Before the article, here\u2019s what\u2019s happening this week on our podcast, <\/em>Personal Finance for Long-Term Investors<\/em><\/strong>:<\/em><\/p>\n I see some people thinking about their portfolios incorrectly, and a concept called \u201casset-liability matching\u201d<\/strong> can help. <\/p>\n Let\u2019s imagine a portfolio\u202650% stocks<\/strong>, half US and half international. Plus 50% bonds<\/strong>, half short duration (~2 years) and half longer duration (~8 years). To make life simple, I\u2019m going to use some ETFs to \u201cbuild\u201d this portfolio:<\/p>\n When I originally penned this post,<\/em> these four ETFs\u2019 performances over the past 2 months had been, respectively:<\/p>\n Combining those numbers, our portfolio of equal weights in all four ETFs is down (-2.8%) over the past eight weeks. That doesn\u2019t feel good.<\/p>\n But I contend that this simple summary of performance is NOT<\/em> <\/strong>the right way to think about our portfolio. That\u2019s where asset-liability matching can help out.<\/p>\n While we could<\/em> consider the entire portfolio to be down (-2.8%), that\u2019s a poor mental model.<\/p>\n Instead, I want to divide our portfolio in two. Our stock<\/strong> allocation is the \u201clong-term growth\u201d half of our portfolio. The bond <\/strong>allocation is the \u201cnear-term spending\u201d half of our portfolio. Depending on the individual investor\u2019s preferences, that \u201cline\u201d between near-term and long-term is probably drawn 8 years, 10 years, or even up to 15 years in the future.<\/p>\n Let\u2019s now re-examine this year\u2019s performance in two halves. <\/p>\n The long-term growth half is catching some flak! It\u2019s down (-8.2%) over the past two months. Not ideal. Thankfully<\/em>, though, because we\u2019ve \u201cdrawn our line\u201d 10+ years in the future, we don\u2019t care too much about two months of poor performance. In this half of the portfolio, we measure in decades<\/strong> and aren\u2019t bothered by short-term performance. <\/p>\n What about the \u201cshort-term spending\u201d bond side of the portfolio? It\u2019s actually up +0.9% over the past two months. This is the half of the portfolio that matters most to this week, this month, this year, etc. <\/p>\n In other words\u2026why fret?!<\/em> The half of the portfolio that matters most right now is up<\/strong>. And the half that\u2019s down? It has a decade (or more) to recover. <\/p>\n This is why I start with financial planning before<\/strong> building a portfolio. A financial plan assigns objective numbers to the goals and timelines in our lives. Some are near-term goals, others long-term. Each goal has its own \u201casset-liability match.\u201d Asset-liability matching (ALM) ensures the money you will <\/em>need<\/strong> (your future liabilities) is supported by the money you already <\/em>have<\/strong> (your assets), while lining up the risk<\/strong> <\/a>of those assets based on the unique timing of that specific need.<\/p>\n In fact, we can use ALM to build an entire portfolio from the ground up. <\/p>\n Let\u2019s use asset-liability to build a portfolio, and we\u2019ll do the right thing by start with a basic financial plan. In other words, we haven\u2019t yet settled on our \u201c25% in 4 ETFs\u201d<\/strong><\/em> portfolio just yet. <\/p>\n Fast forward: we run the details of our plan and find that we plan to spend $50,000 per year.<\/strong> I\u2019m using round numbers to keep the math easy. I\u2019m also going to eliminate inflation from all the math here. Yes \u2013 you can do that.<\/a> Let\u2019s also assume we have $1.2M in investable assets. <\/p>\n So that means: <\/p>\n So we know our liabilities. For Years 1 \u2013 Infinity, we need $50,000 per year. Now we must match those liabilities with assets. <\/p>\n The key \u2013 and beautiful logic \u2013 is that short-term liabilities must be matched by a \u201cshort-term asset.\u201d That is, an asset with a high degree of certainty over short time periods, aka low risk. Long-term liabilities can afford risk and volatility because they have time on their side. We can use a higher-risk asset to match long-term liabilities and assume a higher rate of investment return along the way. We are matching liabilities to appropriate assets. <\/p>\n Let\u2019s start with Year 1. Our financial plan has a $50,000 liability in Year 1. How does that liability\u00a0<\/strong>get funded? I need to match it to an asset. Since this next year is such a short timeline, I cannot take risks<\/span>. Thus, I will match this liability to $50,000 in bonds (specifically, the short-duration ETF\u00a0SHY). Since I\u2019m assuming 0% growth from SHY, I must allocate a full $50,000 to SHY.<\/p>\n I rinse and repeat for many years to come. If I wanted to be detailed, I could build a bond ladder or a set of specific bond funds for every duration I encounter e.g. Year 2 is covered by 2-year bonds, Year 3 is covered by 3-year bonds, etc.<\/p>\n For the sake of simplicity, let\u2019s keep to our 2 ETFs from before:<\/p>\n Now \u2013 what to do about Year 13? <\/p>\n Remember that \u201cline\u201d we drew earlier that separated our \u201cshort-term spending\u201d from our \u201clong-term growth?\u201d Humor me: we will draw the line conveniently after Year 12. In other words, we\u2019re going to say: <\/p>\n \u201cI am comfortable assuming that after 12 years, my stock portfolio will have gone through ups and downs, and its average return will resemble the long-term average of 6% per year, inflation-adjusted.<\/em> Starting in Year 13, I am comfortable taking that future liability, matching it to my stock<\/strong> assets, and then assuming a rate of return on those stock assets between now and then.\u201d <\/em><\/p>\n<\/blockquote>\n This is where the asset-liability matching model gets fun.<\/p>\n Because if I require $50,000 in Year 13, and I\u2019m assuming a 6% annualized return from my stock portfolio, then I must set aside \u201conly\u201d $25,000 of my assets today. Because 6% compounded for 12 years = 2x, and the $50K divided by 2 yields $25K. Whereas before, assuming a 0% return from bonds, I needed to match a full $50,000 in bond assets for a $50,000 liability.<\/p>\n Year 14 is even better. With one more year of compounding at 6%, I only need to set aside $23,500 today.<\/p>\n Year 15 requires $22,100 today.<\/p>\n Eventually, with even time and enough compounding, today\u2019s requirement converges on zero.<\/p>\n Yes, if you take 46 pennies and compound them at 6% for 200 years, you will have the $50,000 in spending money you need for that year. Our mortal financial plans probably don\u2019t need to consider Year 50 or Year 100 or 200. But, this asset-liability thought process is how many university endowments conceptualize their investment plans. Essentially, they have some assets on their balance sheets with infinite<\/em> timelines.<\/p>\n Back to today\u2019s example: if I earmark stocks to cover my liabilities from Year 13 to Year 50, I\u2019ll need ~$390,000. If you\u2019re keeping track at home, we\u2019ve allocated $600,000 to bonds, $390,000 to stocks, and $210,000 left over. <\/p>\n Perhaps I also invest that remaining $210,000 in stocks, assigning them an \u201cinfinite\u201d timeline**, and leave those assets to my heirs or charity. Many people choose to do this. If we did so, that would bring our stock allocation to $600,000 total. Dividing that evenly between domestic and international stocks (ITOT and IXUS, respectively), we\u2019ve constructed our beginning portfolio using asset-liability matching. <\/p>\n **If you\u2019ve ever considered opening your own \u201cinvesting sandbox\u201d or \u201cplay money\u201d or \u201cI want to experiment!,\u201d I recommend you use this kind of \u201cleftover\u201d money with an infinite timeline. <\/em><\/p>\n<\/blockquote>\n The $600,000 in bonds is still covering Years 1 through 12. That should make us feel decent. <\/p>\n And yes, perhaps the $600,000 in stocks did drop (-8.2%), down to $551,000. In my particular example, though, where we had $210,000 of \u201cinfinite money,\u201d our financial plan is literally not affected at all! <\/strong>Despite being down ~$50K, we are still in a position where every liability we could ever<\/strong> have is matched with an asset. That should feel great<\/em>. <\/p>\n Granted, it\u2019s my hypothetical. Perhaps your financial plan looks different. <\/p>\n But I think we should view our portfolios through the lens of asset-liability matching to align our money with our future\u2026and probably sleep better at night, too! <\/p>\n Thank you for reading! <\/p>\n If you enjoyed this article, join thousands of subscribers<\/strong><\/a> who read my free weekly email, where I send you links to the smartest financial content I find online every week. 100% free, unsubscribe anytime. <\/p>\n Also<\/strong> \u2013 our podcast \u201cPersonal Finance for Long-Term Investors\u201d<\/a><\/strong><\/em> has grown ~10x over the past couple years, now helping ~10,000 people per month. Tune in and check it out.<\/a> <\/strong><\/p>\n -Jesse<\/p>\n
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<\/figure>\n<\/div>\nAsset-Liability Matching Example in Our Portfolio<\/h2>\n
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