Ten Steps to an Ideal Retirement Portfolio

Some people organize their thoughts best with a step-by-step list. This book isn’t organized along those lines, but your mind may work best if it’s following a list. So right here I’ll give you my list of 10 steps to creating the retirement portfolio that’s ideal for you. And I’ll tell you where in the book to find out about each one.

This list may seem daunting, filled with tasks that would take you months or even years to complete. But here is something I’ve learned from leading workshops for people who are looking ahead to retirement: Most of these people can accomplish all 10 of these steps by attending a workshop and then spending 90 minutes with a professional adviser. This book gives you what’s in my workshop. If you can manage another 90 minutes with a good adviser (plus the time it takes to do the necessary homework), you’ll have all this done.

1. Determine how much you will need to live on in retirement. This will tell you how big your portfolio must be when you retire. And that in turn will tell you how much you need to save and what investment return you need. Chapter 5 tells you how to establish your basic target for the income you’ll need from your portfolio. Most investors give this step too little attention. Investors who don’t have this information are too often captivated by fear and greed, taking either too much risk or too little risk, depending on what’s happening in the markets. This first step is necessarily the foundation for everything that follows.

2. Determine how much you want to live on in retirement. In Chapter 5, you’ll find out how to establish your live-it-up retirement income target. This gives you a second figure for the target size of your portfolio and the return necessary to achieve it. We talk to many people who, having neglected to take this step, have invested as if they must achieve the highest possible return regardless of risk. Often, analysis will show that they can achieve all their goals with much less risk than they thought.

3. Determine your tolerance for taking risks. You’ll find important insights on this topic throughout the book. Chapter 10 focuses on risk. For every investment you make, you should understand the inherent risks involved and how this investment will affect the overall risk of your portfolio.

4. Make all your decisions based on what’s probable, not what’s possible. From 1995 through 1999, the Standard & Poor’s 500 Index compounded at a rate of 28.5 percent a year, leading many people (including plenty who should have known better) to conclude that successful investing was easy. Some investors scoffed at me in 1999 when I refused to give serious consideration to questions like “What’s a fund I can count on to make 75 percent a year?” I was dismissed as hopelessly old-fashioned when I suggested investors should aspire to long-term annual growth of 12 percent.

The brief bull market bubble in 1999 showed us that returns of 75 percent were possible. But the bear market of 2000-2003 showed us that 75 percent losses were equally possible. As it turns out, we have more than three quarters of a century of history to show us what’s probable. This, not the flash-in-the-pan excitement of a bull market, should be the basis for your planning.

5. Determine the kinds of assets that will give you the returns you need to achieve your goals. Academics have done years of mind-numbing research on this very topic—and some have even won Nobel Prizes for it. I have distilled that research into five chapters (6 through 10) that tell you what you need to know and what you should do about it. Actually, I think you may find this is quite interesting material. You’ll learn how to add nine equity asset classes to the S&P 500 Index in order to achieve extra return without taking any more risk than that of this popular index.

6. Combine those assets in the right proportions into a portfolio that’s tailored specifically for you. I show you exactly how to do that in Chapter 12. I name names of the specific funds you should use at Fidelity, Vanguard, T. Rowe Price, and other sources.

7. Learn to recognize and control the expenses of investing. Chapter 11 tells you how to recognize expenses as leaks in your portfolio and how to plug them. There are many things about investing that you can’t control, but this is one that you can. Savvy investors pay lots of attention to expenses. Sloppy investors would rather not be bothered. Over a lifetime, the difference can add up to hundreds of thousands of extra dollars.

8. Make sure you understand enough about the tax laws to avoid giving Uncle Sam more of your money than you are obligated to. Lots of investors carelessly squander part of their assets because they don’t pay attention to tax issues. This is a big topic, but we hit the high spots in Chapter 11. The advice you’ll find there will help you turn your investments into an efficient machine that works as hard as possible for you, not for the tax man.

9. Establish the right distribution plan that will give you the income you need in retirement along with the peace of mind of knowing you won’t run out of money. Of all the 10 steps, this one is taught and discussed the least when professionals and authors try to help people handle their money. Investors who bungle this by withdrawing too much too fast can wind up impoverished or broke in their old age. Investors at the other extreme can, sometimes without realizing it, pass up fantastic opportunities to enjoy life and contribute to others during their lifetimes. Chapter 13 tells you how to get this step right and gives you much to think about.

10. Put everything you do on automatic pilot. In more than 40 years of working with people and their money, I’ve seen again and again the value of making careful, thoughtful decisions and forming those decisions into a plan that can be executed automatically. Investors who do this are likely to achieve the highest returns among their peers at whatever level of risk is appropriate for them.

There are many good ways to accomplish this last step. Accumulate savings through dollar cost averaging. Invest in funds through automatic investment plans that take money out of your bank account regularly or through payroll deduction. Set up your portfolio for automatic rebalancing at the same time every year, using your electronic calendar to remind you if necessary. Fund your IRA in the first week of every year. If you can, do the same with your 401 (k) or similar plan at work.

Invest in index funds, which by nature will automatically correct for the unexpected disasters in the market. If a big company goes into the tank unexpectedly (think of Enron or Bear Stearns), the S&P 500 Index will automatically correct for that with no action required from you. Set up your withdrawals automatically too, so you never have to worry about how much to take out or when.

In summary, organize your finances so that instead of taking up your time they simply support you while you do what makes your life worth living.

If you want what my schoolteachers used to call “extra credit,” here’s an 11th step: Very carefully, choose and hire a financial adviser. This is such a valuable move that I’ve devoted Chapter 14 to it.

If you apply yourself seriously to these 10 steps (and taking the 11th will make the others much easier and more likely to be successful), you will have the best possible chance for that ideal retirement.

A Note to the Reader

Even a casual reader is likely to notice quickly that this book is unusual. This reflects the fact that not everybody learns the same way. It also reflects my personal commitment to make the material in this book as useful as possible and to keep it up to date for you, the reader.

This book is designed to be read at three levels. The simplest level makes it about a 30-page book. Every chapter begins with a brief introductory essay that presents the main points in the chapter, without the supporting evidence or a full discussion. If you want a general overview of what’s in this book, you can get it by reading only those essays. Of course, I hope you will want to know more and will take the time to delve into the contents.

The second level is the main text, including graphs, charts, and tables. This is the heart of the book, the stuff that makes it worth your money and your time. The concepts presented here are not complex. If you enjoy reading the business sections of daily newspapers, you should have no trouble following my arguments and the evidence that backs them up.

Along the way you will see some graphs and tables unlike any that you’re likely to be familiar with. If you have a little patience, understanding these illustrations won’t be hard. They will help you to see information in new ways so that the important points become obvious at a glance.

You’ll find the third level throughout the book in the form of highlighted text boxes that act as sidebars to illuminate ideas you might want to come back to for reference. You can skip these boxes without missing the main points of the book. But I hope you’ll find them worth your while.

Inevitably, the numbers and the specific fund recommendations in this book will become outdated. The good news is that you’ll always be able to find our current recommendations, along with updated versions of many of the tables in this book, online. You’ll find this at my company’s educational web site, FundAdvice.com. Be sure to visit this site for any updates to our suggested portfolios before you invest.

Finally, the Appendixes at the end of the book contain my suggestions for further reading and education.

Here’s a final important note. I am the founder of a company in Seattle that provides investment education, advice, and management. We are in the business of managing money for clients.

My many years as a hands-on money manager have given me an enormous amount of practical experience with real people in real situations. This book is filled with stories and insights based on decades of being in the trenches, helping investors who, in many ways, may be like you.

Our business is carefully organized so that we have no conflict of interest with our clients. I have done my best to avoid anything self-serving in this book, and I have asked my editors to hold my feet to the fire in that regard. Still, I definitely have a point of view and some strong beliefs about what serves investors best. I am happy to let you be the final judge. Don’t take what I say on blind faith. If you find my views credible, then please use them however you wish.

CHAPTER 1

Why Investors Fail

If you don’t know where you’re going, you might wind up somewhere else.

—Yogi Berra

Investing isn’t terribly difficult, but it’s a specialized area that requires careful navigation. A huge industry has evolved to use a multitude of clever ways to separate people from part of their retirement savings without necessarily providing much benefit in return. In simple terms, this means that neither your broker nor any of the array of experts on Wall Street is necessarily your friend or even on your side.

Think of investing as a journey. You start at one place and head for another. If you want to drive from California to Michigan quickly and painlessly, there are relatively few choices that make sense. Most will probably draw heavily on the interstate highways. But imagine how hard it would be to plan such a trip if sales forces for several hundred competing highways were giving you tantalizing promises, saying they could get you there better and faster if you would just choose their routes.

Investing is a little bit like that: The best route may be efficient though boring. Yet along the way there are hundreds of distractions and opportunities to get you off the track. Most people have a tough time making good investment decisions. They don’t have the necessary training or the knowledge. The difficulty of understanding all the options sometimes appears greater than the benefits of doing so. As a result, somewhere along the way almost every investor makes at least one serious mistake. Some never seem to stop making mistakes.

In this chapter we look at some of the more serious ways that typical investors work against their own interests. Investors procrastinate or remain passive when the circumstances call for action. They ignore the effects of taxes and expenses. They don’t think about their long-term and short-term goals in a clear, organized way. They don’t have a written plan for how to get from where they are to where they’re going. (Think of it as a road map. If you leave it at home, it’s no help.)

Most investors occasionally take way too much risk. Sometimes they don’t take nearly as much risk as they should. Investors pay too much of their hard-earned savings to other people who are not necessarily on their side. Too many investors act as if they think smiling salespeople are their friends. They put too much faith in institutions, as if they believe big companies are organized for their customers’ benefit. They put too much faith in what they see on financial television, what they hear on the radio, and what they read in financial publications. In doing this, they fail to distinguish between facts (which can be very useful) and interpretation, persuasion, and marketing.

Without getting any particular benefit in return, too many investors give up liquidity, making it costly and inconvenient to get their money back when they need it. They have unrealistic expectations. They often treat investing as a competitive sport. They take investment advice or tips from strangers or amateurs. They invest in ways that fill their emotional needs instead of their financial ones. Thus, they give in to fear and greed, arguably the two most powerful forces on Wall Street. They put their money into investments they don’t understand, leading to grief, loss, and disillusionment that sometimes prompt them to give up altogether.

Collectively, that’s the bad news. Whew!

The good news is that investing does not have to be that hard. This book shows you precisely how to overcome all those hurdles and how to draw up a road map that’s right for you. You’ll learn how to implement that plan so that good investment decisions become automatic—instead of random events that seem to happen only by luck.

Investing is about taking risks. When you risk your capital, you are entitled to expect a fair return commensurate with the level of risk you take. But if you’re not careful, your own mistakes can prevent you from achieving the return that should be yours.

When I meet with a new client, one of the first things we talk about is risk. It’s a topic that most of the industry (and most investors) would be happy to avoid altogether. But investors who don’t understand risk cannot understand the choices they must make as investors. You’ll find numerous references to risks in this book, because it is a critical topic.

Imagine you are in a bank applying for a loan. Suddenly you realize that right at the next desk, Bill Gates is also applying for a loan. Who do you think the bank would rather lend money to? Bill, of course! Don’t take it personally, but the bank would always rather lend its money to Bill than to you, because there is simply no question about his ability to pay the money back. He’s as close to a risk-free, perfect borrower as the bank could wish for.

But it’s not quite that simple. Bill Gates is not the sort of person who would hesitate to take advantage of his position. If he told the bank he wouldn’t pay more than 5 percent interest, and if you were willing to pay 10 percent interest, what do you think the bank would do?

The bank can lend money to Bill and earn 5 percent in a risk-free transaction. Or it can lend money to you and collect twice as much. Obviously the bank would like the extra interest, but how reliable are you? Here’s the rub, because the bank can’t ever know for sure.

Therefore, the bank must decide if that extra return is worth the extra risk. And that is exactly the challenge that investors face. If you were the banker and you could make only one of those two loans, you’d have to tell your boss either “I turned down Bill Gates for a loan,” or “I turned down an opportunity to make twice as much money.” Which one would you choose? Would you make that decision on your own without consulting your boss? Probably not!

In real life, bankers have the benefit of institutional and personal experience. They have policies and committees. They don’t have to make decisions like that by the seat of their pants. But every day of every week, individual investors make exactly this type of decision without understanding the nature of what they are doing: taking risks that have real consequences.

I usually start my investing workshops by discussing a dozen or so common traps that investors get themselves into. Almost every investor makes at least a few of these mistakes, and I hope you won’t feel there’s anything wrong with you if some of them sound painfully familiar.

Mistake 1: No Written Plan

According to every study I have seen, people with written plans for their investments wind up with much more money during retirement than those who don’t have written plans.

This important document should spell out your main assumptions about inflation; future investment returns; how much you’ll save before you retire; when you will retire; the amount of money you’ll count on from fixed sources such as pensions, Social Security, and perhaps part-time employment; as well as the amount that you’ll need to withdraw from your portfolio in retirement. Your written plan should specify how you will make asset allocation choices and where you’ll get professional help when you need it.

By the time you finish this book, you’ll know the most important things that should be in your written plan. And to give you more specific help, I suggest two excellent articles you’ll find online at FundAdvice.com. One is called “Don’t have an investment plan? Start here.” The other is titled “Make success your policy.”

Mistake 2: Procrastination

If you wait for what you regard as the perfect time to get your investments organized or reorganized, the wait could ruin your results over a lifetime. Procrastination takes many forms. Some people don’t start saving for retirement until it’s nearly on top of them. Other people know they should review their investments, yet they always give priority to other things.

Some investors are sure they will catch up later. The irony is that the longer they wait, the less time they have. And time, as anybody who has studied compound interest tables knows, is an investor’s best friend. Once you know what you need to do, every day you delay is a day of opportunity that you can never get back.

Mistake 3: Taking Too Much Risk

In the late 1990s, some relatively inexperienced investors began to act as if they believed investment risk had become only a theoretical concept. But the three-year bear market of 2000 through 2002 was a rude wake-up call. Some aggressive investors who were sure they knew what they were doing in 1999 found they had lost more than half their money within two years. I hope you won’t let anything like that happen to you.

Most people understand, at least in general, that higher risks go along with higher returns. Yet too many investors act as if they are immune to risk. Or perhaps they believe they will somehow know when it’s the right time to sell a risky investment they bought. Unfortunately, that realization rarely comes before there have been significant losses.

Investors typically don’t make any up-front effort to understand the nature of the risks they are taking when they make an investment. Only rarely do they have a plan for what they will do if things don’t turn out as expected. People who take too much risk often wind up being speculators rather than investors. Savvy investors, by contrast, pay a lot of attention to understanding, limiting, and managing the risks they take. If they speculate, they do so only with money they know they can afford to lose.

Mistake 4: Taking Too Little Risk

Some people are paranoid about losing any money at all. They want things nailed down, secure, guaranteed. The majority of money in 401(k) plans, at least until the great bull market of the late 1990s, was invested in guaranteed interest contracts, bonds, money market funds, and similar low-risk securities. Those choices give investors the illusion of short-term security. But unfortunately, in the long run, it’s only an illusion.

Especially after the bear market of 2000 to 2002, it may seem important to avoid losses. But an equally important risk, especially for young investors with many years ahead of them, is to give up the long-term gains they are likely to attain by investing in equities. Very-low-risk investments always come packaged with low returns. If your emergency money is in a bank account paying 2 percent interest, you may think there’s no risk. But in fact, you are taking the very real risk (in the long term it’s a virtual certainty) that inflation and taxes will rob your money of much of its purchasing power.

If you’re saving for retirement 25 years down the road, and you opt for a very conservative mix of investments that is expected to return 7 percent annually instead of an all-equity portfolio with an expected annual return of 10 percent, you may be massively shortchanging yourself. After 25 years of contributions of $5,000 a year, a 7 percent portfolio will grow to $316,245. But invest the same amounts at 10 percent and you will have $491,735. (That difference, about $175,000, is much more than the total of all the 25 annual investments.)

Mistake 5: Trusting Institutions

I often ask participants in my workshops if they trust their banks. Most of them answer with a pretty firm “No! ” Yet most of us still habitually act as if we believe our banks will tell us if we should move our money in some way that would be more beneficial to us.

In fact, you and your bank have a classic conflict of interest. Your best interests are served by an account that pays the highest interest along with penalty-free access to your money whenever you need it. Your bank’s best interests are served by accounts that pay you little or nothing. Your bank also wants you to buy products on which it can earn sales commissions, like load mutual funds and various types of insurance.

It’s even worse than that. Perhaps the single most profitable thing that banks do is bounce checks on overdrawn accounts. Bankers who work in branches (and thus deal with customers face to face) will be happy to help you manage your money so that you don’t bounce checks. But if every checking account customer were bounce-free for a year, billions of dollars in profits would vanish—and some executives in bank headquarters would find themselves looking for jobs.

Because of these conflicts, it’s a mistake to rely on a bank to tell you what’s in your best interest. The same is true of brokerage houses and insurance companies.

Mistake 6: Believing the Media

The headlines on the covers of financial magazines are often predictable: “The Six Best New Funds”; “Found: The Next Microsoft”; “Everyone’s Getting Rich—Here’s How to Get Your Share.” (Those are actual examples.) The purpose of those headlines is to get you to dive into the contents enough so you’ll buy the magazine and see the advertising within. We discuss this in more detail in Chapter 4. Here are a couple of high points.

Serious investors need textbooks more than hot ideas. But most people would rather have entertainment, and that’s what broadcast outlets and financial publications provide. Writers and editors and publications follow fads. They write about what’s in favor and what’s in style. When the winds of popularity change, you can bet that they won’t be far behind. The purpose of these articles is not to help you. The purpose of the articles is to get you to buy the publications.

The right way to read financial articles that tout specific mutual funds and stocks is to treat those articles as entertainment. The wrong way is to regard them as prescriptions for investment decisions you should make. If you remember that, you might easily save yourself 1,000 times the cover price of this book.

Mistake 7: Failing to Take Small Steps That Can Make Big Differences

Far too many people fail to make their IRA contributions at the start of the calendar year. Others fail to make IRA contributions at all. They leave money in taxable accounts instead of sheltering it in retirement accounts. They don’t maximize their opportunities for corporate matching money in 40l(k) and similar plans. They have multiple small IRA accounts, paying annual fees for each one, instead of consolidating these assets into a single account that can avoid such fees and make rebalancing easier.

Bank customers, spurred by laziness or inertia or thinking that it doesn’t matter, don’t move their money from checking accounts into money market deposit accounts. Others don’t move their money from money market deposit accounts to nonbank money market funds where they can earn more interest. Each of these steps seems small by itself, yet over a lifetime they can make a big difference—but only to people who act.