I was recently retained by an 84-year-old man who had seen me on Fox Business Network. He had been a successful professional and wanted me to redesign his $2 million investment portfolio. A no-brainer task, I thought. I can do this in my sleep: safe, short-term, fixed-income funds for this well-heeled old guy. Just fill out our standard questionnaire, send me a copy of your current holdings, and I'll have it done in a jiffy.
When the questionnaire arrived in the mail it revealed the following:
• Preservation of capital is his primary concern.
• He's frugal as to everyday spending.
• He expressly wants investment-grade fixed-income holdings that are as safe as possible.
• He broods over bad investment decisions.
• He doesn't like surprises.
• He prefers predictable, steady returns on his investments, even if the return is low.
Okay, so far. But them came this:
• He prefers no short-term bond holdings.
• The average rate of return he expects is "6%++".
Clearly, there would be some inconsistencies to correct in this gentleman's mindset. "Safe as possible" and "6%" are not compatible criteria in today's investment market.
I then turned the page to take a look at his current holdings. As I anticipated, it was almost totally populated by income securities. What I didn't anticipate was that there were more than 70 of them, a vast and random collection of intermediate-term ETFs, mortgage real estate investment trusts and energy master limited partnerships. An 84-year-old man, with no professional investing experience was running a preposterously over-diversified personal fund.
"Admittedly, I am economically challenged," he deadpanned.
Whoo boy, where to start. Not only were there general expectations to adjust, but there was an unmanageable portfolio to get under control. I began with his out-of-whack expectations, which meant first engaging in some gentle client education.
I related that a preservation-of-capital priority dictates that the portfolio have a strong low-risk bias. Of course, in today's market there is no combination of investments that return an average of at least 6% that would be consistent with an investor's primary concern being preservation of capital. Moreover, I would not recommend that an 84-year-old person even seek an average return of 6%, because it would indeed require jeopardizing his capital. Even if he had not stated that preserving capital is his primary concern, I would have imputed that criterion on this particular portfolio.
And despite his expressed preference for fixed-income investments of five to 10 years in maturity, I simply couldn't recommend them in his situation. Instead, I recommended only short-term bond investments. They certainly yield less than longer-term bonds, but that is, of course, because they generally have less interest-rate risk. And because today's rates are extraordinarily low, many economists believe that, sooner or later, rates will rise. When that occurs, bond prices will decline, but shorter-term bonds will be less affected than longer-term bonds.
I then addressed the more delicate matter of correcting his past approach to allocating his investible funds. "Your current portfolio appears to contain a rather astounding number of holdings for an individual investor, particularly one who is in his 80s," I told him. "In my opinion, that, in itself, puts your portfolio in a dangerous position because of the huge responsibility you personally have for managing more than 70 individual securities."
I explained that there were consequences attached to his self-reliant method of investing. One example is that he had included in his IRA and that of his wife, who is also 84 years old, a "tax-advantaged dividend fund." Anything held in an IRA is, of course, already tax advantaged, so putting a (likely) lower-yielding security in an IRA is foolish.
I also warned him that, with so many holdings, were he to die sometime soon - not an altogether unlikely prospect - his family members would be burdened with managing or selling off a very complex portfolio, significantly mitigating the fondness of their memories
The time had arrived to tell him what he didn't want to hear. Dear client, you can't have it both ways. At age 84 and with an expressed priority to preserve capital, you've gotta settle for short-term bonds. We're going to sell 10% of your current holdings each week for 10 weeks, so that at least 90% of your portfolio remains invested during the conversion period. And as we sell, we're going to reinvest in just three funds:
• 40% in the Vanguard Short-Term Tax Exempt Fund (VWSTX), which yields 1.12% and has an average duration of 1.06 years (as of June 28, 2012).
• 30% in the SPDR Barclays Capital Short Term Corporate Bond ETF (SCPB), with a yield of 1.68% and a duration of 1.89.
• And 30% in the iShares Barclays 1-3 Years Credit Bond ETF (CSJ), yielding 1.75% and with a duration of 1.85.
He probably opened the envelope containing this recommendation just today. I hope it didn't give him a heart attack, because it's a far cry from what he was likely expecting. But although he apparently thinks that he's just 54, he's 84, has a ton of money and wants to keep it. He's frugal, so he can live on an average weighted yield of 1.81% plus some modest principal extraction. Not everybody can, but he can. Heck, 1.81% even beats today's inflation rate of 1.7%, so his purchasing power would stay even, at least for now.
And even if inflation does rise, he'll still be in the catbird seat, because he doesn't have to make that $2 million in principal last very long. Within a few short years, he'll be dead. He's in great shape.