Mixed Portfolio Theory Revisited

In the June 2006 Insights I established the basis for a theory I called at the time “Independent Portfolio Theory.”

I have since honed this idea more and developed it into “Mixed Portfolio Theory.” The basis is this; use a mix of real estate, first trust deeds and stocks to increase returns and have investments producing income, capital appreciation and speculative growth.

This, instead of Modern Portfolio Theory that states you can lower your risk and increase your returns by having a mix of stocks, bonds and cash.

This concept just hasn’t held water in the long term. It is mathematically impossible to have, let’s say, 10% of your portfolio in cash that has historically earned 3.7%, 30% bonds that have historically earned 5.5% and 60% stocks, which have historically earned 9.7%. Adding these returns together equals a total return of 7.84%.

After an average inflation rate of 3% that is a net return of 4.84%. So let’s recap, for a net-of-inflation pre- tax return of 4.84% you need to have 60% of your portfolio in the stock market, and 30% in bonds that fluctuate with interest rates while the income remains static and then 10% in cash for emergencies.

Let’s go back to “Mixed Portfolio Theory.” If you take the cash and bond investments of 50% and put those into income producing real estate investments such as first trust deeds that many hard money lenders are currently charging between 8-12% let’s split it at 10% return for 15% of your portfolio and also take a portion, let’s say, 35% and put it into a rental property earning income and growth due to that fact that you are using non-recourse loans.

This now leverages your retirement investment portfolio, an option that is not available to traditional investments in the market. Let’s say the rental properties value goes up in value 3% average annual rate of return. That means at 65% loan-to-value on a couple of rental properties puts your cash on cash return at 30% on that portion of your portfolio.

Let’s look at this with actual numbers to get a feel for it. If an investor bought a couple of bread and butter rentals the investor may pay around $250,000 for two. 35% down is $87,500, 3% appreciation on these properties and current rents would return approximately $26,700.

So a $26,700 appreciation and rents divided by $87,500 investment equals an actual return of 30%.

Now you also have the opportunity to find raw land and add it to your portfolio vs. a high risk stock portfolio.

In our area we were undervalued the last three years so land increased in value 40-100%.

Does this mean the next three years will be that good? Probably not, but land is speculative so who knows what it will do. Let’s be conservative and say it goes up 20% average annually. Now let’s take a look at your portfolio:

15% @ 10% return, 35% @ 30% return and 50% @ 20%.

This gives us a combined rate of return of 22%, after inflation a return of 19%.

So let’s say you have a $250,000 portfolio, let’s compare how your actual returns will end up between Modern Portfolio Theory and Mixed Portfolio Theory:

Modern Portfolio Theory – Based on an initial investment of $250,000:

Beginning of year value: $250,000

10% Cash @ 3.7%

• $25,000.00
• + $925.00
• $25,925

30% Bonds @5.5%

• $75,000
• + $4,125
• $79,125

60% Stocks @9.7%

• $150,000
• + $14,550
• $164,550

‍Total after one year investment: $269,600 or 7.84% after inflation = 4.84%‍

Mixed Portfolio Theory – Based on initial Investment of $250,000:

Beginning of year value: $250,000

15% 1st Trust Deed@ 10%

• $37,500
• + $3,750
• $41,250

35% rental@ 30%

• $87,500
• + $26,700
• $114,200

50% Land@ 20%

• $125,000
• + $25,000
• ‍$150,000

Total after one year investment: $305,450 or 22% after inflation = 19%

One more interesting statistic, and hopefully this will help you to see the advantage of self-direction of your retirement plan portfolio in a mixed portfolio model is as follows:

This rule we are going to use is a model that establishes how quickly your investments will double. It is called the Rule of 72 and it works like this,

72 / % return = years to double.

So let’s look at our above Modern Portfolio that earns 8.26% before inflation:

72/7.84 = 8.7 years or

$250,000 is worth $500,000 in 9.2 years and ($1,000,000 in 18.4 years).

Now look at our mixed portfolio theory example that earns 18.5% before inflation:

72/22 = 3.28 years or

$250,000 is worth $500,000 in 3.28 years and ($1,000,000 in 6.56 years).

Further let’s take this out to about 19 years.

9.84 years = $2,000,000

13.12 years = $4,000,000

16.4 years = $8,000,000

19.68 years = $16,000,000

Choose wisely your investments and how they work best for your retirement plan.

Mountain West IRA, Inc. does not give tax, legal or investment advice and does not purport that any investor can duplicate these returns.

Jon A. Galane, CISP is Principal of Mountain West IRA. He has 29 years experience in the financial services industry and is a retired Vice President of Morgan Stanley.  Jon can be contacted at jgalane@MWIRA.com.