8. Protection

In this episode, Michael discusses theconcept of an efficient frontier and uses a marathon race as a metaphor to helpyou understand it. There is a risk for every return, the more potential returnyou're going to receive. The more potential risk you have to take on. If youhave a short-term horizon, if you are fearful that something bad may happen toyou financially in the next call it five years, you want to make sure you havea certain amount of money invested in very safe vehicles.

[00:00:49] Now nothing is ever guaranteed,but you want to own high quality. Fixed income, high quality equitieshigh-quality real estate. You want to be diversified in the sense thathistorically speaking the volatility is not drastic because you want to be ableto pull that money in an emergency and not worry about having less than whatyou put in.

[00:01:16] Again, there's no guarantee, butif done properly, you should be in a position where it almost looks like paintsdry. It's extremely boring. It's not going to move very much and you're notexpected to make a lot, but the money will be there for you. In case of thatcurve ball, as we call it longer term, of course, you want to put your money atrisk in a responsible fashion, because that will give you the highest potentialreward.

[00:01:43] There's a technical term calledthe efficient frontier that is equivalent of. The horizon in the cockpit, so tospeak. And what it basically says is that for every unit of risk, you take, youbetter get at least an equal amount of reward. So it's the true. When I sayhorizon line, it gives you a really good sense of whether you're above or belowthe horizon.

[00:02:10] And you'll know you want to beabove the horizon. Obviously we understand what happens if you're below it. Sotaking the analogy. Of running. For example, I use the couch to 5k in thebeginning of this time cast. When you run, if you monitor your heart rate,you'll watch it go up. And, you know, over time where your threshold is, wecall it the red zone where the output is not going to match the input.

[00:02:43] So you're going to bunk. At somepoint you're going to crash and burn lactic acids building up. You just cannotphysically maintain that heart rate and that speed for too much longer. That'skind of like the efficient frontier. You will learn where that heart rate is.If you watch carefully that crossover between where you can maximize your heartrate to a point where you're getting a lot out of it and then crossing linewhere you're now getting a diminishing return.

[00:03:14] That's the goal of a financialadvisor from the investment perspective, we want to get as close to the top ofthat heart rate as we can to maximize the potential return. But we do not wantto cross the line because the second we crossed the line, our risk returnequation is now out of whack, and now we're taking too much risk for not enoughreturn.

[00:03:37] So a really good portfolio and areally good balance sheet. Has these uncorrelated investments has thesediversified investments, but when you put them all back together, looking atthat cockpit, you always want to make sure you're above that efficient frontierline and not below it. And if you're below it, there are a lot of warningsignals.

[00:04:01] That means you're not doing thatgreat of a job. And if you're above it, that means you're really doing a greatjob of walking that fine line of balancing risk and return. .