Tailoring a Portfolio

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This post and the next two are devoted to constructing an investment portfolio.  This first post takes up broad divisions – the mix of cash, stocks, and bonds — what professional investors refer to as asset allocation. The next post will focus on the portfolio’s bond assets and the third will discuss its stock assets.

Typically, a broker’s portfolio report begins with the overall amounts you have in cash, in stocks, and in bonds.  The report then gets into intricate detail, listing all the bonds, who issued each, the original “coupon” rate as a percent of the bond’s face amount, and its maturity date.  (See this earlier post for an explanation of these terms.) The broker’s report will probably also show how much you paid for each bond, its current value, and perhaps the interest payments you earned from it since the last report.  A comparable listing of the stocks in your portfolio will show the name of the issuing corporation, the number of shares you own, what you paid for them, their current value, and possibly dividend payments since the last report.

While these reports are useful to brokers, bankers, and accountants, portfolio managers look at holdings more broadly to consider how they can achieve two key objectives for you:

  1. Good diversification: An effort to avoid having too many eggs, meaning dollars, in one basket, that is too many of one security or type of security. If you could always pick the best, you would not need to diversify.  But perfect foresight is impossible, so spreading your wealth among different types of stocks and bonds will protect the portfolio from setbacks by ensuring that its different parts respond to events in different ways.  Such diversification of exposure allows your portfolio to secure the most gain with the least amount of risk.
  2. Serving the specific goals of the investor: Are your portfolio’s assets meant to provide retirement income?  To buy a vacation home? Or to pay for a newborn child’s college education? These and other long-term objectives will determine what sorts of stocks and bonds your portfolio should hold and how it should mix the types of securities to get the greatest prospective return for the least risk.

So think of the stocks and bonds in the portfolio not necessarily as individual holdings but rather as the best possible representatives of the sort of security that serves these basic aims.

There is no perfect mix.  Your right combination will depend heavily on your particular circumstances and preferences — what many in the investment business term your life-cycle/life-style situation.  Some people cope better than others with risk and occasional loses.  Those more suited to a riskier life style feel comfortable reaching for gains in a more volatile portfolio.  The mix you choose should also reflect where you are in your life cycle.  Young people investing for retirement, for example, will not need the money for years, so they can take more risk to earn greater returns than can older investors who are approaching the end of their working lives and have less opportunity to make up for an investment loss or time to wait for a market rebound after a setback.

Portfolios need to reflect such differences.  Young people, who will not need the money for years, particularly risk-takers, may want few or no bonds in their portfolios. They may want to concentrate on stocks, particularly smaller, less established stocks, because these, though more volatile than other investments, tend over time to gain more than bonds and more conservative stocks.  To be sure, stocks generally and particularly those of less established companies may suffer severe occasional reverses.  But as a group they eventually always come back.  An investor with a long time horizon can count on that recovery.  Someone older, with less opportunity to wait out a temporary setback, may want more bonds and stable, dividend-paying stocks. Retirees, who are already living off investment income, may also prefer bonds and dividend-paying stocks because they also tend to generate more immediate income than less established stocks.

There are many ways to combine stocks and bonds to meet portfolio goals. The aim is to learn their characteristics and create a good investment fit for your critical needs.  The next post will explain the role of bonds and the one following will do the same with stocks.

 

So…You’ve Come Into Some Money…

So...You've Come Into Some Money?

Just suppose you receive a windfall: an inheritance, a legal settlement, or the transfer of pension funds when you retire.  Though more money is always better than less, such money flows do impose hard decisions. Many people feel insecure about what to do.  They frequently don’t know what decisions they need to make.  Here are the necessary steps to guide you:

First Steps

First, decide whether the windfall is sufficient to change your lifestyle or simply improve it.

Rule of Thumb: You need investable funds amounting to between 15 to 20 times your annual income in order to quit your job and pursue a life of leisure.

If the windfall and your other savings approach such an amount, you must take two further steps:

  • See an accountant or a tax lawyer to understand the tax implications of the money you have received.
  • Find a reliable financial planner to invest the funds in a diversified conservative portfolio such that it can securely support your new lifestyle. (In later posts I will discuss how to build such a portfolio.)

Two Following Steps

If the windfall does not come up to 15-20 times your yearly income, you will need to make some perhaps difficult personal decisions for yourself and/or your family:

  • Pay off your credit card debt. Interest charges here can be the most onerous short of a loan shark.  The most effective thing you can do with any surplus funds is to discharge these obligations.  Start with the credit cards that charge the highest rates.  (This figure should appear prominently on your card statement.)
  • Identify your critical spending needs. These would be the things you wanted to do before the windfall but couldn’t afford. You may need a new car or a second car. Your home may need repairs you have had to put off.  Perhaps your family or friends need a helping hand.  You, your spouse, or significant other may need a good vacation.  This is a partial list, but it should give the idea. After you’ve made the list, estimate the costs and then put those monies in a safe, relatively liquid account from which you can quickly withdraw them.  (In future posts, I’ll examine such accounts and discuss how to choose one that is best for you.)

Three Additional Decisions

If funds remain in the windfall, you will need to decide three big matters:

  • The Mortgage: If you own your home, you may want to use some of the funds to pay off the mortgage. How much depends on how much you can expect to earn from investing the funds.  If the investments earn less after tax than the interest on the mortgage, then the windfall is well used to pay it off.  If those investments can earn more, then you would do better to invest the funds and maintain the mortgage.  If the difference is close, your desire for security may reasonably sway you to paying it off.

Here’s an example.  Say you have inherited enough so that after “critical expenses” you have $250,000 left.  Say also you have an outstanding mortgage on your house of just that amount and the interest is 5 percent.  The mortgage, aside from payments on principal, costs you $12,500 a year.  If you are taxed at about 30 percent and deduct the interest expense from your tax bill, the after-tax mortgage expense comes to $8,750 a year.  At the time of this writing, an investor can reasonably expect a conservative portfolio to return about 6 percent a year––about $15,000 on the $250,000 windfall.  You will pay 30 percent in taxes ($4,500), giving you an after-tax return of $10,500 a year ($15,000-$4,500).  This significantly exceeds the after-tax annual mortgage expense, so unless owning the house outright is very important to you psychologically, you would do well to leave the mortgage in place and invest the money.  Of course, this is just an example.  Each person or family has specifics that could change the conclusion.

If you are renting or own a place that seems inadequate to your needs, you can legitimately use the money to buy a better place.  How much you dedicate to this–– whether you buy outright or put it down on a mortgage––hinges on the calculation just described.

  • Educating the Kids: A child’s education involves a simpler calculation.  You should have an idea what schooling after high school will cost, and how many years you have to accumulate the funds.  Assuming an annual investment return of 6 percent, you can calculate on any computer or business calculator how much you need to put to work in an investment to accumulate to what you’ll need when your child is ready.  This will tell you how much of the windfall you will need for this purpose.

Again a numerical example might help clarify.  Say you have one child who is five years old when you receive the windfall and that so far you have saved nothing for his or her higher education.  You estimate that by the time your child is ready to attend a state college in some thirteen years, the cost will be $30,000 a year––$120,000 for four years of study.  At 6 percent a year, the calculator will tell you that some $56,000 put to work in investments today will accumulate to what you need in 13 years.  Now you know what portion of the windfall need to go to the college account.  (More specifics on these in a later post.)

  • Retirement Savings: Funding for retirement is the most open-ended question.  Any investment you make instead of paying off the mortgage will contribute to your retirement.  Depending on your age and nearness to retirement, the amounts needed will vary, as will the appropriate kinds of investments.  (A future post will cover this material.)  But generally there is more flexibility here than with the mortgage or school decisions.  Of course, the bigger your retirement pool of assets, the better, so always dedicate as much as you reasonably can to retirement.  You may want to pay for your child’s education, but at the same time you probably don’t want to rely on support from your offspring in your old age.

 

A NOTE TO MY READERS: IF YOU HAVE A FINANCIAL ISSUE YOU’D LIKE ME TO DISCUSS, LET ME KNOW. IF I THINK IT HAS GENERAL APPEAL, I’LL DEVOTE A FUTURE ESSAY TO IT.