If there is sufficient interest, I will post a short movie of a portfolio made up of the top 20 stocks I am tracking, and a well-diversified portfolio made up strictly of ETFs.  These will be “main-stream” ETFs that track broad indexes.

Happy New Year

Lowell Herr

Photograph: Bratislava, Slovakia

While researching the “Investment Policy Explains All” paper, I ran into this Internet source of information. Here are some of the articles I highly recommend.

• The Importance of Investment Policy: A Simple Answer To A Contentious Question
• The Truth About Diversification by the Numbers
• Getting to the Core of Model Portfolios
• Style Analysis

Start with these white papers and then pick up others of interest.

Lowell Herr

Photograph: Saint Paul, France

Here is an exercise that will prove informative to investors who construct portfolios using stocks. Follow these instructions.

• Make up a list of the stocks in your portfolio.
• Go to Morningstar and determine which asset class or style box each stock occupies. Type MSFT in the Quotes option and then click on Snapshot. In the example we see MSFT is a Large-Cap Growth stock.
• Now find an ETF for each style box that contains at least one stock in your portfolio. Since Barclay’s iShares have been around longer than Vanguard’s ETFs, one would do better to go with the iShare. For example, the iShare to compare with the Microsoft stock is IVW as it is a Large-Cap Growth ETF.
• Now open up the Yahoo Finance page. Using a five-year period, compare the stock with the appropriate ETF. In the example, you will see that IVW outperformed MSFT by a little over 20% over five years.
• Perform this comparison with every stock in your portfolio and write down your results. If you held the stocks over a different period, use a comparison that is closest to the holding time.
• There is one more thing you need to examine. Does your portfolio include stocks in all of the “Big Nine” Morningstar style boxes? Does the portfolio include international stocks from developed countries or areas such as Europe? Does the portfolio include stocks from emerging markets? Are there any REITs or commodities in the portfolio? If not, why not?

If most of your stocks outperformed the appropriate ETF, you are a fine stock picker and you should continue to build your portfolio the way you always have. If, however, your portfolio is not well diversified and/or the stocks are not performing as well as the benchmark ETF, then questions arise as to how one is going to change the construction of the portfolio.

Lowell Herr

Photograph: Art aboard Celebrity cruise ship.

What does it take in savings to live during retirement? Here is  data that readers may find of interest as they think about portfolio development and eventual retirement.

A couple nearing retirement anticipate they will need $80,000 after taxes per year to live during their first year without employment. Between them they will receive a pension of $2,000 per month or $24,000 per year. These are all after tax dollars used in this example. Social security will provide another $2,500 per month or $30,000 per year. Eighty thousand minus $54,000 leaves them $26,000 short and this money needs to come from a savings plan.

The question then comes down to what will it take to generate $26,000 in after taxes money each year. I tend to be quite conservative when it comes to thinking through these numbers. Many advisors will tell clients they can withdrawal 5% per year from their retirement funds. My preference is to lower it to 2% so the portfolio has a greater chance to grow and fight off inflation should it raise its ugly head during an anticipated 30 years of retirement.

$26,000 = X * 0.02 or X = $1,300,000. To some, this is a shocking figure. This simple calculation helps one think of the value of a $24,000 pension or a $30,000 social security benefit.  There is a considerable amount of money sitting behind those payouts, even if one uses a 6% figure.  William Bernstein writes about this in his “Four Pillars” book.

If withdrawing only 2% seems too conservative, then move up to 3% or 4%, but my recommendation is to not plan on withdrawing a higher percentage. If one pulls out 4% of the savings, then the required amount of savings is $650,000, still a substantial amount.

If one does not have a pension, it places a greater burden on the individual to save more during a lifetime or cut down their living style, or both.

The next issue facing this couple is to lay out an asset allocation and savings plan that will put them in a position to withdrawal the equivalent of $26,000 to $30,000 in today’s money sometime in the future.

Planning for retirement becomes very complex when one adds in inflation and taxes as both are going to vary a great deal.  This is why I tell couples to plan on saving between 1.2 million and 1.5 million in todays dollars.  That seems like a very high bar to meet, but it can be done with discipline and frugal living.

These sample numbers should provide grist for a discussion.

Lowell Herr

Photograph:  Lighthouse on the northern shore of Kauai, Hawaii

On the Internet there is a site that tracks over 7,000 investment clubs.  These clubs are made up of individuals that pick stocks to populate their portfolios.  Right now their top picks are: GE, JNJ, MSFT, WAG, SYK, CSCO, HD, PG, SBUX, and AFL.  These are excellent companies and I’ve held shares in most of them over the last ten years.  The average portfolio for these clubs is a little over $61,000 so they are sufficiently large to be well diversified.  The data goes back to 12/31/2000 or just one month different from my passive portfolio data.  Here are the results.

The Internal Rate of Return (IRR), for what is known as a Club Index, is negative 4.0% (-4.0%) while the IRR for the VTSMX benchmark is 2.9%.  The passive portfolio (PP) that began on 12/01/2000 or 30 days earlier than the Club Index has an IRR of 5.4% compared to the VTSMX index of 2.8%.  The 0.1% difference in the benchmark is due to the slight difference in the starting dates and the cash flow that occurred in the PP.

The 9.4% (5.4% vs. -4.0%) difference between stock picking and index or passive investing is startling.  The Passive Portfolio (PP) is constructed of ETFs.  We used iShare ETFs to build this portfolio since Vanguard did not have ETFs at the time this portfolio was launched.

If anyone has any questions related to the makeup of the PP, just ask.  Once the August broker statement is available, I will post additional information on the Passive Portfolio over on the Premium Content side of the blog.  One amazing bit of information on the PP is its low risk.  As a result, the Information Ratio (IR) is quite high for this portfolio. I consider the IR value to be the “gold standard” measurement for any portfolio as it takes into account both return and risk.

Premium Content is available for $6.99 per month.

Photograph:  Preparation for national holiday in Tiananmen Square, Beijing, China