8 Point
portfolio Checkup
Have you noticed an
increased attendance at your health club lately or a higher number of
diet and exercise commercials on television? It is that time of year and
in the spirit of New Year resolutions, we thought it would be helpful to
provide our 8 Point Portfolio Check Up:
1. Asset allocation.
The first component to review in any portfolio is the overall
allocation of stocks vs. bonds. Generally, in pre-retirement
situations, we like to see no less than an 80% allocation to stocks.
We believe a strong case can be made that in the long run (5+ year
investment horizon) stocks are actually safer than bonds. In some
cases where your tolerance for risk is not quite as high we might
reduce equity exposure to 60%. For retirees, the amount held in bonds
should be based on a simple formula which uses your annual withdrawal
amount times four. Knowing that the S&P 500 has not had a four year
downturn since the Great Depression gives us the confidence to
essentially ignore stock market volatility. The four year short term
bond portion of your allocation will get you through most any market
cycle. More conservative investors could reasonably use a five year
multiple to make them feel more comfortable.
2. International vs.
Domestic. A common mistake individual investors make is an
under-allocation to foreign equity markets. International exposure for
both pre-retirees and retirees should equal somewhere between 15% and
35% of the total equities. International markets tend to move at a
different pace than U.S. markets. In 2004, we saw a good example of
this as the MSCI/EAFE Index grew 20.2% with the S&P growing 10.8%. The
weak dollar overseas made for some nice international returns. Without
exposure to these markets, your portfolio missed out.
3. Fixed Income.
In a rising interest rate environment as we see currently, short term
bonds are called for. We define short-term as two years in duration or
less. We rarely see any reason for individual investors to go beyond a
six year duration with their fixed income allocation. Bonds should be
considered a tool to dampen volatility and provide cash flow needs.
Longer term bonds inject unnecessary risk into a portfolio with little
or no reward. Use equities to get the long term growth you need.
4. Large Cap vs.
Small Cap. Another common trend in individual portfolios is the
under-allocation to small company stocks. Pre-retirees should have
somewhere between 25% and 50% of their equity allocation – both
domestic and international – in small company stocks. Retirees should
likewise maintain 15% to 35% in small companies. In 2004, small
companies, as represented by the Russell 2000 Index, grew at a rate of
18.3%. Since 1926, we have seen small caps outpace large caps by
approximately 1.5% to 2.0% on average.
5. Growth vs.
Value. There is a perception that "growth" stocks are the place
to be because that is precisely the goal of investors – watch their
portfolios grow. This "growth" nomenclature does a disservice to
investors in that it takes away from the fact that "value" stocks
actually out perform growth stocks over the long run. Perhaps value
stocks are not as exciting to talk about as growth stocks; however, if
the objective is to grow a portfolio, value stocks will fit the bill.
We believe you should maintain 60 to 80% of your stock allocation in
value stocks with the remaining invested in "blend" asset classes as
opposed to the growth category.
6. Consider taxes.
There are four rules to follow when considering taxes in your
investment accounts: a.) You should RARELY pay short term capital
gains. If you do, it is likely because your money manager is picking
and timing the market – a big no no. b.) Use tax-managed mutual funds
in taxable accounts when possible. They can add tax efficiency, and
thus a higher return. c.) Bonds should usually be held in tax-deferred
accounts as the interest they earn is based on ordinary income tax
rates. Retirees may need to hold some in taxable accounts for cash
flow purposes. d.) Use mutual funds with turnover ratios that are
generally in the 20 to 40% range. Anything higher once again indicates
the presence of those evil twin brothers - Picking and Timing.
7. Assess mutual fund
fees. Stock fund fees (expense
ratio) should not exceed 0.50%. In the case of emerging market funds
or some small cap funds it is acceptable to be somewhat higher. Bond
fund fees should stay below 0.30%. Mutual funds that exceed these
parameters are likely to be retail funds that use your money to pay
for their advertising costs, which is of little or no benefit to
current fund shareholders.
8. Assess your advisor.
You should work with a fee only, direct-pay advisor. This means
they do not accept "soft dollars" or rewards such as exotic vacations
from mutual fund companies or other parties. The name at the top of
your advisor’s paycheck should be yours. You should also make sure
they are willing to act in a fiduciary manner in the advisory
relationship. This will put a higher standard of accountability on
them.
All eight points of this portfolio check
up can be achieved easily by finding an independent fiduciary advisor
who provides a written Investment Policy Statement to guide you through
the investing process. By also using a Market Return PortfolioTM
approach (as outlined in detail in our book, There for the Taking)
most of these points will occur automatically, alleviating unnecessary
worries about your investments. Have a prosperous 2005!
Click here for a PDF version of our 8
Point Portfolio Check Up
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