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What to Do With an Inherited Portfolio

Dr. Don:

I've got an interesting portfolio question for you. I'm twenty-three-years old and have a portfolio that was handed down to me by my parents and grandparents through compulsive saving and investing. Now that I'm on my own, I'd like the portfolio to work for me better. My long-term goals are financial security, including paying for tuition for any children that I might have in the future, and generally saving for what will hopefully be an early (50? earlier?) retirement.

I know that my portfolio is weighted toward financials, but what can I do to diversify to provide growth in this topsy-turvy market? I will not take on any more tech, and am leery of biotech because of the poor performance of my health / biotech fund. Also, should I be adding more money to these accounts than what I contribute to my 401(k) account? Your advice would be greatly appreciated, and continue writing such a great column!

Thanks,

KRS

KRS' Taxable Account
Name Shares Market Price Market Value % Total Value YTD Return Stock Industry or Fund Category
(FIGRX)Citigroup (C:NYSE) 894.00 46.34 41,428 54.25% -9.02% Banks
(PNOPX)Putnam New Opportunities A 136.25 43.85 5,974 7.82 -25.20 Large Growth
(SBHTX)SunAmStrat Biotech/Health 30 II 620.00 10.29 6,380 8.35 -19.67 Specialty-Health
(STNTX)SunAmerica Focused TechNet II 777.00 6.24 4,848 6.35 -43.22 Specialty- Technology
Cash 12,875.00 1.00 12,875 16.86
Account total: 71,506 93.64%
KRS' 401(k) Account
(IGRYX)AXP Growth Y 30.52 30.38 927 1.21 -22.64 Large Growth
Account total: Account total: 927
KRS' IRA Account
(SSRAX)State Street Research Aurora A 68.54 29.39 2,014 2.64 5.23 Small Value
(SSRDX)State Street Research Aurora C 68.54 27.98 1,918 2.51 4.99 Small Value
Account total: 3,932 5.15%
Portfolio Total: 76,365 100.00%

KRS,

Your parents and grandparents gave you quite a head start on reaching your financial goals. Many people that receive gifts of securities hold on to the securities forever, thinking that if they were good enough for the giver to hold, then they should continue holding them in the portfolio. That's not always the case, so it's good that you're taking a look at the portfolio to see how it needs to be adjusted to meet your needs.

The first step is to understand your tax costs for the securities in the portfolio. Securities don't receive a stepped-up basis when they are gifted to you, so any realized capital gains will be taxed based on the donor's tax cost. Inherited securities, though, typically have a stepped-up basis, so any realized capital gains are computed based on the value of the securities when they were inherited. Knowing the tax consequences of selling securities in this portfolio is very important in determining what changes you'd be willing to make to the portfolio.

You've got 76% of your portfolio invested in stocks, and 72% of your stocks invested in the financial sector. That's mostly from your large stake in Citigroup (C). A long-term investor doesn't bet the ranch on one sector or one stock, but you're doing that with this one investment. Consider the tax impact of reducing your stake, but don't let taxes be the tail wagging the dog in deciding whether or not to diversify away from a 55% stake in Citigroup.

In your IRA account, you hold two different classes of shares in the same mutual fund, the State Street Research Aurora fund. It's an interesting experiment in valuation, but I can't figure out why you didn't choose one class of fund over the other. The Class A shares have a front-end sales load of 5.75% and an annual expense ratio of 1.40%, while the Class C shares have a 1% deferred load, and an annual expense ratio of 2.13%. It's common for Class C shares to convert to Class A shares after five to seven years, but in this fund they never convert. The good news with the Class C shares is that the deferred load only applies if you sell the shares in the first year that you own them.

While I'm not suggesting you sell your shares in one of them and convert to the other, in the future, it makes sense co contribute to only one of them. The fund's prospectus has a complete discussion on the differences in cost between the different classes of shares. The fund has a great track record, so I'm not advising you get rid of your shares -- just decide which class of shares is right for you and invest in those shares. Read that section of the prospectus and decide for yourself.

In choosing which type of account you want to add money to, you need to consider both your financial goals and how you'll be taxed. An IRA account is a tax-deferred investment, as is a 401(k) plan. Qualified distributions will be taxed at your ordinary income tax rate. Long-term capital gains realized on the sale of securities held in taxable accounts will be taxed at the lower capital gains rate. So it's more important to hold tax-efficient mutual funds in a taxable account than in a tax advantaged account.

If you qualify, contributing to a Roth IRA when you're young can make more sense than contributing to a traditional IRA. The Roth IRA contributions are made with after-tax dollars, but qualified distributions are tax-free. Many investors are in lower tax brackets in their twenties than they will ever be again, so contributing to a Roth IRA makes sense.

You've got 94% of your financial assets in taxable accounts. I'd recommend that you work on changing that balance by increasing your contributions to your 401(k) plan and continuing to contribute to an IRA or Roth IRA account. If your employer matches all or part of your 401(k) contribution, you should contribute to the 401(k) up to the extent of the company match. I'm not enamored of your choice of the (IGRYX)AXP Growth fund (Class Y shares) in your 401(k) account, and would suggest that you consider other alternatives. Class Y shares typically have no sales load and according to the prospectus, that is true for the Class Y shares in this fund.

It's very clear from your letter what you don't want in your portfolio. Now you need to focus on what you do want in your portfolio. Looking at the asset allocation among stocks, bonds and cash, you should first determine what part of your portfolio should be allocated to cash and bonds. An investment in Series I Savings Bonds can provide protection against inflation eroding the purchasing power of the money held in savings bonds, while allowing you ready access to the money in case of a financial emergency. The bonds can't be redeemed in the first six months, and there is a three-month earnings penalty if they are redeemed within five years, but it can still make sense to move some of your cash into these securities. There are also special tax incentives for redeeming these bonds for qualified educational expenses. I think a 20% allocation between cash and bonds is a reasonable place for you to start.

As for your stocks, you've got too many specialty pieces in your portfolio. Looking at the Stock Industry/Fund Category column, you've got two large growth funds, a small value fund, a health sector fund, a technology sector fund and of course the 800-pound gorilla in your portfolio -- Citigroup. The stocks and funds with a focus shouldn't be the focus of the portfolio. The two SunAmerica sector funds you've invested in are both less than a year old, and the sectors that they invest in have taken it on the chin so it's not surprising that the funds are having trouble. I'd like to see 20% to 30% of the portfolio invested in a no-load index fund like the (VFINX)Vanguard 500 Index for large-cap exposure, vs. the large growth funds you currently have in the portfolio.

Putting your feet up at 50 may or may not be realistic depending on how things progress in your life. You've got too much of your life in front of you to know for sure what you'll be able to afford at 50. But building a better foundation for your portfolio is a great way to increase the odds that an early retirement is in the cards.

Doug Kass is the manager of two hedge funds, Seabreeze Partners and Kass Partners, and renowned for his emphasis on a short-selling strategy. Prior to that, he was a portfolio manager at hedge fund Omega Advisors, and head of institutional equities at First Albany and J.W. Charles. At time of publication, Kass and/or his funds had no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Kass appreciates your feedback and invites you to send it to Doug Kass.

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