Retirement Planning

Retirement is a modern concept. As recently as 1900 there was no such thing as retirement. Average life expectancy was around 47 and people essentially worked until they died.

Life expectancy at birth

Life expectancy today is nearly double that and spending 20 or 30 years out of the workforce in retirement is quite common.

Life expectancy at age 65

As recently as 1934 when Social Security was established and the retirement age was set at 65, the expectation was that very few people would live to collect and that those who did would collect only for a few years. Two generations later, American politics is facing the crisis that nearly everyone is expecting to retire and to collect retirement benefits for almost 20 years on average with an outstanding health care system pushing up life expectancy by 2 years per decade; the system is projected to run out of money in our lifetime if no changes are made.

So it's not surprising that society as a whole doesn't know how to handle retirement: it's never really been done before.

At the same time, corporate pensions are rapidly becoming a thing of the past. Even the largest and most stable companies like IBM are doing away with their pension plans, and plenty of other companies never had a pension plan to start with. The corporate pension system is being replaced by a system in which individuals must take of themselves.

personal savings rate

Taking care of yourself isn't a bad thing; it's what America is supposed to be all about. But most people are not prepared to do it because it sort of snuck up on us.

America as a whole is saving less than nothing. This is a pretty amazing statistic given the country's obvious affluence … and the truth is that the statistic isn't well understood even by the Bureau of Economic Analysis who publishes it; but the debt-to-income ratio has been growing for a long time and many people have simply not been saving for the future.

By now, pretty much everyone knows that they should not count on either government help or corporate programs to support them in retirement and the question is what to do about it. The answer, in a word, is PLAN. In a few more words, SAVE and INVEST. We're not concerned with society as a whole here, this is not politics; we're concerned about helping specific individuals. Namely, you.

Everyone's situation is different and needs careful, detailed analysis. This is particularly true because of the complexity of all the rules governing Qualified Plans and tax-deferred accounts, to say nothing of trusts and closely held businesses and so on. However, it is quite possible to get a very good idea of how much money you need to support yourself in retirement. There is an online spreadsheet you can fill in to do this. It won't be exact, but it will be close; and for many people, it will also be a shock.

If you click the link the online retirement savings spreadsheet will open in another tab or window:

Online Retirement Savings Calculator

The first things to enter are

• The number of years from today until you expect to retire, the Years TO Retirement, during which time you can save money
  
• Then, the number of years of retirement itself,
  the Years IN Retirement, which is the amount of time you will live off of your investments, at least partially
  
• How much you currently have invested, your Current Portfolio Amount
  
• The rate of inflation, 3% is a good estimate
  
• And then the amount you expect your investments to return every year; on average, pre tax

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Then enter what you expect to need from your investments every year once you retire. Use today's dollars, the spreadsheet will adjust for inflation.

• First enter the amount of money that you expect you will spend. Taxes are an expense to be included in this amount. The best place to start is with your current expenses.
  • If you stop earning wages, you won't pay FICA taxes, you may have paid off loans and mortgages and your kids will probably be independent, which will reduce your expenses.
  • On the other hand, you may be planning to go around the world on a private jet, which will increase your expenses.
    
  Whatever. Make your best estimate. There are lots of rules of thumb that say you can live off 60 or 80% of your pre-retirement income, but you know your own wants and needs best. And don't forget that later in life you may have very high medical expenses.
  

• Subtracted from that amount will be any outside sources of income. Social Security is inflation adjusted; most corporate pensions are not. Enter whatever outside sources of income you can reasonably expect during retirement.

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Given that input, the minimum portfolio size can be calculated. This is the amount of money you need in the bank on the day you retire.

There are four ways of looking at the amount of money you need.

1. First, you can plan to spend all of your money and have none left over when you die. Philosophically, there's nothing wrong with approach but if any of your assumptions are just a little bit optimistic, you'll find yourself with no money before you die, which is not a good plan.
   
2. Option number 2 is to plan to have the same dollar amount in your portfolio at the end of your retirement as when you start. This is a safer bet than Option 1, but inflation will take a toll.
   
3. So, Option 3 is the amount that you need in order to end up with the same amount adjusted for inflation.
   
   The problem with the first three options is that they just rely on the math of Future Value calculations, and they rely on your assumptions working out perfectly. Which isn't the way life is, particularly over 30 or 50 years.
   
4. Option 4 says, "How big must my portfolio be to allow me to withdraw 4% every year, adjusted for inflation, and not eat into it?"

   This is the highest hurdle but it is the one you should be shooting for. This is the punch line... (See Withdrawal Limits From A Fixed Portfolio )
   
   The link cites a study which looks at what happens to an investment portfolio when nothing is going in and an annual withdrawal is being made.
   If we assume that a good part of the investments are in the stock market, since that's the only way to beat inflation, then there will be times when the portfolio actually shrinks.
   
   When the markets go down, the amount of money gets smaller. And at the same time, you have to withdraw money to live.
   Put all of that into a simulator and the answer is that if you have a life expectancy of 30 years, then you really should not plan to withdraw more than 4% a year.

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Math Favors The Early Saver

The earlier you start saving, and the more consistently you save, the easier it will be to retire comfortably.

Consider these scenarios in which three people save $15,500 a year tax free (the current limit to employee contributions to a 401(k)). All three people earn 10% per year on their investments.

• Person 1 saves every year from ages 25 - 65
  • Total investment: $635,500
  • Amount at age 65: $7,561,703
    
• Person 2 saves every year from ages 25 - 35 and then stops saving but lets the investment grow
  • Total investment: $170,500
  • Amount at age 65: $5,012,046
    
• Person 3 waits until age 35 to start saving but saves every year afterward until age 65
  • Total investment: $480,500
  • Amount at age 65: $2,820,123

How does Person 2, the one who stopped saving at age 35 to raise a family or something, do better than Person 3 who started 10 years later but saved for 3 times as long? It's the power of compound interest ... by age 35, Person 2 had built up $287,233 and that amount, compounded, was too much of a lead for Person 3 to catch.

The lesson is obvious: start saving as early as possible, save every year and put away as much as possible. For Person 3 to retire with as much as Person 1, they will have to work another 10 years or else increase the amount they're saving.

The trend in America has been to start work later and to retire earlier than our parents. To do this and to retire comfortably requires greater savings. If a person wants to become a doctor, say, which will require them to stay in school, etc. until age 30 and they want to retire at age 60 with as much money as Person 1, they will have to save $41,561 every year, at 10% tax free.

The maximum employer_plus_employee contribution to a 401(k) plan in 2008 is $46,000 so it is theoretically possible to achieve this, but not easy. For one thing, you have to forego spending this much money every year for your whole working life and for another, you have to invest at 10%; if you invest the maximum, the lowest interest rate that will allow you to achieve your objective is 9.49%.

If you're tempted to withdraw more than 4% a year from your portfolio in retirement, please read: Withdrawal Limits From A Fixed Portfolio

These sorts of considerations lead all too many people to "reach for yield" or otherwise invest foolishly; risky investments are just that, however, and one bad year can wipe out a lot of exceptional ones. Achieving returns that are better than the return on the 10-year Treasury bond require being willing to take some risk, to diversify and to invest for the long term; a suggestion on how to set up an investment portfolio to support yourself in retirement can be found here: Asset Allocation and Portfolio Rebalancing

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That's the math. Math is important and we can't ignore it; but life is a whole lot more than math.

And retirement is a huge transition for everyone.

Very often people put aside financial planning because of the emotional stress caused by the difficult life transition that is retirement. Just thinking about the subject gives a lot of people agita, no matter how old they are. This is natural.; the fact is that everyone responds this way because being young and in the workforce with plans for the future is what everyone plans for and expects. It is why we go to school for 20 or more years of our childhood, to prepare to be a member of the workforce. Work and family are what define most people at a very deep emotional level. Retirement disrupts everything; and many people compound the stress by moving away from their home on top of it.

What happens to us when our role in the workforce is diminished or eliminated? This is a tremendously hard question that goes to the heart of ...

• our self worth,
• our self-definition
• our place in society.

Preparing for retirement is an act of complete self redefinition during a period in our lives when our physical capabilities are beginning to decline, no matter how hard we work to prevent this. Everything is new and everything is hard. And there's really no one to show the way because ours is the first generation to do this on a large scale. It's no wonder that financial planning takes a back seat. However, having one's finances in good order and well understood reduces fear and stress by replacing an amorphous unknown with a concrete known.

Aristotle said that Well Started Is Half Done and Woody Allen observed that 80% of life is showing up. If you get your financial house in order, you will have a much easier time of dealing with everything else that may be going on in your life; and the earlier the better.

For any individual, there is a lot more analysis required to make sure we get everything right. Furthermore, there's a lot more to Financial Planning than just Retirement Planning. But this should have given you an appreciation of the magnitude of the issues that you face and have given you an idea of what needs to be done to ensure that you are on the road to financial independence. Because ultimately, that's what we're trying to do here.

A detailed look at the investment process can be found here:

Asset Allocation and Portfolio Rebalancing

The Cause of the Subprime Crisis

Asset Allocation and Portfolio Rebalancing

This article describes how to invest for the best long-term results. It applies to all investors but the primary audience is individuals who expect to derive substantial retirement income from their investment portfolio.

• The focus is to generate the highest returns over an investor's lifetime (or longer if you plan to leave money to your estate). The way to do this is to take advantage of the "portfolio effect" of Modern Portfolio Theory ... wide diversification increases returns and decreases volatility.
  
  
• The typical investor gives up as much as 50% of their investment returns in costs. Reducing costs is important to investment success.
  
  
• Portfolio Rebalancing is a technique that helps investors buy low and sell high without attempting to predict market moves.
  
  
• A key recommendation is to minimize income because it generates taxes. If you need cash to pay expenses, it should be created as a tax-efficient byproduct of portfolio rebalancing.
  
  
• View all of your assets as a single portfolio: pockets of underperforming assets - checking accounts, for instance - are a drag on your overall returns.
  
  
• Estate planning is briefly touched on. Transfer taxes are the most onerous in the entire Internal Revenue Code but most people ignore them. A fill-in-the-blanks will off the Internet is not sufficient protection.
  

A problem many investors face is that most advice tends to be piecemeal, often focused on specific products or techniques without the context of the whole portfolio or investment horizon; this article goes through the steps in order and explains specific recommendations.

This article is formatted for printing

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Step 1. Choose the brokerage firm

Individual investors will get the best returns if they take responsibility for their investments. It may be appropriate to hire an advisor because of the constraints of time or out of a desire to get expertise, but it is not appropriate to keep your investment funds in a "full service" brokerage or to cede control of your assets to someone else. Brokers reduce investment returns because their commissions are high and because they have an incentive to recommend "products" that pay them fees.

At the end of the day, for a primary investment account there are really only two choices:
Fidelity and Vanguard.

The advantages of each are these:

Fidelity

• Better website
• Better interface to Quicken
• Better cost-basis accounting

Vanguard

• Better money market rates
• Free trades for large accounts

If you plan to hold a large amount of cash for a long time, you should hold it at Vanguard because the difference in the money market rates is significant (as of January 2008).

Diversification is a good idea in all things and you might consider spreading your total portfolio across both firms to reduce the risk of calamity, in which case you would be inclined to hold your cash account at Vanguard.

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Set account options

We're dealing with regular fully-featured brokerage accounts here, either taxable or retirement, not mutual fund accounts or insurance or annuity. It is very easy to set these sorts of accounts up online; transferring money or effecting a rollover requires specific paperwork and procedures but the recipient brokerage company will be quite happy to help.

There are five choices to be made:

1. Cash or margin
   A margin account lets you borrow against the securities. Margin rates are usually better than home equity rates but the deductibility of margin interest is more complicated and not guaranteed in all cases.
   A cash account can always be converted to a margin account so unless you plan to buy on margin immediately or to take a margin loan, starting out with a cash account makes sense.
    
2. Reinvestment
   There is a very important feature of yield-to-maturity and other compound-return calculations that is rarely emphasized ... these calculations assume that interest, dividends and capital distributions are reinvested. This is described in detail in Reinvestment Considerations
   
   As described in Producing Cash, generating the cash to fund ordinary expenses should be done by tax-efficient portfolio rebalancing rather than by spending interest and dividend payments.
    
3. Wire instructions
   Money will need to be wired in and out and you need to set this facility up.
    
4. Cost Basis Accounting
   This is not optional. You simply must enable lot-specific cost-basis accounting for all taxable accounts.
   Without a record of the cost basis, the IRS will assume zero (0), which means you will owe capital gains tax on the entire amount of any sales proceeds not just the gains.
   
   The longer you go without establishing the lot-level cost basis of your positions, the worse the problem will become; compounding every year until the only salvation is the basis step-up available to your estate.
    
5. Option Writing
   The Options section describes a method for selling options instead of placing market orders. If you want to use this method, the account must be approved for option writing.
    

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Step 2. Choose the asset classes

Modern Portfolio Theory (MPT) is pretty-well established as the best approach to building an investment portfolio. Its two basic tenets are:

1. Diversification reduces risk and improves returns

2. Combining asset classes that exhibit negative correlation (i.e.., their movements tend to be different from each other) will also reduce risk and improve returns

The chart below shows the performance of several broad asset classes in the US since 1926.

click to enlarge

Inflation

Inflation is the gray area at the bottom of the chart. Since the mid 1930s prices have risen every year and what you could have bought for $1 in 1926 costs $11 today. Inflation is usually measured by the Consumer Price Index (CPI) and has been running 3% a year on average since 1926, including the deflation experienced at the beginning of the Depression when prices actually fell.

America hasn't faced serious inflation in nearly 30 years. Inflation wreaks terrible havoc on investment portfolios. Buying zeros at their low point is a bold move and stocks will soar as inflation recedes but financial assets suffer in the years that precede these moments and we need to hope that a combination of control by the Federal Reserve and fiscal restraint on Capitol Hill will keep us in the range of 3% and under.

There is a good deal of debate about how to measure inflation. "Core" inflation excludes food and fuel, which most people can't do without. Furthermore, the way inflation is measured is subject to political pressure: more and more government programs are indexed to inflation; the recipients want the measure of inflation to be rounded up but the government wants to save money by rounding it down.

The truth about inflation matters to a long-term investor. You might be interested in Shadow Government Statistics, which provides an alternative to the government's own measures.

A quick-and-dirty way to figure returns after inflation is to subtract 3% but the actual effect is worse because inflation has a compounding effect.

Stocks

It is quite clear from the chart that equity (stock) outperforms either debt (bonds) or cash (bills). It's also clear that small stocks outperform large stocks.

What isn't so clear from this chart is that owning stocks is a roller-coaster ride of risk and volatility. In 1987, the stock market crashed; it crashed in 1990, it crashed in 1998 and it crashed again in 2000 (the dot.com bust) and kept falling until the end of 2003; it was not until the middle of 2007 that the stock market recovered to the level it had reached in 2000 and it almost immediately started falling again because of the credit crisis brought about by the mortgage-backed security fiasco.

The point is this: you should only invest in the stock market if you are prepared (and able) to hold your position for a very long time; if you can't accept these risks then you should absolutely stay away from the stock market.

However, for people with a long investment horizon the stock market will produce the best long-term results, particularly in an inflationary world which is where we live.

Only US equity returns are shown in the chart above, but as the world gets flatter and non-US economies increase as a share of world GDP it is important to hold equity from all regions of the world.

Bonds

Bonds are a more complicated story. The traditional advice from Wall Street is to hold less equity as you get older and more bonds. The reasons given for this are that when you're in retirement you need to live off the income from your investments and as you get older your investment horizon is getting shorter, so the risk of stock market fluctuations is more significant.

There are several observations to make about this.

First, interest from bonds (except municipals) is currently taxed at a much higher rate than either dividends or capital gains. Obviously this can change at the whim of politicians, but no matter what Washington does, interest payments will always be taxed.

Therefore, it makes sense to consider living off a cash account that you create by taking tax-efficient profits. This requires some effort, but the alternative is to give up as much as 35% in Federal income taxes (plus state taxes).

Second, your investment horizon is growing because of the advances of medicine, which is extending life expectancy by as much as 3 years per decade.

Finally, most people hope to leave a legacy after their death in which case their investment horizon extends beyond their own life.

Bonds tend to be a good investment when interest rates are high because the amount they pay is higher and because their value can be expected to increase when interest rates fall.  At the moment, however, interest rates are low and bonds are not a particularly attractive investment. Investors with concerns about near-term volatility, such as those who derive a substantial amount of their income from their portfolio, should accumulate a multi-year cash pool as described in Producing Cash.

US Government Bonds (Treasuries)

An exception is US Government bonds. Whenever the economy is strong, Government bonds don't look very attractive; but when there is a bump in the road, there is always a "flight to quality" in which people dump whatever else they own and buy US Government bonds because they are safe.

The result is that whenever we are heading into a recession and/or the stock market is falling for some other reason, people buy US Government bonds.

• When people buy something, its price goes up.

Therefore, US Government bonds are a nice thing to own when there is a bear market. This is a form of insurance ... the premium is the drag on your portfolio when there's a bull market and the payoff comes whenever the stock market falls.

A peculiarity of bonds is that when their price goes up, their yield goes down; and vice versa. A Yield Curve shows the yield-to-maturity of US Government bonds.

The graph shows two things:

First it shows that yields on US Government Bonds fell as a result of the credit crisis that began in 2007. This means their price went up ... just as promised. The arrows indicate that the yield to maturity of the 2-year treasury note fell from about 5% to below 2%. This is a significant drop in the yield and the price showed just as significant a rise.

The second thing it shows is that the most-pronounced drop was in the "intermediate" maturity range.

If inflation starts to get out of control we will need a different idea, but for the time being holding intermediate-maturity US Government Bonds is a way to hedge at least a part of your portfolio against bear markets. It's not foolproof and it does have a cost in terms of reduced returns during bull markets but it's something worth considering.

Cash

Your portfolio needs to contain cash because you need to pay your bills unless your outside income covers all of your living expenses. Cash will also dampen a portfolio's volatility, although at a price even higher than that of Government bonds in terms of reduced return because cash does not have the feature of ever going up in value.

Specialized

Real Estate and Commodities are neither equity nor debt but they account for a great deal of the world's economy. Also, their movements tend to be at least somewhat negatively correlated, which makes them attractive asset classes from the standpoint of Modern Portfolio Theory.

The warnings about the risk of equity are doubly applicable to Real Estate and Commodities ... their prices gyrate considerably. However, a number of studies such as the one shown below have concluded that despite their volatility Real Estate and Commodities can improve the long-term performance of a diversified portfolio.

Empirical Confirmation

The January 16, 2008 Wall Street Journal reported a study done by Prof. Craig Israelson of BYU. He studied portfolios from 1973 to 2006 with a 5% inflation-adjusted withdrawal rate. The asset classes were given equal weight.

Each row in the table represents a different portfolio that contains everything above it and adds a new asset class:

First row portfolio	100%  large & small cap US stocks
Second row portfolio	50%     large & small cap US stocks,  50%  non-US stocks
Third row portfolio	1/3      large & small cap US stocks,  1/3    non-US stocks,   1/3 government bonds
etc.

Portfolio	Avg. Annual  Rate of Return	Std. Dev. *	Worst Year's  Decline **
Large & small cap US stocks	10.7%	18.0%	-30.8%
Add non-US stocks to the above portfolio	10.9	17.2	-29.8
Add US Government intermediate term bonds to the above	10.6	13.0	-22.0
Add cash to the above	10.0	10.5	-16.9
Add REITs to the above	10.4	10.6	-18.8
Add commodities to the above	11.3	8.7	-10.2

*     Standard Deviation. Measures how widely each portfolio's annual returns varied from the 37-year average annual return
**  The declines include the annual withdrawal
 

This study clearly supports the predictions of Modern Portfolio Theory. It presents a conclusion that is not commonly understood, which is that wide diversification can both increase returns and reduce volatility. REITs and commodities are not commonly considered a part of a prudent investor's core holdings, but their effect on the performance of a portfolio can be a dramatic improvement. The reduction in the "Worst Year's Decline" is particularly striking. Furthermore, cash is usually considered to be undesirable but its effect on volatility is very positive in this example even though it reduces the return.

Portfolio Rebalancing can further enhance the effect shown here.

Some studies have indicated that all these asset classes are becoming more positively correlated. If true, this would mean that the "portfolio effect" is becoming less pronounced, but it is still a good strategy for building portfolios.

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Conclusion: Which Asset Classes to Choose

       The fundamental take-away is this: always diversify widely.

• Large and small stocks from around the world should form the core of a long-term investor's portfolio.
• Specialized investments in real estate and commodities can improve long term performance.
  • Both equities and specialized investments carry a very significant risk of decline in value and should be considered only by people who understand these risks and are willing to take them in a long-term portfolio
•  
• US Treasuries should be considered as insurance against bear markets as well as a volatility damper.
• Cash is the safest investment in that its face value remains constant, but inflation will eat it away;
  holding one or more years' withdrawal needs in cash will allow withdrawals to be made when the market is declining without the need to liquidate securities at depressed prices.

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Step 3. Active management or indexing?

The 15 year period from 1984 to 1999 was the longest sustained bull market in history. During that time many asset managers ran funds that promised to beat the market.

A comprehensive study1 was subsequently done of their after-tax performance:

• 96% did worse than Vanguard's S&P 500 index mutual fund ... by an average of 4.8% a year
   
• Of those that did beat the index fund, they did so by an average of 0.6%

There is a graph in The Cost of Costs that shows the effects of under-performing by 2%. Under-performing by 4.8% is more than 2.4 times worse because of compounding.

It is certainly the case that some people do beat the market, Warren Buffett has become quite famous by doing so. But should you invest in Berkshire Hathaway when its chairman is 78 years old? Not if your investment horizon is 20 or 30 years you shouldn't.

The problem isn't that people can't beat the market for extended periods ... the problem is finding them when they're starting out.

As far as published claims of sustained investment performance, consider this: there are over 10,000 actively managed funds in America; if their performance were based on the flip of a coin, after 5 years more than 300 of them would have produced continuously-winning records just by the laws of chance. Furthermore, the funds get to pick the index they are compared against.

If you can beat the market yourself ... fine, go ahead;
If you can identify the next Warren Buffett ... great, give him all your money;
If your investment horizon is only a few years and you feel like betting on some hot thing ... well, good luck.

But for the rest of us "indexing" is really the only sensible thing to do.

Indexing involves managing your portfolio to track the performance of one or more indexes that represent the returns of various asset classes.

Many people feel that it is simply common sense that by studying the market an expert will be able to beat the index. But the fact is that most people, expert or not, who try to do this fail. That is the point of the study of active management described above ... most active managers over the long term do worse than the indexes, much worse, not better.

There are a number of reasons for this:

• The first is fees. Active managers charge for their services whether or not they succeed and your return has to beat not only the index but the index plus the manager's fee.
   

• The second is transaction costs. Active managers buy and sell in an effort to own the winners and get rid of (or short) the losers. This generates commissions; sometimes "soft dollars" are substituted but no matter how the manager pays for it, it comes out of the return of the fund.
   

• The third is taxes. Usually the manager's buying and selling generates capital gains. At the end of the year, these are taxable to the investor.

  The Cost of Costs goes into the effects of costs in detail.

• Finally, there is the simple fact that beating an index is a very difficult thing to do. Just doing as well as the index is pretty hard, and not every index fund succeeds; when an index fund doesn't follow the index it's called "tracking error" and it's pretty common.

 

Of course, plenty of people derive a great deal of pleasure from studying the economy and researching stocks and investing in them; and other people enjoy day trading. These are perfectly fine hobbies, but they should be funded with only a small part of the investment portfolio.

It should be noted that the active management described here has to do with your investment portfolio. Someone who develops real estate or an entrepreneur running a biotech company or a doctor running their own practice are all involved in very active management. But the active manager in such a case is you. That sort of active management is the bedrock of the American economy and is something to be greatly encouraged.

 

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Step 4. Stock, closed-end, mutual fund, ETF?

Because holding large numbers of individual securities is impractical, there are basically three security types to choose from to implement an index strategy:

1. Closed-End Funds
   Closed-End funds often sell at a discount or premium to the underlying value of their portfolios which make them suitable for active investors looking for an arbitrage opportunity but not for indexing purposes
    
2. Open-End Funds
   Mutual funds: these were the security of choice for indexing prior to the advent of the ETF
    
3. Exchange-Traded Funds (ETFs)
   • Trade on an exchange just like a stock
   • Rarely trade at either a discount or premium
   • Provide real-time prices
   • Never have "loads" which are fees imposed when you buy or sell many mutual funds;
     the cost of buying or selling an ETF is only the commission.
   • Can be bought in any account, whereas open-end funds are often costly to buy from any but their issuer.
   • The best ETFs have exceptionally low costs.
    

ETFs are the way to go.

It should be noted that "ETF" has become synonymous with "index fund", but actively-managed ETFs have been approved by the SEC and we will soon see many more of them. ETFs are also associated with low costs, but there is nothing inherent in an ETF that makes its costs any lower than any other fund; mutual, hedge or otherwise.

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Which ETFs should you choose?

Indexing means buying funds that track an index rather than trying to beat it. The three important characteristics of such a fund are:

1. Low costs
2. Tracking
3. Low payouts and capital gains

The short story on this one is: Vanguard "Vipers".

• Vipers are a share class of their mutual fund pools and so they have the identical management and composition.
• Vipers have the lowest costs of any ETFs, bar none (as of January 2008)
• Vipers track their indexes very closely.
• Vipers produce the lowest payouts, and therefore the lowest taxes.

You do not have to have a Vanguard account to own Vanguard ETFs. You can buy a Viper in a Fidelity account for exactly the same price and with exactly the same ease (more ease, in fact, because Fidelity's web site is easier to use than Vanguard's).

The only deficiency of Vanguard's ETFs is that they do not cover quite all of the asset classes we've been through. For the gaps, I recommend Barclay's iShare and iPath ETFs.

Exchange Traded Notes (ETNs) are a new form of ETF that significantly reduce or eliminate payouts (and, therefore, taxes); the risk is that the investor is an unsecured creditor of the issuing firm and they have not been fully tested in the tax court. These securities look very promising if you are willing to accept the risks.

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Step 5. Pick the specific investments

Given the asset class choices described above and given the desire to use index ETFs, which ETFs should you choose?

I recommend the following: (the letters in parentheses are the trading symbol ... the links provided are to Morningstar)

US Stocks

Vanguard Total Stock Market (VTI)

This fund tracks the entire US stock market. The most popular index for the US is the S&P 500 but it consists of only large-cap stocks. Since small-caps outperform large over the long term, we want "exposure" to these and VTI gives that to us since it owns pretty much every stock in America

A case can be made for being "overweight" small cap stocks ... the Ibbotson data above clearly demonstrates that small caps have outperformed large caps over  the long term (while also being considerably more volatile). A similar argument can be made for being overweight Value stocks, meaning stocks that have been beaten down for one reason or another and which are usually defined as stocks with a low Price/Earnings or Price/Book ratio. The rationale for Value stocks is that a stock whose price is low relative to the intrinsic value of the company has more upside potential; furthermore, the Efficient Market Hypothesis identifies Value stocks as an "anomaly" which have traditionally defied the theory's assertion that random selection is the only winning strategy.

It is generally helpful to try to keep the number of securities in a portfolio to a minimum and VTI gives us a full spectrum of large, medium, small, value, blend and growth all in one package.

But the addition small and/or value ETFs to a core holding of VTI will allow more granularity for the purpose of portfolio rebalancing. The choice is really a matter of the amount of time you are willing to spend in portfolio administration: more granularity could give you better performance if you are diligent in rebalancing; if you are not diligent, however, your portfolio will tend to drift further and further from your preferred asset allocation, which was presumably set relative to your level of risk tolerance meaning that your risk is likely to increase over time; change in the riskiness of your portfolio is not something you should leave to chance.

Vanguard offers three small/value ETF combinations you might consider if you want to increase your granularity:

• Small-Cap (VB)
• Value (VTV)
• Small-Cap Value (VBR)

Non-US Stocks

Vanguard European (VGK)

Vanguard Pacific (VPL)

Vanguard Emerging Markets (VWO)

The classic index for developed non-US economies is the EAFE: Europe, Australasia, Far East. There are ETFs that track the EAFE but in the 1980s Japan was on a tear & Europe was in a slump and what a person who rebalanced their portfolio wanted to do was sell Japan ("sell high") and buy Europe ("buy low"). But the EAFE bundles Europe and the Pacific together and makes that sort of rebalancing impossible.

Of course, that logic can be extended a lot further than just simply holding two ETFs; you could use that logic to justify owning every single stock in every index you track. But only the most dedicated investor is willing to devote the time to manage such a portfolio and I recommend going no further than holding the two ETFs: VGK for Europe and VPL for the Pacific region.

Non-developed ("emerging") non-US economies are becoming very important. The BRIC, Brazil, Russia, India and China, are getting the most press, but others are important as well. Here again you have many choices that will allow you to be much more granular but VWO is a good compromise.

Non-US Stocks
VEU
VGK			VPL			VWO
Europe			Pacific			Emerging
UK	32.6%		Japan	65.0%		China	17.2%
France	14.1%		Australia	22.5%		South Korea	15.1%
Germany	12.5%		Hong Kong	7.4%		Brazil	12.2%
Switzerland	9.4%		Singapore	3.8%		Taiwan	10.7%
Spain	6.1%		New Zealand	0.5%		Russia	9.0%
Italy	5.4%					India	7.3%
Netherlands	4.1%					South Africa	7.0%
Sweden	3.5%					Mexico	4.6%
Finland	2.8%					Malaysia	2.3%
Belgium	1.9%					Israel	2.1%
Norway	1.5%					Turkey	1.8%
Denmark	1.3%					Indonesia	1.7%
Greece	1.2%					Poland	1.7%
Ireland	1.0%					Chile	1.4%
Austria	0.8%					Thailand	1.4%
Luxembourg	0.7%					Hungary	0.8%
Portugal	0.5%					Czech Rep	0.7%
						Peru	0.7%
						Argentina	0.6%
						Philippines	0.6%
						Egypt	0.5%
						Columbia	0.1%

Vanguard's FTSE All-World ex-US ETF (VEU)

If you want to pare down the number of holdings in your portfolio, consider substituting VEU for the triplet of VGK, VPL and VWO.

Specialized

Vanguard REIT (VNQ)

iPath Commodity ETN (DJP)

A REIT is a Real Estate Investment Trust, which is a way to provide financing to real estate development projects. Holding a collection of REITs in an index fund  provides diversification but the volatility will still be significant. VNQ holds equity REITs, which participate in the income and growth in the value of the properties (rather than mortgage REITs which are essentially loans against the property and are a poor investment choice).

DJP tracks a commodity index that caps the exposure to petroleum products at 33% of the index. GSG and GSP are alternative commodity funds that track indexes that do not constrain the components.

You should be conscious of the fact that the equity ETFs contain stocks of real-estate- and commodity-related companies. The largest holding in VTI, for instance, is ExxonMobil and it also includes Toll Brothers and similar firms.

Debt

iShares 3-7 Year Treasury Bond (IEI)

iShares TIPS (TIP)

IEI tracks intermediate-maturity US Treasuries, which are the ones that tend to show the biggest moves when people are fleeing to quality. Vanguard offers an intermediate-term bond ETF (BIV), with a lower expense ratio (0.09% vs. 0.15%), but its effective duration is longer (5.94 vs. 3.93) and it invests in government mortgage-backed securities as well as Treasuries.

TIPs are inflation-protected US Treasuries; to the extent that inflation exceeds expectations, TIPs will out perform.

Cash

There are two questions to answer with respect to cash: (a) how much to hold and (b) where to hold it.

How much cash to hold depends on your need for cash to pay expenses over and above any outside income sources. How much can you withdraw in retirement? discusses this issue.

Cash can also provide a volatility buffer.

 

Where to hold cash is just math.

Municipals and governments pay a lower return than do taxable money market funds. Your tax rate determines whether you are better off taking a lower tax-free rate or a higher taxable one.

A. Find the rates for Muni State, Muni Non-State, Government and Fully Taxable money market funds.

here: Choices For Cash Account

B. Find the best after-tax choice

here: Tax Consequences of Cash Account Choices

Enter the best of the rates found in A
   into the "Reported Yield" column of B
      and enter your federal, state and local tax rates.

For large cash accounts this calculation should be done several times a year because money market rates change frequently. Funds can be moved between money market funds without incurring taxes.

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Municipal bonds can sometimes provide an opportunity for the taxable investor with longer-term cash holdings. It's difficult to get reliable quotes because dealers tend to have what they have, not necessarily what you want and the two issues of call-ability and AMT can cause problems. But opportunities do sometimes arise. A place to look to get an idea of current rates is the Wall Street Journal online:

• Markets Datacenter
  • Bonds, Rates & Credit Markets
    • Tax-Exempt Bonds

Although many brokers now offer online access to some of their inventory, you will end up talking to their bond desk in person because munis don't fit neatly into standardized buckets. And remember that if you decide to sell before maturity you may not get the price you'd like.

See Reinvestment Considerations below for a discussion about holding bond funds vs. holding the bonds themselves.

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Note: One of the considerations if you choose a municipal investment is whether it is subject to the Alternative Minimum Tax (AMT). It is generally desirable to avoid AMT but individual situations differ significantly and you should analyze your own situation with the help of a tax specialist.

You should also note that a money market fund may not be considered "cash" for the purposes of recovery from the SIPC.

Finally, you should realize that while all money market funds are supposed to retain a per-share value of $1, and reputable fund managers will go to great lengths to ensure that this is always true, some money market funds have "broken the buck" causing their investors to lose money.

An FDIC-insured checking account will yield substantially less than a money market fund, but it will be federally-insured up to $100,000 whereas the money market fund is not similarly protected. As stated elsewhere, if certainty is important to you, you should not follow the advice provided here. The disclaimers go into this in more detail.

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Step 6. Choose the asset allocation

How much of each specific investment should you own?

If you allocate conservatively you may receive a lower return than theoretically possible but the worst thing to do is to allocate aggressively and then bail out when the market goes down. Unfortunately, funds-flow studies have found that many individual investors and a surprising number of professional money managers do just this. People seem to grit their teeth for a number of months and then "capitulate" near the bottom of the market downturn. The result is much worse than allocating conservatively and sticking with it.

So this step is much more a self-analysis exercise than an intellectual or mathematical one.

• Modern Portfolio Theory recommends holding each asset class in the proportion it occupies in the world economy.
• The portfolios studied at BYU, described above, gave each asset class equal weight.
• The average asset allocation of US pension funds in 2007 is shown in the pie chart;
  "Stock" was 42% US equity and 18% non-US equity;
  "Alternate" consisted of real estate, private equity and hedge funds in roughly equal proportions.
• 75% equity/25% debt is a very common recommendation given to retail investors by their advisors, as is 60/40

The first major work on asset allocation was Brinson, Hood and Beebower’s “Determinants of Portfolio Performance” in the July 1986 Financial Analysts Journal; they said that asset allocation explained 93.6% of the variation in quarterly portfolio returns. The implication was that getting the mix of stocks and bonds perfect was very important.

But 10 years later, in "The Asset Allocation Hoax", William Jahnke pointed out that the key word was "quarterly" ... that over periods of 10 years or more, asset allocation explained only 14.6% of the variation in return; over long time frames the dominant consideration in widely diversified portfolios is costs.

So pick an asset allocation that you feel comfortable with and focus a lot more attention on keeping your costs down.

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The following graph is an example of an "Efficient Frontier".

Different portfolios have different risk/return characteristics and if you were to plot every possible portfolio, the best choices would lie along the Efficient Frontier.

What is meant by "best choices" are those portfolios that have

• The highest return for a particular risk level
• The lowest risk for a given return

Obviously if you have two portfolios that have the same return but one is riskier (more volatile), you will pick the one with less risk.

A tremendous amount of time is expended fine-tuning portfolios using Monte Carlo computer simulations to produce just exactly the right combination of assets to locate the perfect spot on the Efficient Frontier.

It's all very lovely in theory but unfortunately it doesn't work especially well. The results are precise but not accurate. That is to say that the result can have sixteen decimal places but its predictive value is no better than most back-of-the-envelope asset allocations.

The graph below is merely an illustration of the common-sense notion that (a) higher-return assets tend to be riskier and (b) when you combine different assets you get a continuum of combinations of risk and return. One counter-intuitive result of Modern Portfolio Theory that bears mentioning is the fact the a portfolio made up exclusively of the least-volatile assets (100% bonds in this example) is not necessarily the best choice because combining some riskier assets can increase the return for the same level of risk.

In conclusion: an individual investor is best served by not getting wrapped around the axle with respect to asset allocation. Pick an asset allocation of a group of widely-diversified asset-class index ETFs that you can live with in down markets and don't pull up the plant too often to look at the roots.

click to enlarge the Efficient Frontier graph

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Step 7. Invest the money

It should be noted that every step described here can be done by the investor online ... there is no need to involve a broker.

When investing a sum of money, you should plan to "leg in" over 18 months or so. That means that you should invest about 1/6 of the amount every three months to try to get a lower average price. Predicting what the market will do is usually futile and leaving money in cash has an opportunity cost of foregone equity growth.

This approach is called "Dollar-Cost Averaging".

Monte Carlo analysis has been done to compare Dollar Cost Averaging to simply investing everything all at once (A Simulation Model for Deciding Between Lump-Sum and Dollar-Cost Averaging). The conclusion is that Dollar Cost Averaging provides a better outcome somewhat more than 50% of the time. It also helps to reduce the fear of committing to an uncertain course of action.

A variation on Dollar-Cost Averaging is Value-Cost Averaging (VCA) which says, essentially, that you should invest less when the market is rising. There is some evidence that this method can be effective (see A Statistical Comparison of Value vs. Dollar Cost Averaging and Random Investment Techniques). My sense of VCA, however, is that it probably is overkill for investing a lump sum amount.

When markets are turning from bearish to bullish the largest gains are often made in the early stages, so it is important to be invested ahead of time. It does not usually pay to try to wait for the perfect moment to invest a sum of money all at once since the perfect moment can usually be recognized only in hindsight.

This link -- Asset Allocation and Rebalancing -- is an online spreadsheet that will allow you to figure out the number of shares to buy when you're "legging in". It will also help you rebalance your portfolio once it's fully invested.

Lump-Sum Example, step 1

This example shows a $1,000,000 lump sum that will be invested in 6 pieces of $166,666 each. Don't be put off by the amount: this works for any investment.

The first step is different from the other five:

1. Set the asset allocation (Alloc) you want.
2. Zero out the Actual amounts for all the asset classes ... except Cash, which will be set to $166,666.
3. Enter the Ask prices for each asset class in the Price column.

The spreadsheet will look like this when you're finished (prices shown are from January 15, 2008).

click to enlarge picture for Step 1

Thus you can see that you should buy 207 shares of VTI (obviously the amount will differ for different amounts, different allocations and different Ask prices).

Lump-Sum Example, steps 2-6

The 5 subsequent leg-in steps are these:

1. Set the asset allocation (Alloc) you want.
2. Set the Actual amounts to the actual amount in the portfolio; ... except Cash, which will be set to $166,666.
3. Enter the Ask prices for each asset class in the Price column.

In this example no market movement has taken place since the first step, which obviously will not be the case in an actual example.

These steps are the beginnings of Portfolio Rebalancing because adjustments will be made for the relative movements in the asset classes since the previous investment. You may decide to adjust the amount of your cash holdings at this point, too, as suggested below in Producing Cash.

click to enlarge picture for Step 2

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Step 8. Manage the portfolio using Portfolio Rebalancing

The most basic principle of investing is to buy low and sell high. But predicting lows and highs is beyond most people's ability.

Portfolio Rebalancing is a method that gets you as close to this ideal as possible without having to predict anything.

As the market moves, some asset classes will outperform others. Portfolio Rebalancing involves selling the asset classes that have over performed and using the money to buy the asset classes that have under performed.

The example of January 2007 is that REITs had grown 35.3% the prior year; Government Bonds, on the other hand, had languished. Portfolio Rebalancing involved taking profits from the REITs at high prices and buying Government Bonds at low prices.

By January 2008, the situation was exactly reversed: REITs had collapsed and Government Bonds had done their flight-to-quality thing and risen. A Portfolio Rebalancer would have made a profit from the REITs and would also have had more "insurance" for when the market fell; not because of genius or deep analysis, but simply because the asset allocation had gotten out of whack.

The major problem with Portfolio Rebalancing is psychological: it is very difficult to sell something that is going up and even harder to buy something that is going down.

How often should you rebalance? In general, a taxable account should be rebalanced no more than once a year. If an asset class is less than 10% out of balance, it's best to leave it alone.

In a taxable account selling winning positions creates capital gains; lot-level cost-basis accounting will prevent you from generating short-term capital gains when you sell; and if you wait a year between rebalancings, the only short-term gains you will need to worry about will be recently-reinvested income. If you use this process to invest any new money you will automatically rebalance and not have to sell as many positions because the new money will go into the under-performing asset classes.

Many people have heard the expression "sell your losers, let your winners run"; that's a strategy for traders in individual securities but it is not good advice for long-term index investors.

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These links are for online rebalancing spreadsheets:

• Either The Model Portfolio as shown in this article
• Or        A Portfolio With The Fewest Securities

The spreadsheet for A Portfolio With The Fewest Securities can be useful both for people who want a streamlined portfolio and for people with very complex portfolios who want to rebalance on the basis of broad asset classes rather than each security in detail (in the latter case, the Price and Shares columns will not apply).

click to enlarge rebalancing calculator

Follow these steps:

1. Set the asset allocations you want (Alloc).
2. Set the Actual amounts equal to the amounts in your portfolio.
3. Enter the prices in the Price column:
   • Ask for buys
   • Bid for sales

The Shares column will tell you how many shares to buy (positive) or sell (negative) for each asset class to get back to your desired asset allocation. (An $8 per trade commission is built into the spreadsheet).

If you issue all your sell orders first and wait for the trades to clear (usually 3 business days), the cash will be available to fund the buy orders.

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Producing Cash

Portfolio rebalancing gives you the opportunity to "fill up" your cash account.

Your annual cash withdrawal is the amount you plan to withdraw for living expenses to supplement outside income or Minimum Required Distributions (MRD). The market downturn following the dot.com crash in 2000 lasted until the end of 2003, so building up three years' worth of cash during bull markets makes sense. Anyone who is concerned about the ability to derive cash in the near term from their portfolio should build up several-years' worth of their cash needs during strong market conditions.

You don't want to have to sell securities to meet cash withdrawals when the markets are declining. Therefore, you should increase the amount of cash when the markets are strong; then, when the market inevitably turns down, cash withdrawals can be made from the cash account without having to sell anything and while continuing to reinvest interest and dividends at lower prices.

The process for managing your cash account during portfolio rebalancing is this:

• When the market is climbing and your portfolio is growing, set the cash allocation to an amount greater than your annual cash withdrawal amount
   
• When the market is falling and your portfolio is shrinking, set the cash allocation equal to the percent it occupies in your portfolio. This will leave the amount in the cash account unchanged during the rebalancing process.

This is a variation on a process known as Dynamic Rebalancing.

For people whose outside income fully covers their expenses, it is still a good idea to have a cash reserve. "Best practice" in the financial planning industry calls for 6 months' worth; you can judge for yourself whether that seems adequate ... any number of situations can arise that might reduce or eliminate your income and having a cash reserve to draw upon is only prudent.

An approach to consider is to have your income direct-deposited into your cash account and to manage it the same way that a person who is living off the portfolio would do: as a part of periodic portfolio rebalancing. Some brokerage cash accounts allow for check writing & online bill payment and will generate far better returns than any checking account.

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Historical Investment Returns

The return on your investment depends on what you invest in, of course. The chart shown in Step 2. Choose the asset classes gives an overview of the growth in several asset classes and the BYU study of diversification shows the interaction of different asset classes combined into a portfolio.

A general rule of thumb, heavily freighted with warnings about past performance not predicting future returns, is that a broadly diversified portfolio will produce in the neighborhood of 10% pre-tax per year over 10 years or more.

A Note On Returns

An average return on an investment is not the simple average of adding up each year's return and dividing by the number of years.

An example will show why:

• Start with $100,000
  • Decrease it  -10% to $90,000
  • Increase it  +11% to $99,900
  
  
• You averaged +½% per year for two years and yet you're down by $100 because percentage decreases reduce by more than percentage increases.

An individual fund's returns will be described using simple averages, but for a portfolio the average return on investment is the geometric average of the returns, which is also called the Compound Average Growth Rate (CAGR); it is the RATE function in Excel and the "i" on an HP 12C calculator, given PV, FV and n.

The CAGR formula is the following:

CAGR = ((FV/PV)^(1/n)) - 1 or
       ((Current Value/Original Value)^(1/# of years)) - 1

Ibbotson Asset-Class Data

The Ibbotson data shown above is probably the best investment-return data available. It shows the following pre-tax returns from 1926 - 2006:

Large-Cap US Equity	10.4%
Small-Cap US Equity	12.7%
Long-Term US Government Bonds	5.4%
US Treasury Bills (Cash)	3.7%

 

S&P 500 and Holding Periods

The classic index for US large-cap equity is the S&P 500. It is quoted all the time as "the market" along with the Dow Jones Industrial Average (DJIA). The S&P 500 is the five hundred largest companies in the US and therefore represents the largest of the large-caps.

For the 27-year period from 1980 to 2007, the S&P 500 returned 10.13% per year on average (pre-tax w/o reinvestment of distributions). This is the standard proxy for the returns a long-term investor can expect.

• You can't invest in the index, so let's look at a real index fund: VFINX is Vanguard's S&P 500 Index Fund (Investor Shares).
• Let's also look at a period that included a real bear market.

After the index fund's fees of 0.15% and including the awful period from 2000 to 2002, this fund produced (pre-tax) 9.17% with reinvestment, 7.46% without:

Time Diversification

S&P 500 data is often used to make the point that you must hold an equity position for a long time to ensure that you will get the average return, and that the longer you hold it the greater the likelihood that you will be successful.

The following graph shows the highs and lows of the S&P 500 over different holding periods.

• Over the course of only 1 year, for instance, you can expect a return that varies between +25% and -11%
• If you hold it for 30 years you can expect a return that varies between, roughly, +8% and +6%.
• For the historical data shown here anyway, holding periods of 10 years and more had no negative returns; this may not always be true but the risk does go down as the holding period goes up.

This is known as Time Diversification.

The volatility of any statistic is measured by its Standard Deviation (SD). The bigger the SD, the more the statistic tends to jump around. For securities, this means price volatility: SD measures the amount the price will be above or below the mean (the average return).

Almost every SD measure you will see is an annual SD: the amount above and below the average return that a security's price is likely to be (with a 68% probability) in one year. This is where Time Diversification comes in: if your holding period for the security is longer than a year, the SD for that holding period will be lower than the annual SD.

Thus, the widely-diversified long-term investor has two forms of diversification working to their advantage:

1. Asset-class diversification, which reduces the annual SD
2. Time diversification, which reduces the holding-period SD

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The Effect Of Diversification

The following graph shows the asset-class performance over the 10 years from 1998-2007. The purpose is not to focus on the particular performance of specific asset classes but to make several general points:

1. Market timing is a loser's game.
   
   Plenty of people talk as though they could predict which asset classes, stocks, etc. were going to turn in the best performance over the short term; they advise investors to be "overweight" or "underweight" and so forth, but the fact is that the swings shown in this chart were not predictable.
2. You must be fully invested to be in on the big jumps.
   
   2002 was a terrible year for stock investors and it was the third of three terrible years in a row. Even those investors who were diversified into bonds and alternative investments were bombarded every day with news of how bad the stock markets were doing around the world and many people were afraid to open their account statements. But the following year was a tremendous year for stocks and you had to have been invested ahead of time to have taken advantage of the surge.
3. Diversification is key.
   
   The 10-yr CAGR shows the returns over the whole period for each asset class. It's impossible to see any detail, but you don't really need to: it's fairly clear that with a combination of wide diversification and portfolio rebalancing an investor would have had about a 10% (pre-tax) return (in fact, an un-rebalanced, un-reinvested equal-weighting of each of these asset classes produced a 10-year CAGR of 8.81% with only two down years: 2001 -2.2%, 2002 -3.7%).