OpenCourseWare: Fundamentals of Personal Financial Planning

While reading this month’s issue of Kiplinger’s Personal Finance magazine, I found that UC Irvine offers a free online course on the Fundamentals of Personal Financial Planning:

This course was produced by a generous grant from the Certified Financial Planner Board of Standards and by the Distance Learning Center at the University of California, Irvine under the OpenCourseWare Initiative. The purpose is to make widely available to the general public a course designed to provide a comprehensive but easily understood overview of personal financial planning.

This course is not intended to replace the professional financial planner, but to help to make the general public better consumers of financial planning advice. It tries to help those who cannot afford extensive planning assistance to better understand how to define and reach their financial goals and provides basic understanding so they can make informed decisions. The course can also be seen as a reference for individual topics that are part of personal financial planning.

While it seems to be a pretty good basic resource for novice investors, I was actually disappointed as I was hoping to see some of the actual courses one would have to take to become a Certified Financial Planner (CFP). Is it heavy on the math? Mostly memorization? I’ve toyed with the idea of becoming a financial planner before, but it always seems like it would be hard to start out anywhere else besides a commission-based sales job.

Posted in Deals & Offers, Investing, Retirement | 28 Comments »

Realistic Goal For Graduates: Accumulate Double Your Annual Salary By Age 40

Enough with the fluffy stuff, how about some firm numbers. Imagine that a young college grad actually has the forethought to even think about what they need for retirement. They check out an online retirement calculator, and see their needed amount is… 5.7 bajillion dollars!¹ Shocked, they shake their head, walk away, and promise themselves to revisit it again in a few years… hopefully.

A more attainable goal: You should aim to accumulate double your salary by age 40. Doesn’t that sound more reasonable? This is the solution proposed by this Wall Street Journal article A $1 Million Retirement Fund: How to Get There From Here. (Thanks Don for the tip.) Why double?

Let’s say your salary has hit that $80,000, you have amassed $160,000 in savings, you are socking away 12% of your pretax income each month and your investments earn 6% a year. Over the next 12 months, your $160,000 portfolio would balloon to $179,518, or $19,518 more. Your monthly savings would account for $9,600 of that growth. But the other $9,918 would come from investment gains.

In other words, you’ve got to the crossover point, where the biggest driver of your portfolio’s growth is now investment earnings, not the actual dollars you’re socking away.

My only beef is that the math in the article is a bit vague. First, the article means double your expected salary at age 40, by age 40. Now, is the 6% assumed return supposed to be real or nominal? Are we assuming this is all in a 401(k)? How much inflation-adjusted money will this give you at age 65?

However, the main points remain. Money saved now will be worth a lot more than money saved later. Once you generate a “critical mass” in your retirement funds, they really do seem to gain a life of their own.

The graph on the right shows three investors, each of whom invests just $1,000 a year until age 65. However, one begins at age 25, investing a total of $40,000; one at age 35, investing a total of $30,000;
and one at age 45, investing a total of $20,000. Each earns 7 percent per year and, for purposes of this illustration, the effects of taxes and inflation are ignored.

The result? The early bird ends up with more than double the one who waits until age 35 and more than four times the one who waits until age 45.²

I’ve certainly experienced this. As our own retirement balances have grown, the recent stock gains alone are often thousands of dollars each month. So what are you waiting for? Get started with just $50 per month!

¹ Actually if you plugged in 21 years old and $40,000, the goal would be $2,591,000. Still big!
² Source: Investment Company Institute

Posted in Investing, Retirement | 11 Comments »

Trying To Avoid Lifestyle Inflation

Most of this post was originally published last year when I was a guest writer at the Get Rich Slowly blog. I have since made some revisions and added some more material below.

One common thread through my How much house should I buy? post is that whatever size house you get, you’ll expand to fill it up. This reminded me a lot about what I call “lifestyle inflation” - the phenomenon where no matter how little or how much someone earns, their spending tends to match their income.

When you were a student, your friends were also broke, and it was easy to eat frozen pizza for dinner and manage without a car. That was probably one of the funnest periods in your life! But when you have more money, you start looking to upgrade: a nicer car, a bigger house, brand name clothes, cooler gadgets. Why? Call it peer pressure, entitlement, or simply money burning a hole in your pocket.

As we progress along our career paths, here are a couple of things that my wife and I are trying to do in order to keep our lifestyles in check:

• Put saving first. You?ve heard it before, but that?s because it?s works. Pay yourself first. If you get a raise, immediately increase the percentage going into your 401k, IRA, or brokerage account. The less that?s ending up in your bank account, the less you?ll have the urge to spend.
• Put debt last. Making more does not mean you should borrow more, contrary to what the credit card companies or other lenders may suggest. If you have debt, pay it down. If you don’t, keep it that way.
• Living on one income. Our dream goal has always been to be able to both work half-time in order to have more time to raise our future children. If this can?t happen, then one of us will work while the other stays home. This is a conscious decision to actually make less money, in order to focus on the more important things in our life. Of course, we’ll have to work double-hard now in order to make our hourly income high enough to pull it off!

  In the meantime, even though both of us are currently working, we are still trying to live as if we only had one income. Over the last 12 months, we saved 43% of our after-tax income.

• Buy an affordable house. For most people their largest monthly expense is housing. Affordable does not mean what the bank will let you borrow! By simply buying the biggest house possible, you?re also inflating many other things. You have to furnish all those extra bedrooms, heat them every winter, cool them every summer, and insure them. As we plan to live in a very expensive area, this rule will probably be the hardest for us not to break, especially on one income.
• Be realistic about cars. Probably the second largest monthly expense for many, I am always amazed when people’s car payments are more than half of their housing payments!! But I also know that a new luxury car means more than just higher monthly payments. It means higher insurance premiums, maintenance costs, and repair costs. It also likely has a bigger engine, which means less fuel economy, and may even require premium-grade fuel. Neither of us have ever owned a new car before, which helps keep our expectations low.

It may seem contradictory that we are moving to an area where the median home price is over $600,000, but that choice is predominantly due to a desire to live near family. In the end, we are trying to define a comfortable, simple lifestyle that focuses on what is really important to us. (Of course, we will won’t lead completely spartan lives…) The things that we buy on a $75,000 salary shouldn?t be much different than if we had a $750,000 salary. For example, my wife cuts my hair because I like having a simple haircut, it?s not difficult, and she does it how I like it. Even if we become millionaires someday, I think she?ll still cut my hair. I’ll let you know when we get there

Posted in Frugal Living, Retirement | 35 Comments »

Vanguard Simplifies Low-Balance Fees, and Even Eliminates Them With Electronic Statments

Vanguard has just announced some changes to their fee schedule, which includes some great news for us smaller investors who like Vanguard but kept getting dinged by their low-balance fees.

Before, you had to dodge the following $10 fees:

• The maintenance fee on index fund accounts with a balance of less than $10,000.
• The custodial fee on traditional IRAs, Roth IRAs, and SEP?IRAs with a balance of less than $5,000.
• The low-balance fee on all nonretirement accounts with a balance of less than $2,500.

These have all been replaced with a single account service fee of $20 annually for each Vanguard fund with a balance under $10,000. Okay, that’s not too special. The good news is that if you agree to get electronic versions of statements and other documents, all the fees are waived!

The waiver is available immediately, so switch now If you have $100,000 in total balances, you’re also fee-free. I already have everything set to deliver electronic format, so I’m all set. (Also you save lots of trees! Those prospectuses are thick.) In addition, you can still choose the “E-delivery and mail year-end-statement” option and get the fee waiver. That’s perfect for me.

I’ve always felt the $10 fees were justifiable, as if you were paying for things a la carte, because otherwise at 0.20% of say $5,000, that’s just $10 a year for IRS filings, paper, printing, postage, great customer service, and so on. Still, they were annoying. Even though my wife and I together have over $60,000 invested with Vanguard, we were still being hit with fees.

Now I’m less likely to switch to Vanguard’s ETF offerings, as I was considering for the future when I start putting money into taxable accounts. I prefer the simplicity of mutual funds.

Posted in Investing, Retirement | 29 Comments »

April 2007 Investment Portfolio Snapshot

It’s time for another bi-monthly update on my investment portfolio.

Thoughts
Not much going on, I have been contributing a $500 a month to my Solo 401k while trying to build up my cash hoard for a house downpayment. I still plan on tweaking my asset allocation, but I’ve just been distracted by other things and kind of want to wait a full year before making any changes.

All of our Vanguard funds are held at Vanguard.com, where there are no commissions for trading their mutual funds. Currently, everything there is in Roth IRAs, one each for my wife and I. Even though Roth IRAs rock, we haven’t contributed to one this year yet because we might be over the income limits for 2007.

The Fidelity fund is also held in-house at Fidelity, where I have my Self-Employed 401k. Funds are also no transaction fee (NTF) there. It’s a bit annoying that both their Spartan Total US and International funds have high $10,000 minimums, but the 0.10% expense ratio is nice. I could also trade ETFs, but at $20 a trade it’s a bit expensive.

You can see some older posts on how this portfolio came to be here, as well as my previous portfolio snapshots here.

Posted in Investing, Retirement | 18 Comments »

Six Key Principles of Saving for Retirement

Ben Stein has an good read on Yahoo Finance about what he terms the Six Key Principles of Saving for Retirement. Although I agree with all six main ideas, I question some of the specific numbers. Here are some excerpts and my comments:

1. How much you save.
Simply put, if you’re a typical American (who happens to save close to zero right now), you have to save more. When you’re young, 10 percent of your income will get you there. If you don’t start saving until middle age, aim closer to 15 or 20 percent. If you don’t start until later than middle age, save every penny you can.

Interesting. Is 10% really enough? If so, maybe I really am saving too much for retirement. To what degree of certainty is that true?

2. How long you give your savings to compound.
A thousand dollars socked away when you’re 20 and growing at 10 percent per year will be almost $73,000 when you’re 65. The same sum saved when you’re 50 will grow to $4,200 at age 65. That’s a stunning truth that should compel any young person to start saving early — and the rest of us to start right now.

As for timing your retirement, Ray advises that if you can push it back by even five years you’ll allow your money to grow and have fewer years to need it.

Compound interest is truly powerful. A dollar saved now is worth more than a dollar saved later.

Although it hasn’t been helping me control my spending as much as I’d like either, I did make the horribly unpopular true cost of frivolous shopping calculator.

3. How you allocate your assets.
Typically, for those who start early, stocks are the answer. Over long periods, a diversified basket of common stocks wildly outperforms bonds, cash, and real estate. The differences are breathtaking.

But, as we’ve seen lately, there’s also a lot of volatility in stocks. As you age, you’ll want more of your money in bonds and money market accounts. These have lower returns than stocks, but they also have far lower volatility.

Phil DeMuth recommends that, as a basic portfolio, you have half of your savings in the broadest possible common stock index such as the Vanguard Total Stock Market Index (VTSMX) and half in the Vanguard Total Bond Market Index (VBMFX)… To me, that’s a bit conservative if you’re young. I would have more in stocks and also a good chunk in international markets.

Here is a compilation of various model asset allocations from other respected sources. Pretty pie charts included!

4. How much your investment returns annually.

Now, this is largely unknown from year to year. But over long periods, stocks return close to 6.5 percent after inflation, and about 10 percent before inflation.

Can we expect 6.5% real returns in the future? Lots of conflicting opinions out there on this, but I really want to look into this more.

5. How low you keep your fees and costs.

This principle is largely about using index funds and no-load mutual funds, which makes perfect sense.

Costs matter, whether you go actively or passively managed. I’ve seen some really expensive index funds. Always look up the expense ratios and any commissions you have to pay either when you buy or when you sell for all the investments you own.

6. How closely you keep an eye on taxes.
Finally, Ray advises maxing out your tax-protected accounts like IRAs and 401(k)s; keeping high-dividend stocks in accounts that are tax-deferred; and, when retiring, carefully considering what bracket you’ll be in and drawing out your funds to remain in the lowest possible one.

Ah, taxes. Here is a discussion on where you should place investments for maximum tax-efficiency.

J.D. of Get Rich Slowly also shared his thoughts on these six points, and believes the most important factor in retirement savings is psychological.

Posted in Investing, Retirement | 10 Comments »

A Warm Slice Of Humble Pie

I’ve been trying recently to try and make some minor adjustments to the target asset allocations of my portfolio. I want to create something that I won’t be tempted to change again for many years. While attempting this, I keep noticing how hard it is for a beginning investor to try and figure out where to put their hard-earned money. So many websites, books, magazines, television shows… and the amount of information being thrown at you just seems to multiply daily. Everybody has an opinion, including me. Am I right?

Who knows? I don’t. I’m simply doing the best anyone can do - read a steady stream of books, academic studies, participate in discussions, and then making a decision based on that information. I try look at the bigger picture and draw conclusions based on historical studies going back from the 1920s and not five-year historical returns. But none of us can predict the future.

What is accepted as common knowledge often changes with time. My own views shift as I read more. I also see a lot information out there that I disagree with. Therefore, I encourage everyone to do their own due diligence, keep their minds open, question things, and try to separate the wheat from the chaff for themselves. All I can do is to promise that I will try to keep doing the same.

(This will be added to my compilation of posts about managing money called My Rough Guide To Investing.)

Posted in Investing, Retirement | 11 Comments »

Create Your Own Pension With Immediate Annuities

People love pensions because of the security that they offer - a steady, guaranteed stream of income that you can’t outlive. Another way to achieve this reliability is to buy an immediate annuity, also called an income annuity. It lets you convert a lump-sum payment into a regular stream of income payments that can last for your lifetime, or the longer of you or your spouse’s lifetime.

Although there are many factors that come into play, very generally immediate annuities pay about 6-7% of the lump-sum back to you every year. So if you bought a $500,000 lifetime annuity, you might get $35,000 every year until you die. You can also play with the quotes at ImmediateAnnuities.com for different ages and survivorship scenarios.

This is much higher than the “safe withdrawal rate” of 4% that many financial folks quote as the amount of your nest egg that you can spend each each without running out of money before expiring. 4% of $500,000 is only $20,000 per year. More info on safe withdrawal rates can be found here.

But remember, with an annuity the $500,000 is gone. If you live another 50 years or just one, after you die there is nothing left to inherit. Also, annuity providers are like life insurance companies in that you really need to make sure they are stable enough that they’ll be around to pay you! Look for ratings from A.M. Best Company, Moody?s, and Standard & Poor?s.

The last article I mentioned when talking about how pensions will be gone soon also suggested annuities as a possible reform to current retirement plans:

If defined benefits are on their last legs, then it would make sense to try to incorporate their best features into 401(k)’s. The drawback to 401(k)’s, remember, is that people are imperfect savers. They don’t save enough, they don’t invest wisely what they do save and they don’t know what to do with their money once they are free to withdraw it. Quite often, they spend it.

Here there is much the government could do. For instance, it could require that a portion of 401(k) accounts be set aside in a lifelong annuity, with all the security of a pension. Behavioral economists like Richard Thaler have demonstrated that you can change people’s behavior even without mandatory rules. For instance, by making a high contribution rate the “default option” for employees, they would tend to deduct (and save) more from their paychecks. If you make an annuity a prominent choice, more people will convert their accounts into annuities.

If you think of pensions as annuities, you can use this to get a feel for how much those pensions are worth! For example, let’s say you’re a teacher and about to retire with a pension paying 70% of the average of your highest 3 years of income. If that number is $50,000, then you’ll be receiving $35,000 every year. If you refer back a few paragraphs, you’ll remember that’s the same as having saved up half a million dollars! Now you see how pensions are so expensive.

Although I’m still far from retiring, I have started considering using part of my savings to by an immediate annuity in order to cover my most basic spending needs and reduce the risk of retiring early in the event of a turbulent stock market. It would be almost like buying my own Social Security safety net But I’ll also need to learn more about how this plan should affect my current asset allocation. Some papers that are on my (really, really, long) reading list can be found here.

(There are also probably some tax considerations that I’m ignoring here.)

Posted in Insurance, Retirement | 20 Comments »

Why Pensions Are Soon To Be History

It’s been a few years since the United Airlines debacle where they unloaded their pensions onto the government-created Pension Benefit Guaranty Corp, but the future of pensions are still a huge issue for many people. If you’re interested in more background, try perusing this New York Times article called The End of Pensions. It’s long, but I found it fascinating.

First, some background:

It happened that 401(k)’s, which were authorized by a change in the tax code in 1978 and which began to blossom in the early 1980’s, coincided with a great upswing in the stock market. It is possible that they helped to cause the upswing. In any case, Americans’ experience with 401(k)’s in the first two decades of their existence was sufficiently rosy that few people shed tears over the slow demise of pension plans or were even aware of how significantly pensions and 401(k)’s differed. But 401(k)’s were intended to be a supplement to pensions, not a substitute.

I find it very ironic that companies are failing to provide for their employee’s retirements, just like individuals are now accused of failing to provide for their own retirements. Simply put, these corporations used rosy predictions to justify not saving enough money!

Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators have found it easier to pay off unions with benefits tomorrow rather than with wages today. Since the benefits were insured, union leaders did not much care if the obligations proved excessive. During the previous decade especially, when it seemed that every pension promise could be fulfilled by a rising stock market, employers either recklessly overpromised or recklessly underprovided - or both - for the commitments they made.

Gee, that sounds kind of familiar. You could partially blame the government for their lax accounting and lack of good funding requirements. Still, if the government provided the bullet the companies pulled the trigger:

For example, United Airlines did not make contributions to any of its four employee plans between 2000 and 2002, when it was heading into Chapter 11, and made minimal contributions in 2003. Even more surprisingly, in 2002, after two of its jets had been turned into weapons in the Sept. 11 disaster, and when the airline industry was pleading for emergency relief from Congress, United granted a 40 percent increase in pension benefits for its 23,000 ground employees.

So what does the future hold?

In 1980, about 40 percent of the jobs in the private sector offered pensions; now only 20 percent do. The trend is probably irreversible, because it feeds on itself. Hewlett Packard, for instance, must compete with younger companies like Dell Computer that do not offer traditional pensions.

And what about state and city governments? Chances are that they’re underfunded too.

Because public pension benefits are legally inviolable, default is not an option. Sooner or later, taxpayers will be required to put up the money (or governments will be forced to borrow the money and tax a later generation to pay the interest).

Thus, unions can bargain for virtually any level of benefits without regard to the state’s ability, or its willingness, to fund them… At least in the private sphere, there are rules - ineffectual rules maybe, but rules - that require companies to fund. In the public sector, legislatures wary of raising taxes to pay for the benefits that they legislate can simply pass the buck to the future.

Yet another form of focusing on short-term gain and not looking at the big picture. Sigh.

Posted in Retirement | 12 Comments »

Are We Saving Too Much For Retirement?

One contrarian article deserves another. This one, courtesy of the New York Times is titled “Save Less and Still Retire With Enough”. The main premise is that contrary to popular opinion, most of us are actually doing just fine money-wise. All this talk of impending consumerism-drive doom? It’s a big scam by the investment companies, who have a vested interested in us keeping big balances in our brokerage accounts.

The more realistic amount could be as little as half the typical recommendation made by Fidelity, Vanguard or any number of other financial institutions. For a middle-income couple, that could mean trading $400,000 in retirement money for about $3,000 a year more during prime working years to spend on education or home improvement. ?For a middle-class household, that?s a lot of money,? said Laurence J. Kotlikoff, a Boston University economics professor, who is on the forefront of this research into spending and savings, and is selling his own retirement calculator.

You can read more of Mr. Kotlikoff’s research here. Here is an excerpt from one paper:

TIAA-CREF is recommending a retirement ?salary replacement? target equal to 80 percent of annual labor earnings. For our stylized household [couple earning $125,000 with two kids], this equals $100,000… This is 78.0 percent higher than the appropriate target!

In other words, his “appropriate” target replacement salary is actually only about 45% of their previous income, or $56,000, for a couple earning $125,000 a year. This is due to a number of factors which aren’t explained in detail, but factor in that their house should be paid off and the kids will be gone during retirement. However, I saw no mention of the increased costs from health insurance and other medical costs that increase with age. He also expects the their investments to earn 9% a year (6% real, 3% inflation), which is a bit optimistic to me.

In the end, of course some people are saving too much. I mean, if you’re eating Cup o’ Ramen ten times a week and checking your million-dollar bank balance on the free computers at the public library, sure, maybe you need to loosen up a bit. I’ve never met any of these people, have you? There’s no way that they outnumber the ones that are saving too little.

And how do we even know what will be too much or too little? Every retirement calculator is simply trying to predict the future. Note the huge “we are not liable if this is wrong” disclaimers. I’ve read a lot of articles that also support the fact that the stock market will only earn about 6% annually in the future, and similar ones that say that the long-term expected returns of stocks will be the same as bonds. Japan’s stock market has been in the dumps for more than decade.

A possible personal solution?
I’m trying to come up with what I call the Core Lifestyle, which essentially includes everything that I would personally really want out of life - things like a job that I value, a small house in a specific area, a skiing season pass, and an international trip every year. The idea that this should require a certain amount of money, for example $100,000 a year. (Yes, I am aware that this is a lot of money. I’m also living in a big West Coast city…) My feeling is that after a certain point, any extra spending just ends up on “stuff” like nice cars, gadgets, brand name clothes, and bigger houses that really won’t improve my quality of life.

Anything above that threshold goes into investments. This is opposite of some plans which suggest socking away a specific percentage of your gross income each year. Then, as our wealth builds, whenever it is that we have enough to cut back on working, we will! It could be 39, 45, or 52. There would be no “squandering of youth”. We’ll live well now, and then we’ll live even better after that. Sounds easy, doesn’t it? We’ll see how it goes

Do you feel like you’re depriving yourself now to save for retirement? If your retirement planner told you that you could save less, would you do it?

Posted in Frugal Living, Retirement | 22 Comments »

My 401k to IRA Rollover Decision Process

A couple of people have asked me about rolling over their 401(k) plans into an IRA. I actually went through the decision process myself back in the middle of 2005, but that was 500 posts ago so nobody can find it anymore! Here they are:

Part 1 - Stay put with old 401k?
Part 2 - Maybe Rollover into Fidelity?
Part 3 - Vanguard Options
Part 4 - Final Decision

The main differences between then and now is that (1) there are more low-cost ETF options available now that cover just about every asset class, and (2) more brokers that offer cheap or free trades. If you are rolling over a lump sum and don’t plan to trade very much, ETFs may present a lower-cost alternative. Still, if I had to make the decision again today I think I would end up at the same conclusion. My expense ratios are already low, and I make enough trades that the net cost difference is minimal. I continue to be very happy with the competent and helpful support from Vanguard. My portfolio has since changed from their Target Retirement funds to something slightly more complicated.

I should add that I also opened a Self-Employed 401k with Fidelity last year, and have also been very satisfied with their customer service. I still wish they would expand their Spartan index fund lineup, though, and if Vanguard offered a low-cost Self-Employed 401k option I would have went with them.

Posted in Retirement | 11 Comments »

Risk and Return Relationships For Different Asset Allocations

After looking at how other people and mutual fund companies choose their asset allocation, I’m a little conflicted. Both the Vanguard and T. Rowe Price mutual funds recommend holding nearly 80% in stocks at age 50. That’s pretty aggressive in my book. To see why, let’s look at some historical numbers.

Coincidentally, a commenter left me a link to a recent FundAdvice article about fine-tuning your asset allocation. I’m actually going to ignore the specific components of his portfolio and focus on the general trends instead. Let’s just say it’s well-diversified.

The article provides historical numbers (1970-2006) that compares risk versus return for portfolios ranging from 0% stocks to 100% stocks. Risk is represented by standard deviation, a measure of volatility.

Risk vs. Return For Varying Stock Percentages

This is pretty consistent with a lot of other similar charts I’ve seen. You’ll notice that the slope of the curve decreases as you move towards holding more stocks. Accordingly, if you compare the differences between successive dots, there risk gap grows larger and the return jump decreases. In other words, you are generally getting less return for each unit of risk as you keep adding more stocks.

Here is another risk-reward chart for increasingly aggressive portfolios.

Still, this chart really doesn’t help too much either. Why not just go for the 100%? Instead of averages, let’s focus on how bad it can get over the same time period (returns not annualized):

This second chart is more important than the first one, because you won’t get any of the returns listed above unless you can “stay the course” through periods such as these.

It’s really easy to say “Oh, 30% drop, no problem”, but that’s not the whole picture. Not only will stocks be dropping, but bonds may be skyrocketing. Imagine if bonds are returning 15% a year at the same time stocks are going down 15%. You will have what appears to be a way out! Personal finance magazines will be shouting “Bonds are back!” Cutting down on your stock exposure will become the “prudent” decision.

Going back to the 80% stocks at 50 years old… Can you imagine losing 35% of your portfolio in one year at 50 years old? I would freak out. This is why age matters, it’s so much easier to shrug off losses when you know you won’t need the money for another 30+ years.

Posted in Investing, Retirement | 14 Comments »

What Percentage Of Your Portfolio Should Be In Stocks?

One of the basic ways to adjust the risk and return characteristics of your investment portfolio is to decide what percentage to hold in stocks and bonds. This is another one of those hard questions for which there is no single best answer for everyone. You must take into account risk acceptance and time horizon amongst other factors.

An old rule of thumb is that your stock allocation percentage should be 100 minus your age. That is, a 30-year old should have 70% stocks/30% bonds, and a 70-year old should have 30% stocks/70% bonds. This was not just taken out of thin air, and has a basis from historical returns. As you near retirement, you want to have more bonds as that reduces overall volatility. More recently, others have altered this to a more aggressive “110-age” or even “120-age”.

Members of the Diehards investment forum recently performed a informal survey of member’s asset allocations versus their age, and here are the results:

As you can see, there is definitely a lot of scatter in the data. However, if you made a linear fit, it roughly corresponds to a formula of stock percentage = 112.5 - age.

This made me curious - what about all those Target Retirement Funds? Their job is to decide an asset allocation that works for as many people as possible based on their retirement date. If I assume that people retire at 65 years old, here is what the asset allocation versus age looks like for three of the more popular fund families: Vanguard, Fidelity, and T. Rowe Price:

As you can see, the funds are actually pretty aggressive. (I covered previously how T. Rowe Price is more aggressive than Vanguard.) If one did force linear fits for all three fund families, it would correspond roughly to stock percentage of 119 - age. However, they don’t really adjust linearly with time. If I use a 2nd order curve fit instead, I can make a little tool that estimates their stock percentages for any age:

None of this is investment advice, it’s just an observation of what’s out there. Next, I’ll try to find some historical return and standard deviation numbers for another view of how to answer this question. What do you think of all this?

Posted in Investing, Retirement, Tools & Calculators | 22 Comments »

Do You Have a 403(b) Plan? Don’t Miss 403bWise.com

I’ve always thought of 403(b)s as identical to 401(k)s, just for non-profit and educational institutions. But upon discussing this with a teacher, I found out that they can have their own unique problems: primarily high-priced annuities. Did you know that 80% of 403(b) funds are currently invested in fixed or variable annuities? This is really surprising, considering that annuities are usually only a good idea for high-income people who’ve already maxed out all their other tax-deferred options - why put a tax-deferred product inside another tax-deferred product?

If you’re not sure what you have in your 403(b) accounts, I would definitely recommend reading up at 403bWise.com. Started by teachers, it has a wealth of information about your investment options. Did you know that if you summed up all the various annuity costs you could be losing 3% to fees every year? If you are stuck with a bad administrator, you may be able to do what is called a “90-24 transfer” to a low-cost provider like Fidelity, Vanguard, T. Rowe Price, or TIAA-CREF. There are some upcoming law changes and this transfer ability expires at the end of 2007, so compare your options soon. Another route is follow other teachers and fight for a change from within.

There is also 457bWise for 457(b) holders.

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Tax Efficient Mutual Fund Placement For Maximum Return

After choosing your asset allocation, it is still important to think carefully about where to place each type of investment. After all, what you actually keep is your return after taxes. For example, a stock index fund that tracks the S&P 500 will have low turnover and primarily pay qualified dividends which are taxed at the lower long-term capital gains rate (max 15%). On the other hand, REITs and bonds tend to distribute a significant amount of their return annually as unqualified dividends, which are then taxed as ordinary income (max 33%). Therefore, you should try to take advantage of your tax-sheltered accounts as much as possible by placing the least tax-efficient assets there.

Below is a chart that shows the major asset classes sorted by tax efficiency. It is based on information from the fine books Bogleheads’ Guide To Investing and The Four Pillars of Investing.

Let me clarify the chart above. You should start with the least tax-efficient assets and place them in your pre-tax accounts (Regular 401ks, 403bs, Traditional IRAs) first. Then the next least efficient assets should into the post-tax accounts (Roth IRA, Roth 401k). Only what is left after this should end up in taxable accounts.

In general, bonds should go into tax-deferred accounts, leaving stocks for your taxable accounts. There are even special “tax-managed” mutual funds which work hard to minimize any capital gains distributions and are designed specifically to be placed in taxable accounts.

This article is part of my Rough Guide To Investing.

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