attempting to find the next Google. Unless you are a professional investor (investing is your “A” Portfolio), it’s unlikely that you will have the time or expertise to pick securities that outperform market averages. And it’s unlikely that you will have the expertise to pick professional managers or financial advisors who can outperform the market averages.
  • Focus on risk. You’re already taking on a tremendous and concentrated risk exposure in your “A” Portfolio, so why take on more ? For example, not selling Restricted Stock Units (RSUs) when they vest because you believe so much strongly in your company is extremely risky. (We prefer that our clients who want to show loyalty and support buy a t-shirt with the company logo instead.) Another unnecessary risk is exercising incentive stock options early and triggering the AMT when there is no liquidity for the stock (click here for more on the AMT).
  • Managing systemic wealth destructors. The IRS and the financial services industry are two biggest culprits of wealth destruction. It’s hard to avoid either party, but very possible to minimize taxes and fees.

Some client examples:

  • A client who invests in a large pool of real estate properties.
  • A Bay Area couple who are saving for a down payment on their house. Although they are young and have high earning potential, they have an extremely conservative portfolio to plan for this liquidity need.
  • A family who has multiple side businesses.

Our role as advisors:

  • Minimize taxes, fees, and other systemic wealth detractors (see Killer Fees)
  • Design portfolios to meet specific risk targets
  • Mostly hit singles (market returns), and sometimes hit doubles (small contrarian bets).

The “C” Portfolio

What is it?
Many of us like to gamble, and most decisions are based on emotions rather than logic or quantitative financial models. Rather than trying to fight that innate part of our being, we advocate embracing it … to a reasonable degree. The “C” Portfolio represents the “gambling” portfolio. This is a combination of high-risk/high-return investments and plain old high-risk/no-expected-return investments.

These include categories such as social ventures, investing in friends’ and family’s businesses, angel investing, and playing blackjack in Vegas. These activities in aggregate will likely yield a negative return or at best break even … but they’re still fun to engage in.

Investment and risk objectives:

Have fun, but don’t bet the farm.

The “C” Portfolio is something you should put limited funds into at most. Think of it as financial entertainment, not something that will take you to the next tax bracket.

Some client examples:

  • A wealthy client provides seed funding for a local bar & grill.
  • A family invests in businesses started by young, disadvantaged students.

Our role as advisors:

  • Help clients understand underlying risks in the investments.
  • Make sure clients don’t bet excessively on these ventures. We normally advocate that no more than 5% of total assets be invested in the “C” Portfolio.

Conclusion

There are many who peddle “secrets” to wealth creation and risk management. We don’t subscribe to the idea that success comes easy or that it’s mainly a matter of luck. We believe that two common characteristics of successful investors are discipline and focus.

Through our observations and client work, we have developed the following framework:

  • The “A” Portfolio is about the investor’s educational background, career, unique skill-set, network, etc. that can lead to abnormal returns per unit of risk assumed. Since most of the wealth will hopefully be generated by the “A” Portfolio, it pays to focus on it as much as possible.
  • The “B” Portfolio involves money that should earn a normal return; the objective is grow steadily and to protect on the downside. We spend most of our time helping clients mange their “B” Portfolios, and we advocate a philosophy of low fees, tax efficiency, and tactical contrarian tilts. Investing in the “B” Portfolio like it’s an “A” Portfolio (e.g., picking stocks part-time) is likely to deliver suboptimal results.
  • Finally, the “C” Portfolio is the fun portfolio. This is the category we use to invest in areas we believe in, such as social philanthropy or angel investing. The likelihood of abnormal or even steady returns is possible but not required.

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.