In a word: fungibility. Many folks are fans of compartmentalising their portfolios: this amount for housing; this amount for retirement; this amount for kids schooling. There’s a behavioural investment bias associated with this, called mental accounting. If memory serves me correctly, the CFA curriculum has a somewhat hand-wavy approach to this bias:
- Mental accounting is suboptimal. The portfolio is all fungible; money is money. Creating silos can inhibit portfolio return, because it’s possible that more assets are kept in safer or less diversified holdings than if the portfolio was considered as a whole. So CFA-designated financial advisors: don’t silo your clients’ portfolios.
- But…. most people have real difficulty thinking of his/her portfolio as a whole. It can be scary to think about (say) the kids’ college money being put into risky investments better left for long-duration retirement funds. In order to sate clients’ needs to ‘see’ certain silos within their portfolios, the financial advisor might relent to this approach.
I think a big area of discussion related to this concept is ‘the emergency fund’ of cash. Suppose the following, silly example:
- Single person, aged 35, with annual living expenses of $25,000 p.a.
- Has a job earning $50,000 p.a., so is saving a fair chunk.
- Due to lottery winnings/inheritance/previous stock options/etc., the person has a $1,000,000 portfolio.
- Conventional emergency fund thinking: stash away 3-6 months of living expenses (e.g. $7-12,000) in cash at all times.
- Total portfolio thinking: keep only necessary liquidity in cash (maybe $2,000, say). Remainder is put in a portfolio of various assets, with a total return objective. If bad times happen job-wise, liquidate some of the portfolio.
Which do you feel is better for this person? What about your own situation? Hmm…