Capital Allocation

I was recently listening to a podcast where a well known investor was being asked questions about the banking scare stemming from the Silicon Valley Bank collapse in March of 2023. The podcast host (a young venture capitalist) expressed a great amount of fear that his deposit, which exceeded the FDIC insurance limit, wasn’t safe in the bank anymore. When the well known investor was asked his opinion about whether he thought individuals should move their money to one of the four “too big to fail” banks, he ultimately said no not necessarily, that he thought the majority of banks are safe. But what I found more illuminating than his answer to the question was the statement he made in return to the young host. He explained to the host that he only keeps the amount of cash that he needs to run his business on a weekly basis in a non-interest bearing checking account due to the lack of income being generated. Any excess he explained is placed elsewhere and that others in a similar situation should think about doing the same. In a similar light I recently read that the NBA star Giannis Antetokounmpo opened 50 accounts at 50 different banks and deposited $250,000 in each in order to stay below the FDIC limit. The article went on to explain that upon hearing of Antetokounmpo’s 50 bank accounts, the team owner (who is a CEO and professional investor) explained to him the error in his capital allocation strategy and decided to teach the players on the team about better capital allocation practices. So this got me thinking… why are so many individuals (even highly successful ones) bad at allocating their capital wisely? Is the skill of good capital allocation only attainable for those with an MBA like CEOs and investment professionals? 

The short answer is of course no. I believe anyone can be a good capital allocator. My goal in this post is to take what successful CEOs and investment professionals do everyday and translate it for individual’s finances. But before we dive into any details, I think it’s important to discuss what “capital allocation” actually is. We’ve all heard the phrase, but what does it actually mean? And is it important to me? To the latter question I’d argue that capital allocation is one of the most important financial topics for everyone to understand, whether you are a CEO, investment professional, small business owner, active investor, or passive investor. To the former question, although the phrase sounds somewhat complicated, capital allocation is a very simple and intuitive concept. According to Harvard Business School “capital allocation is the distribution, re-distribution, and investment of financial resources to maximize stakeholder profits.” So what does that actually mean? Essentially… where are you putting your money? And by money I mean your hard earned cash (equity) and any loans you may have at your disposal (debt) in order to maximize your financial success. As you will see, this maximization of finances is not just for CEOs and investment professionals, but for everyone.

It’s my belief that the first step you must take in order to be “successful” at capital allocation is to clearly define your goals. In terms of clearly defining your goals: I put successful in quotes above because success is a measurement that is tied directly to achieving a set goal. For example, if a couple is saving up for a down payment on a home that they plan to buy in the next couple of years, they will deem themselves successful when they reach a certain dollar amount saved and purchase the home. Whether the couple received a return on their money in excess of inflation is more than likely irrelevant to them so long as they safely reach their goal of purchasing a home within the planned timeframe. However, if this same couple is saving for their retirement that is decades away, they more than likely care very much about the rate of return they receive on their investments above inflation and less so about the principle amount not decreasing over the short term. Upon reaching retirement age they will likely deem themselves successful if they manage to outperform inflation over their decades long investment period and are able to retire around the time they expected. As we can see the couple had to make a decision on how they allocate their capital in order to reach their two very different goals that they defined ahead of time.

The second step after defining your goals is to align your investment choices with the stated goals. If you are new to investing and don’t know what your choices are don’t worry, I will discuss the specifics of what my wife and I do shortly. But to conclude the example from above, when saving for a home purchase that is just a couple of years away, the primary focus should be on the safety of the investment and less on the rate of return. Meaning when the couple goes to reach for their money in 2-3 years time it should be there. So therefore the decision to allocate their capital to low risk, short term oriented investments is prudent. For example U.S. treasury bills, money market funds, or even an FDIC insured high yielding savings account would be wiser than say investing in stocks, longer duration bonds, gold, or crypto for example. Those same short term investment choices however, would more than likely end in failure for that couples goal of retirement. The future retirees will find their nest egg insufficient due to their real rate of return (rate of return - rate of inflation) being around zero on their savings throughout their investment period if the money is allocated to the aforementioned short term options. Therefore, with the clearly defined goal in mind of retiring in 20-30+ years, achieving a real rate of return in excess of inflation is key. And because of their extended time frame, the future retirees are able to take the volatile ups and downs of the stock and bond markets. Therefore, an investment decision to invest in historically higher returning stocks and bonds as opposed to a cash equivalent is called for.

This simple concept of defining your goals and then aligning your investment decisions to achieve those goals can also be applied to other areas of your personal finances. When making a decision of paying off debt vs. investing an individual can make a good capital allocation decision by simply defining their goal. Which is typically some combination of safety of investment combined with an adequate rate of return and then allocating their capital in a way that achieves that goal. For example if an individual has a car loan with a 9% interest rate (about the average in the U.S. as of my writing) and you have excess cash (excess meaning above what you need monthly + an emergency fund of say 6 months) sitting in a money market fund earning 5%, then the better capital allocation decision would be to use the excess capital in the money market to pay of the vehicle. You would achieve both a safer and higher return. This is because your current real return of negative 4% (5% money market - 9% loan) is exchanged for a real return of 0% (no money market fund - no car loan).   

Ok now on to the part where I discuss our personal framework for making capital allocation decisions. This is not investment advice, because everyone’s situation is different, this is just how we do it. Personally I have 3 “baskets” in which we keep our money. Basket #1 is the “short term” basket. This money is kept in a typical non-interest bearing checking account at a large FDIC insured bank. Our regular income goes directly into this account. Any money in excess of what is needed to cover living expenses is quickly moved into one of the other 2 baskets, this is due to the lack of income being generated while the money is sitting in basket #1. Basket #2 is the “mid term” basket. Basket #2 is where we keep our emergency fund and any money we plan on using in the near future. We allocate our capital to this basket, in order to maintain our emergency fund of 6 months of living expenses, or if we have a planned expense that exceeds our normal monthly expenses. For example, if we are saving for a large purchase like a vacation, new vehicle, house project, down payment on a home, etc. Before moving any money into basket #3, we always ask, “are we going to need this over the next 2-3 years? If the answer is yes, then it stays in basket #2. This mid term basket is a no fee brokerage account at a large brokerage house (Fidelity or Schwab), and is a combination of short term U.S. treasury bills and a money market fund. Basket #3 is just what you’d think, “long term” investments. Essentially, if we are allocating money to this basket we don’t plan on needing it for at least 3 years, and probably much longer than that. This basket is made up of many different tax advantaged accounts: 401(K) plans, traditional IRAs, Roth IRAs, SEP IRAs, HSAs, etc. and even another taxable brokerage account once we have reached the yearly contribution limits on the tax advantaged accounts. But whatever type of account it’s in, the goal here is long term compounding of your capital. In my opinion owning high quality businesses, run by good management teams, that you understand, can own for a long time, and that you purchase at an attractive price is the best way to accomplish this. That is why I invest in stocks and equity funds in this 3rd basket. I don’t really mind if this basket goes down in value over the short term so long as it grows sufficiently over the decades.

So, you can probably see right away that we have clearly defined my 3 baskets by their time frames, safety tolerance, and rate of return expected. Basket #1, the FDIC insured checking account earns me nothing but it is about the safest place to put money as long as you are under the FDIC limit of $250,000. However, I am very careful not to allow the levels in this account to grow above what we need monthly because I want that capital working for me in either of the other two baskets. As you have now seen, in basket #2 the short term investment choices made should roughly equal the rate of inflation. For example, today those investments are yielding around 5%, however when inflation is at a more normal level of say 2-3%, interest rates will follow and the yield will move lower accordingly. I am aware that I am giving up a higher potential rate of return but am happy to do so because of the immediate access to the cash, safety of principle, and predictability these lower yielding investments give me. Over the long term the yield earned in basket #2 will be more than the 0% that is earned in basket #1, but less than what is earned over the long term in basket #3. As basket #3 does NOT offer safety of principle or predictability, I am nevertheless willing to make these trade offs in order to grow my capital at a rate well above inflation. 

Now that we’ve defined in layman’s terms what capital allocation is, looked at some examples in terms of personal finances, and shown that its not just for CEOs, lets look back at the two examples that I discussed at the beginning of the article. With your opportunity cost lenses on, do you think keeping over $250,000 ($12.5 million in Antetokounmpo’s case) in cash that was earning them close to nothing was the right capital allocation decision? Perhaps it was… I don’t know their specific situations, but unless they needed access to it in less the 48 hour timeframe that money market funds give you, I’d say they left a lot of money on the table. Not to mention if these assets could have been invested in stocks or bonds.

Hopefully you now have a clearer mindset regarding financial decision making and I haven’t left you thinking that this sounds like a lot to keep track of. Just remember to ask yourself “defining” questions like do I need this in the next 30 days to pay for normal living expenses? Do I need this money in the next 3 or so years for a specific purpose? What rate of return is adequate for the risk I am taking? Trust me that it will become second nature to you. I can honestly say that I rarely think about it anymore. When our regular income comes into basket #1 I ask myself these questions and am done with allocating the money in less than 5 minutes per week. So with just a little questioning and planning you too can maximize your financial assets like a CEO.

Thanks for reading