With the election blues boosting pundits' bank accounts and puncturing everyone's portfolios, now might be a good time to tune out the Beltway din and get back to the basics of how you should build your portfolio.

This week, we put

10 Questions

to veteran financial adviser Frank Armstrong, president of Miami-based

Managed Account Services

and chief investment strategist for

DirectAdvice.com

. Armstrong is a die-hard index-fund proponent who's been helping people build portfolios for the past 27 years. Here he gets down to brass tacks, laying out how much money he thinks long- and short-term investors should have in U.S. and foreign stocks, and how much you should keep in cash at all times.

If you like what he's got to say and are hunting for additional pragmatic advice, check out his book

Investment Strategies for the 21st Century

, which you can read for free on Armstrong's

Web site.

Financial Planner: Frank Armstrong

Firm: Managed Account Services , Miami Fla.

Experience: 27 Years

Assets Under Management: $89 million

1. Everybody talks about asset allocation, they throw figures around, but it really is not necessarily a given or a simple thing. What kind of allocation do you typically recommend for a long-term investor -- somebody with a 15-year time horizon, let's say?

Armstrong:

OK, well, presuming that they have an adequate emergency fund available or other liquid assets that they could call on in an emergency.

What would you say is, what would you typically advise as being an adequate emergency fund?

Armstrong:

It varies. But typically, three to six months cash available, but that doesn't have to be in a savings account. Some people feel comfortable knowing that they could margin their investment account or use credit cards or go to the bank and get a loan.

Right. But what if you're somebody who likes to save fruit?

Armstrong:

Then Treasuries. A short-term bond fund or money market fund or a CD or something of that nature that's going to be there come heck or high water. Presuming you've passed that threshold and you've done your insurance work, then I would be comfortable with 100% equities for that person if they're comfortable, because maybe a full measure of market risk is more than they would enjoy. Sleeping well at night is a legitimate financial objective.

Within that equity portfolio, how would you break it down between U.S. and foreign stocks?

Armstrong:

Well, we break it down 50-50. But we then break down each of those into four or five different categories. Within the U.S., we tend to have domestic large, which is the

S&P 500

, micro-caps and then large and small value. We do the same thing in the foreign emerging markets and with the exception of, in foreign markets, we have a fifth category for emerging markets. Now that's a token exposure, 5% of the total equity portfolio.

Now if this person isn't comfortable with 100% equity, what do you think is the range for throwing fixed income there to smooth the ride?

Armstrong:

Well, you do get a lot smoother if you put fixed income in there, but it's a drag on performance based on historical records. We figure for every 10% of fixed income you're probably losing 8/10 of a percent of total performance potential.

Every year?

Armstrong:

Every year, compounded, so that would be a significant drag over the long period of time. But again, if you're the kind of guy who would see the market go down and would sell your whole portfolio because it makes you nervous, then if you can't stand that amount of risk, you're far better off to have a portfolio that is dragged down a bit by fixed income.

2. Now one thing that folks overlook is that, oftentimes, we don't have long-term goals. We all become shorter-term investors near retirement or investing for a home or a college education. So what about the same kind of allocation question for someone who has, say, five years?

Armstrong:

Well, if it's five years until you're going to eliminate the whole portfolio, you get a different answer than if it's simply five years until a change in life event.

Let's take the first. Let's take the one where in five years I'm going to need all of this money. Then we can examine the next one: In five years I'm going to have to start drawing on the money.

Armstrong:

OK, well, if in five years you need all the money you're getting pretty close to the point where you should be out of the market, really.

Out of the stock market.

Armstrong:

Absolutely, and into very short-term bonds or money markets -- either U.S. bonds or hedged foreign bonds. We use a global portfolio but the currency is hedged, so that we have the opportunity to go for the higher yields, if, after the cost of hedging they're higher than U.S. yields, there's no reason not to buy sovereign foreign bonds.

Right. How about somebody that's five years from retirement and they'll need money for about 30 years?

Armstrong:

Here's my rule of thumb. I think that an investor should hold enough in short-term bonds or money market funds (or whatever safe assets that you care to use) to cover their next, all of their cash requirements in the next five-seven years. The balance can be devoted to long-term investing, which could then be 100% equities.

For instance: Let's say you were 60 years old and going to retire today and you expected to draw down 6% of your portfolio every year. Then I would recommend to you that at a minimum, you have 30% -- and I'd feel more comfortable with 40% -- in fixed income, so that that money's there no matter what the rest of it does, the stock market does.

Then, it wouldn't matter if it's retirement or your child's college education or the boat purchase or the house purchase. That's a known cash flow. It would be extremely unfortunate to have to pick the day you retired based on what the stock market did yesterday or to have your child go to night school instead of Harvard because the market went down while you were trying to eke out that last possible gain.

3. One concept that's always intrigued me is mad money. Ask 10 people, get 10 views on this. A lot of people they can see the benefits of index investing and asset allocation. But there's always that little voice that says, wow I'd really like to buy this stock, this seems like a great idea, but it's not part of my plan. What's your thought about somebody making a deal where they're going to toe the line with the vast majority of the portfolio but maybe each year, take part of the bonus or some other windfall and buy that speculative stock?

Armstrong:

I don't have any problem with that at all if they're disciplined about it, the problem comes in when they begin to confuse investment success with genius because they happen to have been in the right spot a couple times.

If they hit it big on the tech stocks several years ago, at a time when everybody who could spell tech was making big money, that's not necessarily a sign of genius -- that's not necessarily a sign that it can be repeated indefinitely.

But people do find that the stock market is entertaining; they do want to play in the same sense that they want to gamble or play golf. And everybody's got a hobby and there's nothing inherently evil about taking a small portion of your assets and playing the game.

Just like it's not evil when my wife takes $5 and goes plays on the one-armed bandits. I can afford to lose $5 and she finds it extremely entertaining. You've gotta have the discipline to stop. Investing is not about gambling. It's about investing in markets all of which have positive expectations and doing what you can to control risk.

4. Speaking of risk: You've been investing for a long time. Have you ever seen one sector dust the market to the degree it happened last year with tech stocks?

Armstrong:

Oh, sure. I got out of the Air Force in 1972 or so. Every housewife and secretary was studying to be a Realtor. We were all going to get rich somehow trading our houses to one another, because real estate was the top performing asset class, and for most families it was the biggest asset they had, and that was going to go on

forever.

Shortly thereafter, we had the oil crisis and everybody wanted to invest in oil. And they did crazy things like partnerships, because the price of oil was going to go to $100 a barrel and became the predominant wisdom.

Later we began to have inflation, and about that same time, money market funds became the predominant savings vehicle over checking accounts and bank accounts because the banks weren't allowed to pay competitive rates of interest. Money market funds went to very high rates of return, and everybody dumped everything else in order to buy money market funds. We were all going to get risk in the zero risk investment vehicle.

Then we've had health stock booms. Then Japan went through an incredible phase where everybody believed that Japan was going to take over the world.

We were all learning to scrape and bow and present our business cards with two hands. We were sending managers to Japan to learn consensus management, we had learned how evil the focus on profits was as opposed to market share, and so all we needed to do was invest in Japan and we were going to be wealthy. Japan was a market like no other. It didn't follow regular roles, and all that stuff was regurgitated ad nauseam, the same thing you hear about dot-com today was said about Japan 10 years ago.

5. Right. One thing that probably hurt a lot of folks this year was an overexposure to tech, even folks that established a portfolio that was diversified before. But since tech really took off in the past few years and led the market, they were probably sitting there with kind of a tech hangover. The average growth fund had more than 40% of its assets in tech if you look at it the start of the year and it still does today. This raises a question of rebalancing and giving your portfolio a checkup. How often do you recommend rebalancing, and how do you recommend they go about actually doing it?

Armstrong:

First of all, we don't take any sector bets here. We buy the broad index. It's absurd to believe that any industry, any country, any company can continue to grow faster within the economy as a whole.

Even so, broad market sectors take off. We believe that you should examine your portfolio once a year to see if your portfolio is significantly out of whack. If it exceeds some tolerance that you preset it may make sense to rebalance. But you have to take a look at your tax considerations and your transaction costs.

These are probably selling positions that are in the black.

Armstrong:

Right, and that typically does force you to buy low and sell high. It's a great mechanism, especially in a qualified plan. Because you don't have the tax considerations to deal with.

An IRA, a 401(k).

Armstrong:

Right, but if you're a slave to some kind of theoretically perfect asset allocation and you rebalance every day, what you'll find is that your transaction costs and taxes simply eat up any potential benefits of being "perfectly balanced."

Every time there's a cash flow is the appropriate time to rebalance the portfolio, because it's painless. If you're taking money out, you can sell the high asset, take a capital gain. Hopefully, if you're putting money in, you can do a rebalancing report for yourself, and put money in the assets that are performing poorly, waiting for them to hopefully recover. So that's the way we handle that internally here, hopefully, when there's a cash flow in the account.

6. I know that you are a big proponent of index investing and that's part of your DNA. But there are a lot of folks out there that say they favor a blend of both indexed and asset management. What's your take on that?

Armstrong:

Dysfunctional, delusional. I know that's the accepted wisdom. What you found is that it's a progression of a number of years ago when index funds were brand-new everybody thought it was completely crazy.

Now that index funds have proved themselves especially in the S&P 500 in the last several years, if you're an active manager you can't just simply throw up your hands and say well, I think I'll retire, I've gotten mine.

You have to continue to try to justify active management some place. So what you've seen is, the active managers have pretty much given up on the idea that they can beat the S&P 500, but now they're making the argument that they can win in smaller, less efficient markets.

7. If you had to pick an active manager, who do you think is the best out there in terms of managing responsibly and offering solid risk adjusted return?

Armstrong:

TIAA-CREF. Because you know what? They will tell you that they're basically indexers who nibble around the outside.

They do very little ...

Armstrong:

They do very little, but the closer you come to owning the whole market, the less you take bets against the market, then on a risk adjusted basis, the better you will do within that market.

8. In the past two and three years, the percentage of cash flow to sector funds relative to the percentage of cash flows to all stock funds has really skyrocketed. What's your take on sector fund investing and how much of someone's portfolio should a sector fund comprise?

Armstrong:

There's never been a sector that for extended periods of time outperformed the economy as a whole. And so if you're going to take a bet against the market, you've got two problems. When to get in, and when to get out. And the tech fund hangover occurred because people leading up to 1999, everybody wanted to be in the S&P 500. And nobody had heard of tech. There was not all this buzz about tech in 1999 because the S&P dominated all the conversation.

As the S&P performance somewhat fell off, as the year went on, everybody discovered and the buzz turned to tech stocks. Well, the longer that went on the harder it was for people to keep themselves from doing something really stupid. So about December or January they said, hey, this tech stock thing has got something to it, they started buying in the portfolio at times and prices that made no economic sense at all and they were fully invested in that sector for the crash.

Very few people knew that tech was the place to be in 1998 and loaded up their portfolio. Obviously, some did. But for the number of winners vs. the number of losers in the tech fund business, I think you'll find it's disproportionate.

But the longer it goes, the more people will convince themselves that this time something's different -- the most dangerous concept in the market. So I don't use any sector funds.

9. What are the most common mistakes you see in the portfolios of new clients?

Armstrong:

The biggest one that they've made, typically, is that they'll have 16 mutual funds all of which hold the same assets. From

Morningstar

, we do a cross holdings report.

And a portfolio overlap report?

Armstrong:

Right. It's awesome. You'll see 16 funds, all of them hold very similar holdings in every single stock.

They've got most of the large cap too? Large cap growth?

Armstrong:

Right. And so what they've got is a malformed S&P 500 index for which they're paying close to 2% when they could be paying 20 basis points for a portfolio. And so they concentrate their holdings in one small market based on what happened in the last 12 months, typically. So they're constantly buying high and selling low and wondering why their portfolio isn't dazzling everybody around them.

10. One thing we haven't talked about is investor expectations. The past few years we've had go-go growth years and funds have routinely outperformed, posting more than 11%-12% annualized returns which are the historical average for the broader market. What's your take there? Have you noticed some clients with higher expectations?

Armstrong:

Oh, sure. They believe they're entitled to 20%-30% returns and they're moving their money into asset classes that have done that historically at exactly the wrong time. But anybody who does their planning based on a more than 10%-11% return is likely to have a very bad outcome. Those high returns are not sustainable, they're not repeatable and most academics don't even believe that 11% is a fair return going forward.

The biggest debate in financial economics today is in why the premiums should be so high. They cannot figure it out and most of them are leaning toward much smaller premiums going forward.

What they're saying is that even the 11.2% that the S&P has done since 1926 may be too high. There's a lot of concern that that risk premium of about 8% is 3%-4% or more too high. That going forward, you should expect high returns from stocks and bonds, but not necessarily an 8% risk premium. At the very high prices that we're seeing around the world today, that's got to be a concern.

Not to scare people out of equities, but if you're doing your planning based on a guaranteed rate of 20%, you'll put too little too work, and you'll have too little probably when you get to retire to sustain yourself.

And if for planning purposes, you're going err, do it on the conservative side. No one ever has too much money when they get to retire. It's just not a problem in my client base. But a lot of them didn't save enough and they're now trying to figure out how they're going to get through the next 40 years, they and their wives, on very skinny financial assets.