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How To Build A Retirement Portfolio

When you retire, you’ll stop receiving a paycheck and begin collecting a pension as well as Social Security benefits. Chances are, though, that you’ll need more income for a long, comfortable retirement-income that needs to come from a retirement portfolio. You probably have some money that you’ve invest over the years. In addition, you may be a participant in an employer-sponsored retirement plan (for government employees, a Thrift Savings Plan) that you can roll over into an IRA. Taken together, these amounts comprise your investment portfolio in retirement.

At this point, you’re the one responsible for making decisions. It’s up to you to invest the funds, or to choose an advisor whose advice you’ll rely upon. The decisions you make may have a tremendous impact on your retirement lifestyle.

Developing A Powerful Portfolio

Astute asset allocation can help you preserve your investment principal yet still generate the growth you’ll need to meet present and future needs. Many studies have shown that asset allocation is far more important to investment performance than market timing or securities selection.

Asset allocation, as the name suggests, is the process of dividing your investment portfolio among different types of assets. Historically, retirees have emphasized fixed-income securities such as bonds, which generate relatively high levels of spendable income while safeguarding principal. In the past few years, falling investment yields have led some retirees to reach for income by shifting from stocks to bonds. However, bonds lose ground to inflation while stocks have proven to be superior investments over most time periods. Thus, you need to go beyond "buy bonds and spend the interest" if you want a productive retirement portfolio.

Class History

You should derive your asset allocation based on the historic rates of returns of various asset classes. For each class of asset, an expected total return can be determined, based on prior performance. Total return is the current yield (dividend or interest) plus or minus appreciation or depreciation. While the expected returns probably will hold up, over an extended time period, the assets with greater expected returns also may generate greater losses in any short time period. Stocks, for example, have returned over 10% per year for the past 75 years while long-term government bonds have returned about 5% per year.

However, stocks—as represented by the Standard & Poor’s 500 Index—have had nearly two dozen losing years since 1925, with losses as high as 43% (in 1931), 35% (1937), and 27% (1974). Long-term government bonds have never lost more than 9% (1967) in any year since records have been kept. Such losses may be critical because you might need to liquidate assets at a time when values have been sharply devalued. The greater your allocation to stocks, the greater the risk of having to liquidate depressed assets at a loss.

If you had been 100% invested in stocks at the beginning of 1973, for example, you would have lost 50% of your portfolio value in two years and taken two more years just to get back to where you started. The closer you are to 100% in stocks, the more you have to be able to face those kinds of risks.

To enhance expected returns while minimizing potential losses, asset allocation calls for blending stocks, bonds, and cash equivalents such as bank accounts. A stock-bond-cash mix naturally will have less exposure to loss than a 100% stock portfolio simply because bonds and cash don’t lose 30% or 40% of value in a year. Just as important, these types of investments aren’t perfectly correlated—if stocks go down, bonds might hold their own or even rise. In 1974, for example, while stocks skidded, long-term government bonds had a positive return over 4%. In 1990, the last year stocks lost money (-3%), long-term government bonds returned more than 6%. This non-correlation leads to further smoothing, lowering the peaks and raising the valleys investors experience with a stocks-bonds-cash portfolio.

Small Packages, Big Returns

Today, asset allocation goes far beyond stocks and bonds. Among stocks, small-capitalization domestic stocks and foreign stocks may be added. Small-cap stocks, inherently riskier than large-caps, may actually reduce risk when added to a diversified portfolio because they move out of sync with the blue chips.

Similarly, fixed-income allocations may include foreign bonds or even junk bonds. Again, the addition of an intrinsically risky asset class may actually lower overall portfolio risk while boosting expected returns. Of course, you shouldn’t load up your portfolio with junk bonds, just as you shouldn’t overdose on small-company or foreign stocks. However, adding small amounts of such asset classes to a basic portfolio of blue-chip stocks and investment-grade bonds can be expected to enhance total returns over a period of years while leveling out year-to-year returns.

How much should you have in stocks? You might want to follow the "rule of 65." That is, at age 65 you’ll have 65% of your portfolio in stocks, the remainder in bonds and cash. As you grow older you’ll gradually move out of stocks, to 60% at age 70, 55% at 75, etc. By this strategy, at age 60 you’d have 70% of your portfolio in stocks.

After you set your basic portfolio, you can allocate your stock holdings among large-company stocks, small companies, foreign stocks, etc. You’re probably best served by having at least half of your stocks in large domestic companies because they have proven to be profitable enterprises over the years.

If Your Portfolio Tilts, Rebalance

From 1997 to 1999, extraordinary stock market results have been posted, mainly for the stocks of large domestic corporations. The Standard & Poor’s 500 Index, for example, returned over 27% per year for those years.

Other groups of stocks fared well, but not that well. The Russell 2000, a popular index of small-company stocks, gained less than 10% per year and the S&P MidCap 400 gained almost 22% per year in the same period. The Nasdaq Composite Index, heavily weighted towards technology stocks, soared to incredible returns, a process that continued in 2000. International stocks, meanwhile, have stumbled and skyrocketed.

Altogether, the Morgan Stanley EAFE Index, composed of stocks from the developed nations of Europe, Australia, and the Far East, gained nearly 16% per year in 1997-98-99. Concurrently, the Morgan Stanley Emerging Markets Index gained less than 2% per year-and that counts a 66% gain in1999.

In brief, domestic stocks, especially large companies, have outpaced foreign stocks, especially emerging markets. As a result, your asset allocation may be skewed towards large-capitalization U.S. stocks—it may be time to re-balance your portfolio.

Suppose, for example, you adopted an asset allocation several years ago calling for 40% large-cap U.S. stocks, 15% small-cap U.S. stocks, 20% foreign stocks, and 25% bonds. After the events of the past three years, large-cap domestic stocks might be up to 50% of your portfolio while international stocks might be down to 10%. What should you do about it?

A Second Look

You need to decide whether the asset allocation you chose five or 10 years ago is still appropriate. For example, you might have decided on an asset allocation that was designed to return 10% per year until you reach age 65, when you’d need a certain amount of wealth in order to retire in comfort. In the past few years, you’ve earned 15%-20% per year so you’ve exceeded your goals. Now, you might want to adjust your portfolio so that it’s aimed at delivering an 8% return rather than 10%.

You could shift assets from stocks to bonds, which are less risky. Within your stock market allocation, you might shift from small-caps and internationals to large-caps. There’s no need taking unnecessary risks if you can achieve your goals without them. If you live 20 minutes away from a movie theater and you leave home half an hour before the movie starts, it doesn’t make any sense to drive there at 80 miles an hour.

Changing Times

If your underlying asset allocation should be changed, you may need to shift some of your investment portfolio from stocks to bonds. Conversely, if your basic allocation still makes sense, you may want to consider shifting from large-cap domestics into foreign stocks, which likely will make up some of the ground they’ve lost in recent years. If you have a system and the discipline to follow it, you’ll take advantage of the best opportunities.

How often should you evaluate your portfolio with an eye toward rebalancing? Once a year is probably adequate. If you change your allocation more often you run the risk of losing momentum, moving out of an asset class while it’s in favor and thus giving up some returns. Moreover, rebalancing every month or two gives you a short-term focus; few market timers manage to beat buy-and-hold investors. Weighing your portfolio is relatively easy if you hold stocks and bonds directly but may be a bit more difficult if you invest through mutual funds. You need to read your quarterly fund reports to see what securities they’re holding. That will tell you if a particular fund fits into your overall portfolio design.

If you evaluate your portfolio once a year, you need to decide when it makes sense to rebalance and when to leave your current holdings in place.

Insight: Some investment advisers recommend a 5% trigger. That is, if you desire a 20% exposure to foreign stocks, you should rebalance once that allocation dips to 15% of your portfolio, buying enough foreign stocks to reach 20%. If your allocation tops 25%, cut back to 20%.

Sell High, Buy Low

Once you decide to rebalance, execution can be tricky. Unless you can do it with new money, you’ll have to sell winners, which can be frustrating and expensive, after paying taxes.
 

To simplify, suppose you have a 100% stock portfolio, meant to be 60% domestic and 40% international. At the end of 1999, you had $130,000 in domestic stocks and $70,000 in international stocks: an unbalanced 65-35 ratio. In 2000, you expect to be able to invest $10,000. If all $10,000 goes into international stocks, you’ll wind up with a $130,000-$80,000 split, before any price movements. That would be a 62%-38% allocation.

You’d have to sell an additional $4,000 worth of domestic stocks and reinvest the proceeds in foreign shares to get a 60-40 ratio. If you need to sell, lighten up on the companies or mutual funds where the prospects are least appealing. If taxes will be a problem, you might be able to take gains inside a tax-deferred retirement plan, without immediate tax consequences.

Don’t Bank On High Yields

Bank accounts. Rather than take the trouble of determining an asset allocation for your portfolio, your first reaction may be to put your money into a bank, or into several banks. Your money will be "safe"-backed by federal deposit insurance. Your principal will go in one direction-up-as you keep collecting interest on your bank accounts.

You could do worse: you could turn your money over to an unsavory promoter and watch it disappear. However, putting your entire retirement portfolio into bank accounts probably isn’t an ideal approach.

Why not? Because you’ll wind up with low returns. Assuming interest rates remain at current levels and you keep a mix of short- and medium-term bank accounts, you’ll probably earn no more than 5% per year. Thus, if your portfolio is $200,000 IRA you’ll be earning only $10,000 per year.

If you earn that $10,000 per year from bank accounts, moreover, you’ll probably owe $1,500 to $2,000 in income tax, depending upon where you live. Thus, from a $200,000 portfolio, you’d only be adding $8,500-$8,000 per year to your retirement income. If you withdraw more money you’ll eat into your principal, which means you’ll earn less interest the following year, and so on.

For more information on how to build a well-balanced portfolio go to the publications section of our website at http://www.armedforcesnews.com/pub/index.php and check out "Your Strategic Guide to Investment & Financial Planning".