I am 41, married with two children ages 3 and 7. My spouse and I have a combined income of $100,000 per year and we expect it to grow at the rate of inflation. I invest $15,000 annually in my 401(k) account. I'm able to invest another $15,000 annually over the next 10 years until my oldest starts college. My plan is to retire at age 65, pay all college expenses for both children to attend a private college and have a $5 million portfolio at retirement. I'd appreciate your advice. -- K.P.
My initial reaction is that you're expecting too much from your portfolio. Where did the need for a $5 million valuation at retirement come from, and why did you set such a high bar for college savings?
Use a retirement
calculator to help determine what size portfolio you will need to meet your needs for income in retirement. Realistic goals make for better portfolios because you're less likely to take on unnecessary risks to meet those goals.
Meeting the goal for your children's college expenses is, by itself, going to be a challenge. How big a challenge? Well, there are a lot of different college-cost calculators available. I used the one at
WiredScholar.com, a site sponsored by
-- the student-loan people. Using $21,500 as the current estimate for the cost of a year's tuition, room and board, and assuming annual increases of 5%, you'll need about $760,000 to pay for the children's college expenses. Stating the expense in today's dollars, if 45% of your current portfolio ($218,000) is allocated to the children's education, and those investments average a 10% annual return after taxes, you could meet your goal of eight years of private education for each child. If the investments only average an 8% return, you'd need to allocate about $279,000 of your current portfolio to meet their college expenses. You should further discuss the college savings goal with your spouse to see if there's a compromise that you both will find acceptable.
The nice thing about expressing the college expenses as part of the current portfolio's valuation is that we can then assume that all new investment contributions will go toward your retirement goal. You estimate that you can save $30,000 annually, with $15,000 of that in the tax-deferred 401(k) account. Ignoring taxes and again assuming an investment return of 10%, this series of investments would be worth $2.9 million when you turn 65. If the portion of the current portfolio not allocated to college expenses also earns an average annual return of 10%, that $270,00 will be worth $2.65 million. You will have exceeded your goal of $5 million at age 65. But if the returns on your portfolio average 8%, you'll only have a portfolio worth $3.5 million at retirement.
So it comes down to this: How realistic is it to expect a 10% annual return on your investments? On an after-tax basis, it's not very realistic. Capital gains are taxed at 20%, and ordinary income-tax rates are between 28% and 36.9% for most investors. State income taxes further reduce after-tax return. The stock market has averaged an 11.3% annual return since 1926. Returns in recent years have been higher, with the
index averaging almost 20% over the past 10 years. But that doesn't mean investors can realistically expect these higher returns to continue.
You've got almost 25% of your portfolio in cash. That's a smart move with the stock market stumbling for much of the year. Keeping some money in cash for liquidity needs is always a good idea, but having 25% of your portfolio in cash has to be a temporary situation if you want to meet your investment goals. You're not going to average 10% after taxes by investing in cash. Ask yourself what you need to see happen in the marketplace before you're ready to invest again in stocks. Set targets above and below the current market levels for the
Nasdaq Composite Index
, S&P 500 and the
and raise your asset allocation in equities when two out of the three indexes reach the target levels. You're not going to be able to, nor should you try to, pick the market peaks or troughs, but you've got to have some kind of decision rule about getting back in to the market.
I'm hoping that you re-evaluate your goals so your portfolio won't be diagnosed with performance anxiety a few years down the road. Asset-allocation decisions, like your current decision to hold 25% of the portfolio in cash, and sector rotation trading could help you improve your performance. For example, your best performing mutual fund on a year-to-date basis is the
Vanguard Health Care, a sector fund.
With a sector rotation approach you would concentrate investments in the economic sectors that are outperforming the general market, rotating your investments in utilities, energy, financials, cyclicals, services, health, etc., as market conditions change. If you decide to take this approach, you should consider owning more funds and fewer individual stocks. You can control tax exposure better with individual stocks, but you won't be as nimble, and you'll be taking on too much risk with the individual holdings. Sector rotation has its own problems -- like buying biotech at the end of its run vs. the beginning -- but if done successfully, will improve your portfolio's returns.
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Dr. Don Taylor has been an investment professional for nearly 15 years, most recently as the treasurer for a nonprofit organization where he managed more than $300 million in assets. He is a chartered financial analyst, holds a Ph.D. in finance and has taught investment and personal finance courses at the University of Wisconsin and at Florida Atlantic University. Dr. Don's Portfolio Rx aims to provide general investing information. Under no circumstances does the information in this column represent a recommendation to buy or sell. Dr. Don welcomes your inquiries and feedback at