Act your 'economic' age

by Don Kuehn

At the beginning of the year, news reports hailed the return of "normalcy" to the stock markets, citing 2003 gains of more than 25 percent in the popular averages like the Dow Jones Industrials and the Nasdaq. Friends, this is not normal.

Sure, it’s nice to see a quick recovery after the devastation that began in March 2000 when the telecom and technology bubbles burst. But a normal market return is more like 10 percent a year. When we get results of up to 40 percent, like we had in 2003, the caution flags should go up. A new bubble may be forming.

Building a portfolio, whether you focus on mutual funds or individual stocks and bonds, is as much about protecting against declines in the market as it is about participating in run-ups. How do you do that? By diversifying you holdings to protect your total return; by dollar-cost averaging; by taking a buy-and-hold approach; and rebalancing your portfolio as you age.

If you have 20 or 30 years to retirement, you don’t have to worry too much about volatility in the markets. You’re going to be around plenty long enough to ride the expected ups and downs in stocks. In the next two or three decades, we should see three or four cycles where the markets get "overpriced" (i.e., stock prices outrun the value of the companies they represent) and correct themselves by declining for a time while things get back into sync. But, as I have written here many times, over time it is the American equity markets that will provide the best chance of growing your money and beating inflation.

And what if you are an older investor, or are investing for goals closer at hand? How do you know what a good portfolio looks like?

There used to be a rule of thumb: Subtract your age from 100 to determine how much you should have in stocks (or stock funds). Under this rule, people 65 years of age, for example, should limit their exposure in stocks to 35 percent. These days, however, most experts caution that a healthy portfolio should never drop below 50 percent stocks. The reason is that inflation is the greatest enemy of your portfolio and stocks, or equities as they often are called, are the only major investment class that will protect your portfolio against inflation. True, the near-term risk is greater, but over time, stocks prove themselves superior in any 20-year period.

Your "economic age" can be quite different from your chronological age. A 40-year-old couple with a young family has much different investing goals than a 40-year-old with no children or whose kids are finishing college.

The couple with young children faces stiff challenges in the short term with the cost of child rearing as well as the mid-term financial goal of paying for college and the long-term goal of a comfortable retirement. These three distinct time frames might call for no-risk, conservative and moderate-risk approaches to meet different goals.

The cohort that doesn’t have kids can be saving for retirement or other goals for a longer period and can take on much greater risk in their investments.

Retirement savings should always take precedence over other goals, especially college savings. Parents should not forego putting money away in 401(k), 403(b) or traditional and Roth IRA accounts just to save for their kids’ college. Trust me, I’ve looked all over and I haven’t yet found a scholarship to cover the cost of retirement!

Rather than just focus on your age, it’s more productive to look at how much time is left to reach your goals, then build an appropriate asset allocation model. For example, starting with a sufficient cash reserve (at least six months’ living expenses readily available in a money market account) and 20 or more years to retirement, you might put 80 percent of your investments in stocks to pile up as much growth as possible (40 percent in large-company, 20 percent in small-company, 10 percent in mid-size company and 10 percent in international). The fixed income portion might be 10 percent in high-quality bonds and 5 percent each in high-yield and international bonds.

With 10 years to your projected retirement, seek added safety by shifting to 30 percent bonds, then during the first 10 years of retirement when you begin tapping into your nest egg, shift another 10 percent into bonds (making your ratio 60:40 in favor of stocks).

Finally, to increase your income later in retirement, while still protecting against inflation, split your holdings equally between stocks and bonds. (See table drawn from various sources.)

How to arrange your eggs in the basket

Most teachers and educational employees are eligible for some form of state (defined benefit) retirement plan. The general rule is to multiply your expected monthly benefit by 100 and count the result as a bond asset.

Think about that for a minute. If your state retirement system office tells you that you can expect a monthly retirement payment of, say, $595, you have almost $60,000 in "bonds" before you even start this exercise. To meet the asset allocation models for a person within 10 years of retirement, you should have another $140,000 in equity investments divided roughly according to the table. The more the better.

If you have been investing for some time and have $250,000 in various stock funds and another $100,000 in bond investments, you come pretty close to the recommended 70:30 formula. However, factoring in the bond value of your state retirement account throws your proportions way out of whack. Your total portfolio is now valued at $410,000 and your stock holdings only represent 61 percent of the total.

Within the categories in the table, there are many choices. You can use Morningstar or almost any financial brokerage Web site (Schwab, Fidelity, Vanguard) to investigate various companies or mutual funds within each category. Several Web-based sites like www.smartmoney.com/ and cbsmarketwatch.com/ provide resources for beginning investors as well as fund search tools. Select fundamentally sound investments and stick with them.

As always, my preference is to start with index mutual funds that track the S&P 500 and the so-called "total bond" index, and grow your portfolio from there.

You don’t have to choose between General Motors and General Electric, but you do have to get started. As Will Rogers said, "Even if you're on the right track, you'll get run over if you just sit there."