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Recently, I decided to take a career break to pursue things that I really want to do in my life. One of the many very important matters on my to-do list was to spend more time with my family and use my knowledge and skills to help them as much as I can. The first thing in his area was to use my investing experience to go through the retirement portfolio of my mother and see if I can optimize it and prepare it for her retirement. With just three years left until her regular retirement age, I am convinced it is very late for any major readjustments in terms of the level at which she has been saving for retirement. On the other hand, opportunities are still abundant in the actual allocation of the existing portfolio and any future savings she manages to put aside before she retires.

Crunching the numbers

The existing portfolio consists of one older apartment which is fully paid down. The rent generates a steady net monthly income of $450 already adjusted for the costs and fees related to maintaining the apartment and the taxes. We will not analyze this investment and keep it as it is. We will instead focus on the eight different mutual funds from two different investment companies which are in the portfolio. There are all basic types of funds - money market, bond as well as stock funds in her portfolio. They were purchased five years ago in 2008 as recommended by two different financial advisors who I am sure raked in a hefty commission from the fund owners for closing the sale.

After running some basic calculations on this existing portfolio of eight funds, I found out that the average annual management fee is 1.3%. The lowest fee of .5% is charged for the money market funds. And 2.1% being the highest management fee for the growth opportunities fund. Most of them have no entry surcharge, however, almost all of them have a hefty 5% redemption fee if you want to say goodbye to them. Majority of the investments were one-off purchases. Three of the eight were set up as an initial investment coupled with regular monthly additions.

The average total expense ratio is 2% p.a. If you put the total expense ratio into context, it is as high as the average U.S. inflation rate has been in the past five years. In another comparison, the expense ratio also represents a significant portion of the average benchmark index S&P 500 return, which has been 5.53% annualized for the most recent five-year period if you include the dividends. So the expense ratio represents 36% of the total return of the S&P 500 index. If we adjust the S&P returns for inflation to obtain the real returns, we end up with 3.53% annualized return for the S&P 500. In such case, the total expense ratio of 2% represents 56.6% of the real returns. To summarize, we are leaving over half the real average returns on the table due to the mutual funds' expenses.

Further calculations revealed that the average annual return of the total portfolio was just 1.42%. The return has not even kept up with the average annual rate of inflation. As a result, the portfolio has been losing value in real terms and would not be able to serve as a source of decent retirement payments in the long run.

Based on the above mentioned facts, my first recommendation was to sell all these eight mutual fund positions as soon as possible and explore options to replace them with more effective alternatives, while taking this opportunity to adjust the portfolio structure at the same time. Selling the funds now when the U.S. markets are reaching new all-time highs gives us a fortunate timing to unload these investments at remarkably reasonable prices. The 5% redemption fee is high and painful. However, if you spread this fee to the entire holding period of five years, it represents just 1% annually, and we are investing for the long term. Moreover, this 5% cost will be quickly more than made up for from the savings in the total expense ratio.

Selling of the existing retirement portfolio will free up the capital, and we can now focus on the main task at hand, which is to design a completely new retirement portfolio from scratch.

Building the new portfolio

The portfolio is required to generate retirement payments over a period of at least 30 years. The monthly income required from this nest egg is $600. The monthly Social Security benefit is expected to be around $800. The third and final income source will come from the apartment rent, which is expected to remain at $450, to create a well-balanced retirement income of $1,850 per month in today's prices.

The new investment portfolio is expected to generate $600 monthly income in the first year of the retirement, which is $7,200 annually. General consensus is that 4% annual withdrawal rate from a retirement portfolio still provides high probability that the principal will not be depleted within 30 years even if the portfolio sails through some extremely rough financial waters in the future. However, we can never be sure. The most recent study released in January 2013 by Morningstar provides data that suggest that previous assumptions of the safe 4% withdrawal rate seem highly optimistic when we take into account today's ultra low interest rates, which depress the bond yields to substantially lower than historical levels. On the other hand, even if this income portfolio is depleted, the Social Security benefits and real estate rent will still provide emergency income. If things really turn sour, we can always sell the apartment or get a reverse-mortgage on it to generate additional sources of income. Therefore, we are calculating with a 6% withdrawal rate. The size of the nest egg at the time of the retirement needs to be $120,000, because 6% of the portfolio equals $7,200.

Portfolio diversification

Diversification can take many different forms. For the retirement portfolio, we will be looking mainly at balancing our portfolio between all main asset classes. Diversification within each asset class will be achieved by purchasing index or very broad investments, which are themselves internally diversified by representing the entire given asset class as broadly as possible. The basic asset classes are:

  1. hard assets such as real estate, gold and other commodities
  2. cash in the form of savings account, Certificates of deposits, money market funds
  3. stocks including value stocks, growth stocks, large cap, small cap, domestic, international, etc.
  4. bonds which include government treasuries, corporate bonds, municipal bonds, etc.

In terms of regional diversification, we will make sure international assets are represented hand in hand with the U.S. investments. It is worth noting that approximately half of the S&P 500 index's earnings are generated from sales realized abroad. Final two considerations on the diversification topic. Diversification comes at a cost. By holding more items in your portfolio, you are sacrificing some of the return because by definition, the best return can only be achieved by one item and all the others have lower rates of return. Secondly, holding many investments means you have to spend a lot of energy monitoring them. The transaction costs can also be increased when you trade smaller amounts. Therefore, we will put maximum focus on simplicity and smart diversification not only in the initial phase of portfolio creation, but also in the regular rebalancing method which we will use.

Are we safe?

Two important thoughts which apply to all asset classes are how safe they are and if they are insured. In relation to our retirement portfolio, savings accounts and certificates of deposit are insured, up to $250,000 in each institution for each account owner. Also, assets held in certain retirement accounts are insured up to $250,000. Let's have a look at the information taken directly from the FDIC website:

The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the United States government that protects the funds depositors place in banks and savings associations. FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC was established in 1933, no depositor has ever lost a single penny of FDIC-insured funds.

FDIC insurance covers all deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. FDIC insurance does not cover other financial products and services that banks may offer, such as stocks, bonds, mutual fund shares, life insurance policies, annuities or securities.

The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.

Source: FDIC

As you can see, no depositor has lost money, which was insured since the inception of the FDIC in 1933. However, the most recent events from Cyprus remind us that each kind of guarantee or insurance is only as good as it's guarantor, in this case the United States government. That is one reason why we include the holding of physical gold into our portfolio.

Now let's take a closer look at the individual holdings of the new portfolio one by one and explore the details, pros and cons.

House of cards

Our holding: real estate - apartment for rent worth $140,000 (54% of the portfolio)
Alternative real estate holding: Vanguard REIT ETF (NYSEARCA:VNQ), or iShares Dow Jones US Real Estate Index Fund (NYSEARCA:IYR) to cover the U.S. real estate market, and the SPDR Dow Jones International Real Estate ETF (NYSEARCA:RWX) or iShares FTSE EPRA/NAREIT Global Real Estate ex-US Index Fund (NASDAQ:IFGL) for international real estate exposure.

First, let's cover the existing real estate in the portfolio, which we will keep as it is.

Unlike some other financial assets, value of which can evaporate overnight like a house of cards, real estate is a hard asset, which has its intrinsic value in the form of a monthly rent, and is therefore a good investment for inflation protection purposes as well as for regular income, if properly insured. If you buy the apartment at a fair price at which your net annual rent represents at least 3% of your purchasing price, it is highly likely that the rent will keep moderately rising hand in hand with inflation and your rent income will be automatically inflation-adjusted over the many future decades. Not to mention that the price of the apartment itself is likely to increase to copy the future inflation in the long term.

One significant downside of owning a real estate for rent is that it is quite a hassle to maintain the property and to manage the relationship with the tenants if you have just one property. There are fixed costs in time and money, which you have to make sure you are willing to undertake regularly and for the long term before you decide to purchase an apartment for rent. You can mitigate some of these risks and costs by renting the apartment to family, friends or other people you know well. They are likely to cause less trouble and take better care of the property.

The second biggest drawback is that a real estate is much less liquid than other asset classes and has many fees and costs associated with its sale. You have to make sure you will not need to sell the apartment if the prices are momentarily depressed and that you can keep the apartment for at least 10 years to mitigate the impact of these transaction costs.

The third negative aspect of owning just one property is its riskiness. Its value and its fate can be extremely volatile and unpredictable. There is too much exposure to the individual neighborhood, city and country. Many factors can change.

If you don't own real estate yet, if owning a real estate is too much of a hassle for you, or you want a truly diversified and hassle-free real estate ownership, there are other effective alternatives to get more balanced exposure to real estate by purchasing one of the top real estate ETFs, such as the Vanguard REIT ETF , or iShares Dow Jones US Real Estate Index Fund to cover the US real estate market, and the SPDR Dow Jones International Real Estate ETF or iShares FTSE EPRA/NAREIT Global Real Estate ex-US Index Fund for international real estate exposure. All of these funds have high liquidity and relatively low annual fees of between 0.1% and 0.59%. Vanguard is my personal champion with the annual expense ratio of just 0.1%.

Our current exposure to real estate of over 50% of the overall net assets is too high and should be gradually decreased in the future by adding all future savings into other asset classes. We will not decrease the share of the real estate now simply due to the fact that we would have to sell the entire apartment with too many costs and hassle associated. Ideally, the real estate portion should represent only 30% of the overall portfolio in the long term.

Good as gold

Our holding: Physical gold worth $6,000 (2% of the portfolio)

The first component of our retirement portfolio will be gold. Physical gold. In small individual quantities, to be able to sell it piece by piece if needed, without the need to sell your entire gold holdings. If we were holding gold just for inflation protection, we could and would choose to purchase a stake in the largest exchange traded fund, the SPDR Gold Shares ETF (NYSEARCA:GLD) or some gold mining stocks. However, we want to have some true last-resort protection in case the entire world collapses by which we mean some unpredictable, unimaginable black swan event, which would render all paper money and other currencies obsolete and all our non-gold holdings worthless. In such event, the counterparty risk becomes a major issue. Therefore, we not only want to own physical gold. We want to store it at home where it would be always available for use, instead of a bank's vault. Physical gold worth of $10,000 will form the ultimate last-resort, worst-case insurance of our future existence. The value of $6,000 should cover at least six months of basic lowest-possible living costs in case of an emergency.

Cash is king

Our holding: Savings account with an average balance of $6,000 (2% of the portfolio)

A savings account will be used for ongoing incoming savings from salary. It will also be used for the retirement income withdrawal purposes. The third purpose of this savings account will be to park cash for future purchases of other asset classes, waiting for interesting long-term investment opportunities. It is here where the Social Security benefits will be routed. This savings account will also be used as a rebalancing tool. Any proceeds from the other assets sold will be going into this account.

The savings account should hold at least three months worth of your average monthly retirement needs. However, holding too much cash means losing in the long term because generally, the savings account interest rates are far from being able to keep up with the inflation rate.

Certificates of deposits

Our holding: Certificates of deposit (CDs) in a ladder with an average balance of $12,000 (5% of the portfolio)

CDs are a better form of keeping your cash parked. The interest rates don't usually beat the inflation. However, in some circumstances, they can, if you lock in a high interest rate when the expected future inflation is high and the real inflation falls in the future. We are investing for the long term and not speculating, and therefore we will try to minimize the impact of such changing environment of inflation and interest rates by building the so-called CD ladder. This is achieved by spreading the total money you intend to put into the CDs into different durations at first to invest all the money. As the shorter durations gradually expire, you reinvest them all into the longest maturity CDs.

Maturities usually range from one month to five years. We will pick the relatively short duration of one year at first because we want to start our portfolio with a higher portion of money generated from the sold mutual fund holdings in the CDs and use the future opportunities to buy riskier assets when the prices of stocks and bonds are more reasonable than today. However, in the long run, when the initial asset allocation is complete, we want to maximize the annual interest rate by choosing the longest duration of five years and building a ladder to be able to withdraw a portion of money in regular shorter intervals to reallocate them or use them in an emergency if needed. Building the ladder will give us the benefits of the highest interest rate on the longest duration while keeping a chance to touch part of money in case of an emergency or opportunity. Moreover, when reinvesting expired CDs, you can invest them in a different bank to mitigate risks of holding all CDs in one institution, or to take advantage of the highest interest rates offered at that time.

Stocks

Our holding: Vanguard Total World Stock ETF (NYSEARCA:VT) worth $50,000 (19% of the portfolio)
iShares MSCI ACWI Index Fund (NASDAQ:ACWI) worth $30,000 (12% of the portfolio)

This category should hold a large portion of the retirement portfolio due to the fact that this is the one asset class that is able to outperform inflation as well as other asset classes significantly in the long-term. The goal of a well-balanced portfolio is to gain as much exposure to diversified stocks portfolio while keeping risks and volatility low. The historical performance of stocks over other asset classes is clearly visible from the Morningstar very long-term analysis and their charts below:

(click to enlarge)Historical asset class performance

(click to enlarge)

Source

Countless studies and articles have been written on which stocks or funds to choose for a stock portfolio. Our approach for stock as well as bond allocation will respect our main goals which are:

  1. maximum simplicity, which means as few holdings as possible
  2. maximum safety, which means choosing highly liquid investments with low volatility
  3. high diversification meaning choosing broadly diversified and regionally balanced investments
  4. low costs in terms of money means we will be choosing investments with low annual fees or expense ratios and other fees
  5. low cost in terms of time and expertise means we will pick investments which don't need to be followed on a daily basis and don't require deep knowledge of the individual markets, industries or individual stocks.

However, if you have time and stock-picking is your hobby, individual stock-picking is a terrific way of increasing long-term returns while giving also a better feeling about having your investment portfolio more under control. For individual stock-pickers, I recommend looking in the value investing area and pick Dow Jones stocks paying stable dividends and my personal favorite is the IBM, which has a decent P/E ratio just below 15, good stable business model and revenue stream, plus a healthy dividend yield of below 2% p.a. Alternatively, you can find inspiration in my previous article about decreasing investment risk using natural hedging.

Our criteria and examination of individual funds result in the following list of recommended holdings for stock asset class exposure:

Vanguard Total World Stock ETF . The annual expense ratio is 0.22%. This fund tracks the performance of the FTSE All-World Index, which includes approximately 2,900 stocks of companies located in almost 50 countries, from both developed and emerging markets. In order to lower the counterparty risk, we will diversify the stock holdings into two funds run by different institutions. Therefore, we will add the iShares MSCI ACWI Index Fund .

If you are less confident in getting international exposure and prefer to stay in the US, the best option is to purchase the Vanguard Total Stock ETF (NYSEARCA:VTI). The VTI aims to track the MSCI US Broad Market Index, which represents more than 99% of the total market capitalization of all of the U.S. common stocks traded on the major U.S. stock exchanges. It's expense ratio is extremely low, 0.06% annually.

Bonds

Our holding: PIMCO Total Return ETF (NYSEARCA:BOND) worth $10,000 (4% of the portfolio)
Vanguard Total Bond Market ETF (NYSEARCA:BND) worth $6,000 (2% of the portfolio)

The same criteria as for choosing our stock exposure apply. Therefore, we will pick broad large cost effective bond funds, the PIMCO Total Return ETF , which is an ETF version of the largest and most famous bond mutual fund run by none other than Bill Gross and Mohamed El-Erian with stellar returns and reputation. Please just note that the correlation of its mutual fund PTTRX and its ETF BOND, which I recommend is not 100% but rather just around 60%. This means you should not expect exactly the same returns and same ups and downs in the price of the funds. The second bond fund choice will be the Vanguard Total Bond Market ETF . The fund tracks the Barclays Capital U.S. Aggregate Bond Index, which represents the U.S. investment grade bond market.

The following is the table summarizing individual holdings of our newly designed portfolio and the corresponding percentage share of the total portfolio:

(click to enlarge)

Below you can find the overall asset class composition of the portfolio:

(click to enlarge)

Future rebalancing

Every long-term portfolio needs rebalancing in order to continue serving its purpose, in our case to generate long-term retirement income and provide asset appreciation over time higher than the inflation rate.

We will do rebalancing once a year. We will aim to maintain the percentage share of the asset classes. This will automatically lead us to sell the assets that would gain the most in value. What is notable about this built-in rule is that we will be selling high. Each year, we will sell assets worth $7,200 in order to generate the annual retirement income expected from this investment. We will move this money into CDs and savings account according to our allocation rules stated above so that over time, the cash released from CDs will move to the savings account to be consumed as a retirement income. Selling stocks when their price is relatively high will also help conserve a maximum amount of the principal because we will be drawing from the profits and not from the equity itself. In fact, it would be recommended to draw temporarily more money from other assets such as CDs and savings account within safe levels, in order not to sell stocks after major downturns because we would be drawing too much from the equity and not from the profits. This would cost us a lot in future lost growth opportunity.

The main actions in the first years of the portfolio rebalancing are expected to be to utilize the cash generated by the real estate rent and interest earned on the CDs and the savings account to invest in stocks and bonds. The aim will be to decrease the share of the real estate on our portfolio, which is unnecessarily high at the moment. I will keep you posted on the future value and rebalancing moves of this newly built retirement portfolio. Until then, I wish you good fortune with your retirement portfolios. It's never too soon to begin. Time in the form of the compound interest is a formidable force.

Source: Complete Makeover Of A Retirement Portfolio