Before we can talk about asset allocation, diversification, and investment selections we have to talk about risk and how we manage it.

Simply speaking, the higher the risk, the more the potential return. For most of my adult life the US stock market has averaged 7-8% annual returns. This is incredible math and means that your investment doubles every 10 years! The downside of risk is loss, in this case the S&P 500 index experienced a drawdown of approximately 56.8% from its peak in October 2007 to its trough in March 2009.

Reading these numbers is relatively abstract, and watching at your portfolio go up in flames is an entirely different thing. So we have to understand and manage our psychology with investing. Both to make sure we are not overly conservative (I'm guilty). Or taking on too much risk which can lead to outsized losses, potential panic, and selling in a down market.

By holding un-correlated assets in your portfolio (aka equities and bonds) when "something" happens that causes one to crash the other should be unaffected and lower the impact to your portfolio.

We do this by managing the percentage of our portfolio invested in one asset class vs another. This ratio is our asset allocation (AA) and is referenced like 80/20, or 60/40 where the first number is the percentage of equities and the second the percentage of bonds.

There are plenty of "rules of thumb" on how to figure out what your asset allocation should be. Usually they are based off your age (aka how close are you to retirement, how soon will you need the money), but this is really just a proxy for how much risk should be in your portfolio.

I spent 2-3 years trying to understand these different rules and figure out which one was right for me. Risk is a moving target and it's basically impossible to find one system and stick with it.

Warren Buffet threw a curveball when he shared his investment advice for his estate after he dies. 90% invested in a low cost S&P 500 index and 10% in short term US government debt.

First off 10% of his net worth is more money than anyone will need for generations! But more importantly, the 10% represents enough assets to comfortably live off of through any period of upheaval. And second, short term US government debt is in theory the safest investment possible.

Trying to understand and figure out if I could apply this advice to my own investing led me to a huge unlock understanding my psychology for investing:

To manage risk, you first have to manage your emotions.

This is nearly impossible when you are under stress and don't feel safe. For me safety is about my cash flow needs - how much cash do I need in order to live for how long. This meant I could model my own Buffet 90/10 rule by figuring out what time horizon gave me safety and ensure I had enough cash for that in place.

So how much cash is enough?

Conventional wisdom is a six (6) month emergency fund - that was definately not enough for me. I played around with a lot of different time horizons and ended up with two (2) years. Two years gives enough time to get through a major economic event (at least the one’s I’ve lived through so far) without panic selling anything in an investment portfolio. While I’ve modeled this out at normal cash flow, I’d imagine that if a real emergency hit we’d tighten our cash flow almost immediately and stretch out the buffer even longer.

In the end I’ve decided to keep my 80/20 AA untouched and build a two year EF in cash and treasuries. When I hit that number I’m planning on investing in equities only until 90/10 and then keeping a 90/10 AA from that point forward.

It will be interesting to see how this held up when we sit down and talk about it.