The point of his piece is that bond yields will most likely fall below inflation for years to come due to excessive debt and low interest rates and that investors should take a look at their portfolios and make some changes. He recommends…

I think there are two reasonable strategies that investors should consider. The first is to look for bonds with moderate credit risk where the spreads over U.S. Treasury yields are generous. The second is to consider substituting a portfolio of dividend-paying blue chip stocks for a high-quality bond portfolio.

For the first, he recommends tax-exempt municipal bonds that get reliable revenues:

The first class is tax-exempt municipal bonds. The fiscal problems of state and local governments are well known, and the parlous state of municipal budgets has led to very high yield spreads on all tax-exempt bonds. Many revenue bonds with stable and growing sources of revenue sell at quite attractive yields relative to U.S. Treasurys.

For example, the New York/New Jersey Port Authority gets reliable revenues from airports, bridges and tunnels to support its debt. Long-term N.Y/N.J. Port Authority bonds currently yield close to 5%, and they are free of both federal and state and local taxes in the states in which they operate.

He also recommends foreign bonds in countries with low debt-to-GDP ratios like Australia.

Finally, he recommends investors consider a portfolio of bluc-chip stocks with generous dividends. One stock he highlights is AT&T.

All of this makes me wonder:

At what point does portfolio tweaking become market timing?

I ran the numbers under the following two scenarios:

• $500 per month with no rebalancing.

• $500 per month with annual rebalancing.

Here are what the numbers look like:

I have to say that this one surprised me until I considered everything that has happened over the last 19 years. So much of portfolio returns are due to timing. The equity portion of the portfolio grew nicely throughout the 90s but cratered with the bursting of the internet/tech bubble in the early 2000s and then again in 2007 and 2008.

So there you have it. Bonds beat stocks in this scenario so bonds are better, right? Not so fast. Take a look at the next graphic, which is like the first graphic only this time, the portfolio is rebalanced back to the original allocation at the end of each year.

Rebalancing was the difference maker. The sweet spot seems to be around a 50/50 split between stocks and bonds. Rebalancing is important because it adds a sense of discipline to the portfolio in that investors are selling appreciated assets and buying more of assets that have decreased in value. This was particularly important over the last 19 years due to the way the stock market behaved.

It’s important to note that we shouldn’t focus too much attention on a two asset portfolio. This was more of an exercise in seeing how stocks and bonds work together.

What does the future hold? Well, that’s anybody’s guess. If we have inflation (as many economists are expecting), U.S. bonds will not do well. If we don’t get our economy back under control, stocks won’t perform well either.

That’s why at this point in the game, I’m thinking a prudent portfolio is something like Craig Israelsen’s 7Twelve portfolio, which invests in 7 different asset classes via 12 different funds/ETFs. For those who are interested, I interviewed Dr. Israelsen recently.

Okay…

I took the monthly total returns for the Barclays Aggregate Bond Index and combined them with the total returns for the S&P 500 Index and ran some numbers. I started with 100% in stocks and ran the numbers for the nineteen year period (1991-2009). Then, I re-ran the numbers, adjusting the allocations by 5% (you can see this in the following graphic). The results are here:

What I found interesting was the how adding bonds didn’t reduce the performance of the portfolio but did reduce the volatility. Granted, this is a very short-term look at returns. It was also a period in time that saw stocks get hammered in the early 2000′s and again in 2008. BUT…that’s the purpose of ASSET ALLOCATION!

From this study, it seems that the sweet spot was a portfolio of 85/15 stocks/bonds or 80/20 stocks/bonds. The ending values are nearly identical to the ending value of the 100% stock portfolio but weren’t nearly as volatile based on monthly standard deviation.

We’re not done looking at this. Tomorrow I’ll look at the same portfolio from a dollar-cost averaging point of view. The results are pretty interesting.

Here’s a brief look at the book:

Part I Looks at investment strategy in an uncertain world. Chapter 2 is dedicated to the importance and creation of your investment policy statement. I would have preferred Larry spending more time on the IPS—perhaps giving an example or two of different statements or even a sample worksheet to help aid the reader in putting together their own IPS.

Part II is the meat and potatoes of the book: asset allocation. Part II has chapters dedicated to asset allocation in general, equities, fixed income, alternative investments, and liabilties and asset allocation. I really liked these chapters, particularly the chapter on alternative investments because Larry gives recommendations on whether or not each asset should be a part of most investors’s portfolios. Of the nineteen alternative investments discussed, only one of them get’s Larry’s recommendation (EE Bonds).

I also liked the chapter on equities because Larry lays out reasons why an investor would want to increase or decrease their equity exposure. Among the reasons to increase equity exposure:

• Longer time horizon

• High tolerance for risk (I prefer to call it volatility)

• High marginal utility for wealth (a technical way of saying that an increase in wealth is important to you)

Part III is about implementing the plan. It looks at things like whether or not to use individual stocks or mutual funds, active vs. passive management, where to hold assets, and portfolio maintenance.

Part IV addresses all the other areas of planning. Things like college savings plans, insurance, IRAs and retirement plans, social security, safe withdrawal ratess, and estate planning. The most interesting chapter in Part IV (in my opinion) was the one addressing safe withdrawal rates. Larry’s discussion of the usefulness of Monte Carlo simulations was interesting (and food for future AFM blog posts).

The book closes with several helpful Appendices that look at diversification, dollar cost averaging, reverse mortgages, and how to choose an advisor.

Overall, this is a great resource for everyone (beginner and those who are further down the investing and planning road).

Related books (affiliate links):

• Wise Investing Made Simpler (Second in a series)

• The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Invests Today

• The Only Guide to a Winning Bond Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today

• The Only Guide to Alternative Investments You’ll Ever Need: The Good, the Flawed, the Bad, and the Ugly (Bloomberg)

*Affiliate Link

A) $5,000 lump sum in Vanguard’s 500 Index Fund and $5,000 lump sum in Vanguard’s Total Bond Index Fund

or

B) $10,000 lump sum invested Vanguard’s 500 Index Fund

If you chose A, and reinvested all dividends, your account value at the beginning of July would have been $35,125.

If you chose B, your account value would have been $50,743 (again, assuming all dividends were reinvested).

Now, the picture changes drastically if the beginning period is January 2000. The 50/50 portfolio would have grown to $12,278 while the 100% stock portfolio would have been worth $9,418.

What’s the point?

First off, hindsight is 20/20. Second, diversification is insurance. It looks like expensive insurance when the stock market performs well and it makes you look like a genius when times are tough (like the last decade). I realize a 50/50 portfolio is pretty conservative. In a future post, I’ll look at other portfolio weightings.

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.