It’s time for another bi-monthly update on my investment portfolio.

Thoughts
Not much going on, I have been contributing a $500 a month to my Solo 401k while trying to build up my cash hoard for a house downpayment. I still plan on tweaking my asset allocation, but I’ve just been distracted by other things and kind of want to wait a full year before making any changes.

All of our Vanguard funds are held at Vanguard.com, where there are no commissions for trading their mutual funds. Currently, everything there is in Roth IRAs, one each for my wife and I. Even though Roth IRAs rock, we haven’t contributed to one this year yet because we might be over the income limits for 2007.

The Fidelity fund is also held in-house at Fidelity, where I have my Self-Employed 401k. Funds are also no transaction fee (NTF) there. It’s a bit annoying that both their Spartan Total US and International funds have high $10,000 minimums, but the 0.10% expense ratio is nice. I could also trade ETFs, but at $20 a trade it’s a bit expensive.

You can see some older posts on how this portfolio came to be here, as well as my previous portfolio snapshots here.

Ben Stein has an good read on Yahoo Finance about what he terms the Six Key Principles of Saving for Retirement. Although I agree with all six main ideas, I question some of the specific numbers. Here are some excerpts and my comments:

1. How much you save.
Simply put, if you’re a typical American (who happens to save close to zero right now), you have to save more. When you’re young, 10 percent of your income will get you there. If you don’t start saving until middle age, aim closer to 15 or 20 percent. If you don’t start until later than middle age, save every penny you can.

Interesting. Is 10% really enough? If so, maybe I really am saving too much for retirement. 🙂 To what degree of certainty is that true?

2. How long you give your savings to compound.
A thousand dollars socked away when you’re 20 and growing at 10 percent per year will be almost $73,000 when you’re 65. The same sum saved when you’re 50 will grow to $4,200 at age 65. That’s a stunning truth that should compel any young person to start saving early — and the rest of us to start right now.

As for timing your retirement, Ray advises that if you can push it back by even five years you’ll allow your money to grow and have fewer years to need it.

Compound interest is truly powerful. A dollar saved now is worth more than a dollar saved later.

Although it hasn’t been helping me control my spending as much as I’d like either, I did make the horribly unpopular true cost of frivolous shopping calculator. 😉

3. How you allocate your assets.
Typically, for those who start early, stocks are the answer. Over long periods, a diversified basket of common stocks wildly outperforms bonds, cash, and real estate. The differences are breathtaking.

But, as we’ve seen lately, there’s also a lot of volatility in stocks. As you age, you’ll want more of your money in bonds and money market accounts. These have lower returns than stocks, but they also have far lower volatility.

Phil DeMuth recommends that, as a basic portfolio, you have half of your savings in the broadest possible common stock index such as the Vanguard Total Stock Market Index (VTSMX) and half in the Vanguard Total Bond Market Index (VBMFX)… To me, that’s a bit conservative if you’re young. I would have more in stocks and also a good chunk in international markets.

Here is a compilation of various model asset allocations from other respected sources. Pretty pie charts included!

4. How much your investment returns annually.

Now, this is largely unknown from year to year. But over long periods, stocks return close to 6.5 percent after inflation, and about 10 percent before inflation.

Can we expect 6.5% real returns in the future? Lots of conflicting opinions out there on this, but I really want to look into this more.

5. How low you keep your fees and costs.

This principle is largely about using index funds and no-load mutual funds, which makes perfect sense.

Costs matter, whether you go actively or passively managed. I’ve seen some really expensive index funds. Always look up the expense ratios and any commissions you have to pay either when you buy or when you sell for all the investments you own.

6. How closely you keep an eye on taxes.
Finally, Ray advises maxing out your tax-protected accounts like IRAs and 401(k)s; keeping high-dividend stocks in accounts that are tax-deferred; and, when retiring, carefully considering what bracket you’ll be in and drawing out your funds to remain in the lowest possible one.

Ah, taxes. Here is a discussion on where you should place investments for maximum tax-efficiency.

J.D. of Get Rich Slowly also shared his thoughts on these six points, and believes the most important factor in retirement savings is psychological.

I’ve been trying recently to try and make some minor adjustments to the target asset allocations of my portfolio. I want to create something that I won’t be tempted to change again for many years. While attempting this, I keep noticing how hard it is for a beginning investor to try and figure out where to put their hard-earned money. So many websites, books, magazines, television shows… and the amount of information being thrown at you just seems to multiply daily. Everybody has an opinion, including me. Am I right?

Who knows? I don’t. I’m simply doing the best anyone can do – read a steady stream of books, academic studies, participate in discussions, and then making a decision based on that information. I try look at the bigger picture and draw conclusions based on historical studies going back from the 1920s and not five-year historical returns. But none of us can predict the future.

What is accepted as common knowledge often changes with time. My own views shift as I read more. I also see a lot information out there that I disagree with. Therefore, I encourage everyone to do their own due diligence, keep their minds open, question things, and try to separate the wheat from the chaff for themselves. All I can do is to promise that I will try to keep doing the same.

(This will be added to my compilation of posts about managing money called My Rough Guide To Investing.)

After looking at how other people and mutual fund companies choose their asset allocation, I’m a little conflicted. Both the Vanguard and T. Rowe Price mutual funds recommend holding nearly 80% in stocks at age 50. That’s pretty aggressive in my book. To see why, let’s look at some historical numbers.

Coincidentally, a commenter left me a link to a recent FundAdvice article about fine-tuning your asset allocation. I’m actually going to ignore the specific components of his portfolio and focus on the general trends instead. Let’s just say it’s well-diversified.

The article provides historical numbers (1970-2006) that compares risk versus return for portfolios ranging from 0% stocks to 100% stocks. Risk is represented by standard deviation, a measure of volatility.

Risk vs. Return For Varying Stock Percentages

This is pretty consistent with a lot of other similar charts I’ve seen. You’ll notice that the slope of the curve decreases as you move towards holding more stocks. Accordingly, if you compare the differences between successive dots, there risk gap grows larger and the return jump decreases. In other words, you are generally getting less return for each unit of risk as you keep adding more stocks.

Here is another risk-reward chart for increasingly aggressive portfolios.

Still, this chart really doesn’t help too much either. Why not just go for the 100%? Instead of averages, let’s focus on how bad it can get over the same time period (returns not annualized):

This second chart is more important than the first one, because you won’t get any of the returns listed above unless you can “stay the course” through periods such as these.

It’s really easy to say “Oh, 30% drop, no problem”, but that’s not the whole picture. Not only will stocks be dropping, but bonds may be skyrocketing. Imagine if bonds are returning 15% a year at the same time stocks are going down 15%. You will have what appears to be a way out! Personal finance magazines will be shouting “Bonds are back!” Cutting down on your stock exposure will become the “prudent” decision.

Going back to the 80% stocks at 50 years old… Can you imagine losing 35% of your portfolio in one year at 50 years old? I would freak out. This is why age matters, it’s so much easier to shrug off losses when you know you won’t need the money for another 30+ years.

I’ve always thought of 403(b)s as identical to 401(k)s, just for non-profit and educational institutions. But upon discussing this with a teacher, I found out that they can have their own unique problems: primarily high-priced annuities. Did you know that 80% of 403(b) funds are currently invested in fixed or variable annuities? This is really surprising, considering that annuities are usually only a good idea for high-income people who’ve already maxed out all their other tax-deferred options – why put a tax-deferred product inside another tax-deferred product?

If you’re not sure what you have in your 403(b) accounts, I would definitely recommend reading up at 403bWise.com. Started by teachers, it has a wealth of information about your investment options. Did you know that if you summed up all the various annuity costs you could be losing 3% to fees every year? If you are stuck with a bad administrator, you may be able to do what is called a “90-24 transfer” to a low-cost provider like Fidelity, Vanguard, T. Rowe Price, or TIAA-CREF. There are some upcoming law changes and this transfer ability expires at the end of 2007, so compare your options soon. Another route is follow other teachers and fight for a change from within.

There is also 457bWise for 457(b) holders.

After choosing your asset allocation, it is still important to think carefully about where to place each type of investment. After all, what you actually keep is your return after taxes. For example, a stock index fund that tracks the S&P 500 will have low turnover and primarily pay qualified dividends which are taxed at the lower long-term capital gains rate (max 15%). On the other hand, REITs and bonds tend to distribute a significant amount of their return annually as unqualified dividends, which are then taxed as ordinary income (max 33%). Therefore, you should try to take advantage of your tax-sheltered accounts as much as possible by placing the least tax-efficient assets there.

Below is a chart that shows the major asset classes sorted by tax efficiency. It is based on information from the fine books Bogleheads’ Guide To Investing and The Four Pillars of Investing.

Let me clarify the chart above. You should start with the least tax-efficient assets and place them in your pre-tax accounts (Regular 401ks, 403bs, Traditional IRAs) first. Then the next least efficient assets should into the post-tax accounts (Roth IRA, Roth 401k). Only what is left after this should end up in taxable accounts.

In general, bonds should go into tax-deferred accounts, leaving stocks for your taxable accounts. There are even special “tax-managed” mutual funds which work hard to minimize any capital gains distributions and are designed specifically to be placed in taxable accounts.

This article is part of my Rough Guide To Investing.

Fidelity has a new tool called the myPlan retirement calculator. It’s very soothing and is only 5 questions long, why not give it a whirl? What I like about it is that it doesn’t just deal with average numbers. People like to use round numbers like 8% annually and pretend like they are a sure thing, but the fact is with some bad timing we could end up doing a lot worse.

Using some rough numbers from our own situation – age 28, $100k income, $100k saved so far, $2,500 saved monthly, Aggressive Growth investment style, we get the following result:

Not bad, right? If the market performs on average, we will easily exceed what we need to retire on. (Yes, the numbers are huge!) If the market performs poorly however, we’ll be significantly short. Now, what if we change the investment style from Aggressive to Conservative?
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