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10 Questions With Financial Planner Harold Evensky

Harold Evensky has been a diversification evangelist and you might be a lot richer if you'd heeded his advice.



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A principal of Evensky Brown & Katz, an investment advisory firm in Coral Gables, Fla., he's long been a fan of spreading his clients' assets among a broad range of sectors and styles. That means his clients' portfolios tend to see more moderate gains, but fewer losses too. Risk control and tax-efficiency will be key for the next 10 years, according to the bow-tied financial planner, because overall stock returns might be well below their historic averages, let alone the outsize gains we saw in the 1990s.

If your portfolio rode the tech tiger and got scratched up, you should probably consider his advice. How do you build a diversified portfolio and keep it on target? What returns should we expect from stocks and what are the classic mistakes we all make? Read on.

1. After two lousy years, what would you say to folks who are rattled?

Step back, take a deep breath, and start doing what in hindsight you should have been doing before. To start, figure out where your money is [invested] now. Most people don't really know how much they have in stocks and bonds, how much they have in big- or small-cap stocks, how much they have in growth or value funds. The next step is to figure out where your money should be -- not what stock it should be in, but what allocations should be where. You also need to figure out what kind of risk you can live with. You're going to have to do some homework. [Check out our Big Screen Archive to see a blueprint of a diversified stock-fund portfolio.]


Talking With:
Harold Evensky
Firm:
Evensky, Brown & Katz , Coral Gables, Fla.

2. During the tech mania, lot of investors bought funds that were riding that wave, rather than diversifying their money across sectors and styles. What's your philosophy on portfolio construction?

Diversification works and it always has. In the last two years, it worked great. We asset allocators looked stupid back in 1998 because 50 stocks out of the S&P 500 went straight up and people thought that was the market. Because we had value funds and small-cap funds, the returns were lousy. But in the last two years, we kept a lot of money while others lost a lot.

A big part of the power of diversification is simply preventing the huge losses we've seen.

3. For a conservative investor who's at least 10 years from their goal, how would you suggest he or she divide their money between stocks and bonds?

I'd say 60%/40%. That's our baseline conservative model. If you look at a portfolio over the last 70 years and you were taking money out, the combination that would last the longest is somewhere between 50/50 and 70/30, and 40/60 is right in between.

What if the person is less worried about the stock market's risk?

I would move 10% more to stocks. Understand, we don't consider having more in bonds to be less risky because now they've got a greater risk of inflation erosion. Bonds are certain because they pay a fixed amount of interest. They're not safe, though, if inflation goes up.


Safety First
There was a right way to dabble in tech and a wrong way --which did you choose?
Sources: Morningstar. Returns through March 5.

4. Some investors who started out with a diversified portfolio still got into trouble because market shifts left them with a tech-heavy portfolio that they never rebalanced. How do you handle rebalancing?

People need to remember that the market can skew their portfolio. Let's suppose you decide you're going to be 40% in bonds and 60% in stocks. Well, it starts off that way, but it changes due to market changes. We review allocations quarterly. We shift things if they're skewed by more than 7%. What that means over time is that you're forcing yourself to sell high and buy low. In 1998, when the market was going through the roof, to the extent that we owned growth funds, we sold some of our stakes there. With that money we bought value funds, which were being clobbered. It meant that when value started roaring back last year, we had a lot of value and we bought it cheap. Holding a diversified portfolio doesn't mean being passive necessarily and that's important to remember.

5. After such strong gains in the 1980s and 1990s, have you lowered your expectations for stock returns in coming years?

One fundamental change is our belief that over the next 10 years or possibly longer, equity returns are likely to be less than they've been not just over the past 10 years but the past 70 years.

Historically stocks have averaged an 11% annual gain. What kind of return are you expecting over the next 10 years?

The basic numbers in the past have been 5% for bonds and 11% for stocks. We think bonds will return a little more and stocks will return a little less over the next 10 years. So, right now we're expecting a real return, after inflation, of about 6% for stocks, certainly under 10%.

6. Do those lowered expectations change your priorities in building portfolios?

Expenses and taxes are going to play a much bigger role than they ever did. If you're earning 15%, and you pay 20% taxes, you still have earned 12%. Take off 3% for inflation, you still had a 9% return. But if you get a 9% return and you take off 2% for taxes and 3% for inflation, you're down to a 4% return.

We think that investors with taxable accounts need to significantly rethink their whole investment approach. Instead of spreading money among 14 different funds, we put the bulk of the money with a core equity manager, someone managing a portfolio similar to a broad index like the Russell 3000. That might be 70% of the equity portfolio. We divvy up the other 30% among managers we believe can add after-tax outcome.

7. Given the prospect that stock returns might be lower down the road, some investors might be looking for an alternative. What would you say to them?

Why does there have to be an alternative? And if there is one where there's a high chance of making great returns, there's also a high chance of big losses.

8. One thing that a lot of folks forgot and are revisiting now is that you need to have an emergency cash cushion. How many months' expenses should you have on the sidelines at any given time?

It should be between three and six months' living expenses. The short end, three months, would be for someone who's got a good job where everything seems secure. Six months is for someone whose job is more vulnerable, like if they're in sales, for instance. We typically don't go much under that unless people have a lot of other money, and we typically don't go much over that because people won't do it and the opportunity costs get too big. So yes, you should have a cash cushion. How much is a function of what your job is, your disability insurance, that sort of thing.

9. What are some of the most common mistakes you see when you look at people's portfolios?

The most common are confusing a good company with a good stock. There's not necessarily a relationship. You may have a lousy company with a cheap stock valuation. Or the company may be doing well, but the stock may be priced higher than the future growth will ever be. That's the most common problem. Another is an unwillingness to sell because they lost money on the stock or fund and they want to wait for it to come back up. We try to help reframe that by asking, "If you had the money, would you buy it today?" On the flip side, some people are unwilling to sell a stock or fund because they got a big gain and they don't want to pay the taxes on it. That leads to a heavily concentrated portfolio with lots of risk.

In that case, we explain that the only way they're going to avoid taxes is to wait until it comes back down and erases the gain, which many people did, or die. Finally, a lot of people just don't have a clue where their money is invested or why it's there. That way, their current asset allocation is almost always an accident.

10. Another simple idea that some investors ignored was that you can avoid a lot of risk by simply using a broad, cheap index fund for your core equity fund holding. This is a good idea for just about everybody, right?

Yes. If you keep your risky investments on the fringe of your portfolio, their volatility won't make a whopping big difference. We tell people all the time, we're not in the business of making people rich, we're helping them achieve reasonable returns.


10 Questions Archive
Legg Mason Bargain Hunter Lisa Rapuano
Silicon Valley Pro Kevin Landis
Growth Survivor Jeff Van Harte
Health Care Veteran Jordan Schreiber
Utilities Expert Bern Fleming
Janus High Yield Pro Sandy Rufenacht
Oakmark's Bill Nygren
Berger Tech Pro Bill Schaff
Tech-Critic Robert Sanborn
Dividend Disciple John Snyder
Fidelity Expert Jim Lowell
Janus Growth & Income's David Corkins

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to imcdonald@thestreet.com, but he cannot give specific financial advice.

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