JLP,

Greetings! Yours is an awesome website, and it has proved to be very helpful ministry to me as of late. I had a quick question for you.

My wife and I are in our 20’s. We have no kids, but I have recently curiously contemplated maybe buying a new, bigger, more expensive home in order to take advantage of the current real estate situation. The house is in the best school district in the state, and nicely situated close enough to some nice restaurants and shops, etc.

In 2006, when the neighborhood broke ground (it’s in the Birmingham, Alabama area), the houses were listed for pre-sale at $689,000 or so. I know for a fact that one of the residents in that neighborhood with a similar house to the one that I want paid taxes on $707,000 last time around. This particular house has been listed for 13 months, with the price slowly falling. The home currently says $569,000. I asked the sales agent / realtor about her coming down and she told me that they are very negotiable, of course. I can get in the low 500’s, I’m pretty sure. It is a very impressive home.

The down payment of $450,000 is nearly all of my net worth. It is a large inheritance, and it will cover about 80% of the purchase price of the home. Besides that, I would have my cars, possessions and a $15 or $20 thousand savings portfolio. I would, however, be debt free. So, I guess a major part of my question is, is a luxury home a good investment vehicle in these troubled times? I’d look to sell in 10 or 15 years, hopefully making a good bit of money on the house.

I do not have a retirement account or anything along those lines. My “career” will officially start when I finish law school and pass the bar, one year from now.

My question: Is it time to move, or wait for the market to drop even more, or stay put? If I don’t buy this house, the money will probably just be sitting in a CD of some sort.

All the best,

-SM

Wow! Lots of things to think about. Unlike lots of people, I look at a house as an investment—afterall, it IS an asset. So, I would look at this from an investing point of view. You have to decide for yourself whether or not you want to allocate your entire net worth (at least right now it would be your entire net worth) to one asset. Lack of diversification is something to think about.

It could be years before housing prices start to recover so I wouldn’t plan on any more than a 3% to 3.5% appreciation rate on the house over the next five to ten years. Based on that, you could expect the house to be worth somewhere in the neighborhood of $700,000 – $740,000 in ten years. Keep in mind that there are no guarantees that housing prices will move up. If things don’t turn around in this country soon, we could be facing a long-term recession. That would not help housing prices.

Personally, I don’t think the worst is over for housing prices. There are more foreclosures looming out there and they are only going to put downward pressure on housing prices. Sure, some areas will be hit harder than others but how bad it will get is anybody’s guess.

In addition to the purchase price, you’ll also have to pay more property taxes and the upkeep on a larger home will naturally be higher. Will you be able to afford those expenses? I know in my town, a $500,000 house probably has a $12,000 per year tax bill.

If it were my money, I think I would hold off on buying the house. I would keep an eye on housing prices and if you think they are turning around, you could jump then. You have one huge advantage over most people in that you have a hunk of cash sitting around waiting to be used. Other people don’t have that luxury.

Since you have plans for using the money for the purchase of a house, I would keep it fairly liquid. Shop around for CD rates but be careful.

That’s my opinion. You can take it for what it’s worth.

Now I’d like to open it up to AFM readers and see what they think.

Much like a blueprint for building a house, an Investment Policy Statement serves as the blueprint for building your optimal portfolio. This policy is crucial to the long-term achievement of your specific financial goals. First and foremost, an Investment Policy Statement helps you learn more about what your needs and priorities are, how to best address them, and the risks involved with investing. Secondly, this policy allows you and your portfolio manager (if you elect to employ one) to gain a better understanding of your objectives and constraints and how to best manage your portfolio to accomplish your specific financial goals.

A written Investment Policy Statement will not alone guarantee success in protecting and growing your optimal portfolio. Rather, it will shelter your portfolio from ad hoc revisions, made by either you or your portfolio manager, from a sound long-term asset allocation policy.

Basically, an Investment Policy Statement should explain why you’re investing (your goals) and what you are investing in. Why is this important? Because human nature tends to take over when times get tough and might cause you to make changes to your investment plan based on emotion rather than sound logic. Being able to pull out and read through your Investment Policy Statement (IPS) will give you comfort and just might keep you from making a serious mistake.

Frush recommends that the following be included in your IPS:

1. Your current portfolio
2. Your objectives and constraints
3. Recommended (or desired) portfolio
4. Portfolio construction process
5. Portfolio monitoring process
6. Portfolio rebalancing process
7. Annual review process
8. Agreement between you and your portfolio manager (you can leave this out if you manage your own money)

While researching this post, I came across a very helpful Investment Policy Worksheet (PDF) that asks the following questions in order to help you put together your IPS:

Executive Summary

1. What are the current assets of my portfolio today?
2. How much do I plan to invest each month?
3. how many years will I be investing?
4. How much do I expect my portfolio to return each year over inflation?
5. How much of a loss can I accept over:

• a three month period?
• a one-year period?
• a five-year period?

6. What is my target asset allocation?

• Cash
• Bonds
• Large-comany stocks
• Small-company stocks
• Foreign stocks

7. What are the benchmarks for my portfolio?

Investment Objectives

1. What is my financial goal(s)?
2. How long will I need to be funding this goal?
3. how much will this goal cost every year?

Investment Philosophy

1. What’s important to me as an investor?
2. What’s my philosophy about risk (or volatility)?
3. What’s my philosophy about core versus noncore investments?
4. What’s my philosophy about diversification?
5. What’s my philosophy about trading?
6. What’s my philosophy about costs?
7. What’s my philosophy about taxes?

Investment Selection Criteria

1. What are the investment selection criteria for my mutual funds or exchange-traded funds?
2. What are the investment selection criteria for my stocks?

Monitoring Procedures

1. How often will I monitor my portfolio?
2. How will I determine how well my individual investments are doing?
3. How will I determine how well my overall portfolio is doing?
4. How will I determine if my portfolio is meeting my expected return?
5. How will I determine whether losses fall within my accepted range?

After answering those questions, you are then supposed to take your answers and rewrite them in the form of a statement. The process is similar to writing a mission statement. I’ll admit that some of those questions are bit vague and would require quite a bit of research in order to answer them properly. In fact most of the above questions are potential blog posts by themselves, which I will tackle over the next few weeks so that we can build a process for creating our own Investment Policy Statements.

So, that’s something to look forward to. In the meantime, I suggest you download Morningstar’s Investment Policy Worksheet and begin filling out what you can. If you have any questions, either leave a comment below or send me an email.

I read your article the other day Should Portfolio Rebalancing Be Considered Market Timing? and it got me thinking about my 401k balance. I’m turning 40 next month and am looking at my 401k balance, thinking should someone with my level of investment knowledge be managing this account?

Over the years, it’s grown to a significant amount without any research on my part, I just deposit money spread it over several funds and watch it grow. Rebalanced the 401k last year using a financial engine software supplied by my company, but as it turns out my market timing was bad. Overall, I think the diversification across 12 mutual funds is good, but still wonder if I could maximize gains or choose better times to rebalance the portfolio.

I’m guessing that most people manage their 401k’s themselves, but should they? Especially once the 401k reaches a higher balance as there’s so much more growth potential. Is there any added value to authorizing a professional to manage your 401k?

Thanks,
Ken

Wow! I can’t believe one of my friends is turning 40!!!!!

First off, just because you made changes to your plan and the market went down, does not mean you made a bad choice. Remember, we’re looking long-term here so we really shouldn’t care what happens right now. No, it’s not fun to watch a 401(k) balance drop but we have to look at the big picture.

If you have a relationship with an advisor, they might be willing to take a look at your plan. However, if they are commissioned-based, I wouldn’t expect them to spend a lot of time analyzing your plan and making suggestions since they don’t get paid for that kind of work.

There are lots of fee-only financial planners out there that will offer advice on 401(k)s. You’ll have to pay an hourly fee but it might be worth it if you think you need a second opinion. I will tell you that lots of planners are just going to run your fund choices through Morningstar or something similar to Financial Engines, so you’ll most likely get the same results as you already got when you ran the numbers yourself. A good planner will also help you assess your risk tolerance and educate you on the best asset allocation for you based on your risk tolerance, age, and time horizon. So, there could be some value added there. Just be prepared to spend $150 – $300 for the advice.

I’m not sure it is necessary for you turn over management of your 401(k) to a professional. Asset allocation is pretty cut and dry and can be easily grasped by most people by reading any number of books. I realize that reading a book on asset allocation is probably not at the top of most people’s list of desirable activities but I honestly believe that EVERYONE should have a basic grasp of investing and asset allocation. Fortunately, there are books out there that are very easy to understand and are actually interesting. One of the best books I know of is a short little book called The Coffeehouse Investor (Affiliate Link), which I read in a couple of hours. It will give everyone a basic understanding of asset allocation and investing. EVERYONE should read “The Coffehouse Investor.”

If you want something beyond that, I would suggest taking a look at The Intelligent Asset Allocator (Affiliate Link) by William Bernstein. It’s a little on the dry side but is still a very good book and will definitely give you a better understanding of asset allocation.

So, those are my thoughts on 401(k) management. What do you guys think? Should people hire a professional to manage their 401(k) account? Why or why not?

I knew stocks were down year-to-date, but I didn’t realize by how much stocks have underperformed over the last 10 year period. The S&P 500 Index (large cap stock) has returned only 3.89%, and the Russell 3000 Index (total stock market) has returned 4.28% for the 10 years ending 4/30/08.

Of course that’s before taking any taxes or fees into account, meaning most people’s returns – even if they had their stocks sitting in a stock index fund from April 98 to April 08 – essentially were flat and certainly didn’t beat inflation.

What’s more, the Lehman US Aggregate Bond Index annualized a 5.96% return over the same period, outperforming both major US stock indexes.

Now of course if you’re only looking at the last 5 years of performance, stocks have performed rather well – 10.62% for S&P 500 and 11.40% for Russell 3000. Bonds were 4.37%. Then again over the last 1 year, both stock indexes have negative returns (-4.68% and -5.15% respectively) while bonds are up 6.86%.

We must keep in mind that stocks are down over the last 10 years mainly because 1998 was near the peak of the internet stock bubble, which promptly burst soon after. If we look at returns over longer periods such as 15 and 20 years, returns are solidly positive (I don’t have that data, or I would provide it).

The point is that investing in stocks is truly for the long term. People like to talk about the average 8-12% return over 5+ decades, but the truth is that stock market indexes do have long periods of negative and/or flat growth during their historically upward ascent. You might get lucky over a 3 or 5 year period, but the best thing to do is to invest in stocks only when your savings goals are truly long term.

But what exactly constitutes long term? If you are saving for a house or car or vacation or anything that you want to purchase within the next 10 years, you would be better off to invest in mid-term investments (bonds, 5-7 year time horizen) or CDs, savings accounts, or money market funds (1-4 year time horizen). If you’re shooting for something in the 8-10 year range, go ahead and bet on stocks if you like. But remember, it is a gamble.

More from Meg at The World of Wealth

Jones, who is the Chief Investment Officer of Financial Engines, writes that people who invest using a fixed-proportion portfolio (i.e. 70% stock/30% bond portfolio) are essentially market timing when they rebalance their portfolios. Why? Because the act of rebalancing requires the selling of an asset class that is “overvalued” and using the proceeds to purchase another asset class that is “undervalued.”

I’ll have to admit that I never really looked at in this way but I can see his point. I always considered rebalancing as a prudent way to limit risk. If a person desires a 70/30 portfolio of stocks and bonds, over time the percentage of their portfolio that is exposed to stocks will increase as stocks typically appreciate faster than bonds. Take a look at the graphic below to see what I mean:

Assuming a 10% rate of return for stocks and a 5% rate of return for bonds, in ten years this portfolio would nearly become an 80/20 portfolio. For a personl only desiring a 70% exposure to stocks, an 80% allocation would seem inappropriate.

So my question to you is:

Is portfolio rebalancing the same thing as market timing?

I’m not far enough into the book to tell you what the author’s view on this topic is. I’ll be covering more of this book in the near future.

I was wondering if you could do a post on what you think would be a good long term stock portfolio allocation. I saw an earlier post of yours on Kiplinger’s 2008 recommended allocation and tweaked it a little to create the allocation below. Like Kiplinger’s allocation, I stuck to only equities, intend this to be a long term portfolio (i.e., no withdrawals for at least 15yrs+) and stuck with only Vanguard funds because they’re generally the cheapest. Obviously, an emergency cash cushion would be maintained, I just didn’t include that in this allocation. I also didn’t include a bond position even though I’d keep a small bond allocation. I really wanted to just concentrate on a good mix of equities only.

I’d appreciate any thoughts you or your readers might have on a good equity allocation.

Regards,
JB

Proposed long term portfolio:

30% – Large-Cap Domestic / Vanguard 500 Index (VFINX)
10% – Small-Cap Domestic / Vanguard Small-Cap (NAESX)
10% – Mid-Cap Domestic / Vanguard Mid-Cap Index Fund (VIMSX)
20% – Large-Cap Int’l / Vanguard Total Int’l Stock Fund (VGTSX)
20% – Int’l Emerging Markets / Vanguard Emerging Market Stock Fund (VEIEX)
10% – Real Estate Investment Trust / Vanguard REIT (VGSIX)

JB,

Based on the information you gave me, I see nothing wrong with that allocation. If this is a lump sum you are investing, don’t forget about the possibility of using exchange-traded funds. Vanguard has ETFs for each of those asset classes (for more information, click here).

The main thing I would suggest is that you make sure you stick with your allocation by rebalancing every year or so—depending on how far your portfolio deviates from your chosen allocation plan.

Finally, if you are interested, you might want to check out my post, Building a Portfolio for Retirement, that I did a few weeks ago. This is a diversfied portfolio that invests equal amounts in seven different asset classes. The portfolio was based on the work of BYU professor, Craig Israelsen.

In a discussion with a new client, a 55-year-old investor I learned the following:

• He currently had $2.5 million of net assets.
• He wanted to retire in 10 years.
• He was a long-term investor with a high tolerance for risk, evidenced by his current portfolio’s equity allocation of almost 100%.

When asked how much money he felt he would need to comfortably retire. He responded: “$4 million.” I then asked him whether his lifestyle would change much if instead of $4 million he ended up with $6 million. He said: “No.” I then asked him if his lifestyle would change if he ended up with just $3 million. He said: “Yes, I would have to keep working.” Clearly the reward of his ending up with more dollars than his goal was far less than the pain of ending up with less. In other words, while he had a long investment horizon (the second to die life expectancy between he and his wife was about 30 years), and he apparently had a high risk tolerance (as evidenced by his current 100% equity allocation), he was clearly a risk averse individual. I then showed him that to achieve his $4 million goal in 10 years, including the savings from his salary over that period, he would need to earn less than the rate of return on a money market account. He didn’t need to take the risk of an all-equity portfolio to achieve his objective. Financial economists would say that his utility of risk was very low. The marginal benefit of the upside was very low, while the pain of a downside outcome was severe. He ultimately decided to substantially reduce his equity allocation. An irony about investing is that the very people who can most afford to take risk (the very wealthy) have the lowest utility of risk, and therefore the least need to take it.

Since this guy’s goal was $4 million and he already had $2.5 million, he didn’t need to take on the unnecessary risk associated with a 100% stock portfolio. Of course not everyone has that option. For people who have a small retirement plan balance, they will need to 1) invest more, 2) invest more aggressively (but not stupidly), and 3) accept the volatility.

I think this example shows the importance of having a goal to shoot for when saving for retirement. If your goal is a $4 million retirement balance by age 60 and you are now 30 and have a balance of $100,000 in your plan, you can calculate how much you need to save per year based on your expected rate of return as the table below shows.

NOTE: I ignored inflation, taxes, and contribution limits in my calculations.

I don’t know too many 30-year olds that could afford to sock away $4,500+ per month. Therefore, it’s important when you are younger to take advantage of the better returns usually offered in stocks because you have time on your side, which lessens the impact of volatility. In other words, if you have a few bad years, you have DECADES to make it up.

One other thing is that if you know what your retirement goal is, you can gauge your performance to see if you need to make any changes. For example, we can calculate where you should be at age 35, using the numbers from the table above:

It’s important to note that I used straight-line appreciation when calculating the growth. In real life it would be much more variable than that. That said, the last table could give you an idea of where you should be based on your goal and your required rate of return. Then, as you get closer to retirement you can assess your situation to see if you can adjust your allocation and put less of your portfolio at risk by moving it into more conservative asset classes, which is what Larry suggested in the story above.

This is a pretty broad topic. Just putting this post together has given me more blog post ideas, which I’ll be adding later. If you have questions or comments, please leave them below.

*I plan to make that paper available as soon as I get it formatted properly.

It’s time to start saying goodbye to 2007 and get ready for 2008. The yearend is a great time to make adjustements to your portfolio. We call those adjustments “rebalancing.” The easiest way to understand the rebalancing process is with an example.

Let’s say you had the following portfolio at the beginning of the year:

Your allocation calls for you to hold equal allocations of each of the ten sectors of the Dow Jones Total Market Index. So, each sector would represent 10% of the total value of the portfolio.

On December 16, 2007, the portfolio looked like this:

As you can tell, some of the sectors are worth considerably more now than they were at the beginning of the year, while other sectors are worth a lot less. In order to keep our allocation the same, we need to rebalance by selling off some of the sectors that performed well and buying more of the sectors that did poorly. Now, this might run counter to your emotions, but selling “good” investments and buying “poor” investments is exactly what you need to do in order to keep your emotions in check.

How you go about rebalancing depends on following:

1. Commissions charged on the account. Do you have to pay commissions based on the transaction? If so, you might want to limit the number of trades you do since transaction charges can really eat into your returns. On the other hand, if your account is charged a fixed amount each year, such as FOLIOfn, you can most likely reallocate without incurring extra fees.

2. Whether it’s a taxable or non-taxable account. Since transactions will result in capital gains, it might be to your advantage not to rebalance if your current allocation isn’t much different from your target allocation. A general rule of thumb is to reallocate when one asset class or sector is 5% higher or lower than the orginal allocation. If your acount is held in an IRA, then taxes aren’t a concern.

The first step in reallocating a portfolio is to calculate how much over or under the current allocation is from the target allocation:

If your account is held at FOLIOfn, you can rebalance your portfolio with the click of a button. If not, you’ll have to do a little more work by selling off some of the overallocated funds and buying more of the underallocated funds in order to bring you back to your original allocation.

Here’s an example of what your portfolio might look like after reallocation:

If you’ll notice, I didn’t bring this portfolio back exactly to its original allocation. I left IYK alone since it was only $200 off from its original allocation. If you had to pay commissions on each trade, you might decide to even less reallocating than I did by only reallocating the top two and the bottom two.

I can’t emphasize enough how important reallocation is. Sectors and asset classes fall in out of favor all the time. By selling off those sectors that outperform and buying more of the sectors that underperform, you essentially “lock in” your gains. Yes, there’s always the chance that the poor sectors will continue to perform poorly, but there’s also the chance that the better-performing sectors will underperform. As the chart below shows, it’s incredibly difficult to know which sectors are going to perform the best from year-to-year:

Hopefully, I given you the basics on rebalancing your portfolio. I welcome any questions or comments you might have.

Now, here are the links to the other posts in the MoneyBlogNetwork’s Yearend Money Moves Series:

Blueprint for Financial Prosperity – Dumb Year End Money Moves

FiveCentNickel – Clearing Out Your House For Fun and Profit

Consumerism Commentary – Use Your Flexible Spending Account Before It’s Too Late

NoCreditNeeded – Jump Start Your Debt Reduction Using Christmas Gifts and Year End Bonuses

FreeMoneyFinance – Make Your Charitable Deductions Before Year End

MightyBargainHunter – Grab Some Year End Bargains

Get Rich Slowly – Paycheck and Witholding Calculators for Year End Money Moves

First of all, every investor has a unique time horizen and risk tolerance, so any rule of thumb is hardly adequate. Secondly, I think the typical rules of thumb are too conservative anyway. Many people are now living well into their 90s–and a recent article in Time suggests that some women in their 20s today may live to be over 120. Additionally, careers and aspirations are changing. Few folks can or want to quit earning income and live totally off of their retirement funds at 65.

So the method of “subtract your age from 100″ or even from 115 to get the percentage of your portfolio that should be in bonds seems rather outdated. Target Retirement Date funds that allocate half of a middle aged person’s portfolio to bonds can actually be much too conservative, especially if that person has significant short-term assets outside of their retirement portfolio or if they expect to have other sources of income past age 65 such as pensions, passive income, earned income, or social security.

And yet funds that allocate smaller percentages to bonds are labled “aggressive” or even “very aggressive” which can confuse and scare away investors who wouldn’t categorize themselves with those lables. Words like “balanced” describe funds with upwards of 35% in bonds–which can actually be very conservative if you’re investing for the long haul.

I’m also particularly tired of all the articles that seem to come out of the woodwork when the market is “unstable” which ask, imply, or suggest that one should shift a larger percentage of their portfolio to bonds. Just yesterday a commenter suggested that I shift a third of my stock holdings into bonds.

Last time I checked, selling stocks when the market goes down is NOT the best way to maximize your return. Isn’t “buy low, sell high” supposed to be the goal? Besides, your allocation decision shouldn’t have anything to do with what’s going on in the market in the short term. Or perhaps I just missed the memo announcing that the media has suddenly gotten really good at predicting the market.

Personally, I don’t think ANY significant percentage of my retirement portfolio should be in bonds. I have almost 4 decades before I am legally supposed to touch my 401k or IRA. And even then, I plan to have enough “passive” income to keep me from having to totally live off my retirement funds. Plus, basically all of my non-retirement funds are in cash or bonds.

What’s your view on the stocks vs. bonds debate? What factors should determine your asset allocation?

More from Meg at The World of Wealth

So, let’s begin…

First we’ll look at the total returns through 2006 for various indexes (asset classes) found in the Callan Periodic Table of Investment Returns:

Here’s the asset class that each index represents:

MSCI EAFE – International
S&P 500 Index – Domestic Large-Cap Stocks
Russell 2000 Value Index – Domestic Small-Cap Value Stocks
LB Agg Bond Index – Investment-Grade Bonds

I realize that there is no midcap index. We’ll just do without it for this example.

Now we’ll decide what percentage of the portfolio should be allocated to each asset class. It’s easy to look at the above chart and just pick out the indexes with the best returns. That’s not the way to do it! Why? Because that graphic does not show you the volatility that the index contains. Without getting into the specifics (food for another post), here’s how the asset classes rank in volatility (from least to most):

LB Agg Bond Index – Investment-Grade Bonds
S&P 500 Index – Domestic Large-Cap Stocks
Russell 2000 Value Index – Domestic Small-Cap Value Stocks
MSCI EAFE – International

Your asset allocation will depend on factors like your age, time horizon, risk tolerance (I hate that term), and other various factors. All this makes asset allocation a very personal choice. What’s right for me may or may not be right for you.

So,… here’s how we can use the information we have covered so far to estimate the total return on a portfolio:

Let’s say you have decided that you want the following allocation:

30% – Large-Cap Stocks – S&P 500 Index
30% – International – MSCI EAFE
30% – Small-Cap Value – Russell 2000 Value
10% – Bonds – LB Agg Bond Index

Using the 20-year returns from the chart above, we’ll construct the following portfolio:

As the graphic suggests, you take the percentage allocation times the expected return of the asset class to estimate that asset’s impact on the portfolio. You repeat this for each of the asset classes. Then you simply sum those returns as I did in the last column to get an idea of how a particular portfolio will perform. If you are interested, you can download a simple spreadsheet I put together. You can then play around with it by making changes to the allocations and expected returns to see their impacts on the total portfolio. You can also use my Portfolio Tool that I recently created.

If you took the time to read this post, you now have a understanding of how to construct a portfolio and how expected returns impact the return of the entire portfolio. Isn’t learning fun?