Dr. Don, I manage a small portfolio for my sister-in-law. It is currently worth about $47,000 and is mostly in an IRA account. She has Social Security, her husband's pension and owns her house. She requires about $400 a month from this portfolio. She is 70. The equity portion of this portfolio needs to grow robustly over the next five years. We feel that the growth is required because her family has a history of living well into their 90s. The bond and cash portion will last for five years. No extraordinary expenses are expected. I select funds with four- and five-star ratings for the account. Originally, we were classically diversified between stock and bond funds, small- and large-cap, growth and value, and domestic and foreign. Each investment was originally $2,500, or as little above that as possible. But with her husband's death in 1997, the monthly cash requirements temporarily exceeded $400. Then she needed a new car. In the environment of 1999-2000, the bond funds, foreign funds and, finally, many value funds were sold. However, as 2000 ground on, we found many four- and five-star funds were performing as badly as pure tech funds. Thus, in January 2001 and in March 2001, we rebalanced radically. We bought bonds and sectors expected to do well with the rate cuts. I search every week for growth and value funds that are not closet tech funds. I cannot find them. With the debut of the Vanguard Total Stock Market Vipers (VTI) - Get Report on May 31st, I am now considering another radical rebalancing in favor of indexing. At least then, tech will be 17% of the portfolio and not 40%. Neither my sister-in-law nor I are against tech stocks; we are against bad performance and buying five-star pigs in a poke. For instance, we started out with three evenly balanced high-yield corporate bond funds that were carefully screened for as few tech and telco junk bonds as possible. Within the quarter, Janus High Yield was full of telco junk, (STHBX) Strong Short-Term High Yield Bond was on the border and only (CMHYX) Columbia High Yield had resisted buying this junk. Thus, we sold Janus, limited Strong and added more Columbia. I expect that my next move in this portfolio will be out of the high-yield funds into one of the Vanguard index funds. If you could help rebalance this portfolio, we would greatly appreciate it. BZ & MA
BZ & MA,
You have very high goals for this portfolio, and I don't expect you will be able to accomplish them. Ignoring any adjustments for inflation, your sister-in-law wants to withdraw $4,800 a year from a portfolio currently worth about $47,000. For the portfolio to continue to provide that income stream over the next 20 years, it has to earn an average annual return of about 8.5%.
But, paraphrasing Nobel Laureate
Bill Sharpe, "You can't eat average annual return." Extraordinary needs for income and lackluster investment performance have reduced her portfolio's ability to weather downturns while still providing the income required. Put another way, earning an average return of 8.5% over the next 20 years won't be enough if returns are poor in the next few years. The account's cash position is appropriate and consistent with MA's need for income. I expect that she's earning about 4% on that investment. That puts additional pressure on the stock and bond allocations to pick up the slack in coming up with that 8.5% return.
Aside from this overall assessment, my biggest concern with the portfolio is your willingness to make wholesale changes in how it is invested. Part of that comes from the pressure you've placed on the portfolio to perform. Knowing what's going on in the portfolio and monitoring its performance is important, but take the time to devise a rebalancing that you're willing to stay with for at least a year so that you give it a chance to perform.
Here are some more specific recommendations. I think it's a smart move to get out of the high-yield funds. Retirees are attracted to these funds in their quest for current income and often don't understand the risk they are taking on to get that income. Remember that rate cuts by the
don't necessarily have to translate into higher prices for high-yield bonds if the issuing firms' interest coverage ratios decline because of a slowing economy.
Tempting as it may be to decide which mutual fund to invest in based on its
rating, even the folks at Morningstar wouldn't recommend that you base your investment decisions solely on these ratings. Digging deeper to find out what the fund is investing in and reading the fund prospectus will give you a better sense of the fund and its manager. Before rushing out to buy Vipers, read
article on the stock. I did, and came to the conclusion that your sister-in-law doesn't need to be in the exchange-traded fund (ETF) version of
Vanguard's Total Stock Market Index fund and that investing in the mutual fund was fine.
MA should work with her tax adviser to determine the required distributions from the IRA. I expect that her income needs would exceed the required distributions from the account, but it's good to know the exact amount so she can plan how she wants to take those distributions. Generally, she must start taking distributions by April 1 of the tax year after the year when she turned 70 1/2, and take the total required distribution by Dec. 31 of that later year.
Publication 590 has additional information on required distributions.
As for her other funds, I don't think she needs the hybrid fund in the portfolio. Hybrid funds invest in both stocks and bonds. She's got plenty of stock exposure, but if you sell the high-yield funds, she won't have much bond exposure. Consider the
Vanguard Total Bond Market Index,
Dodge & Cox Income fund or the
Fremont Bond fund.
Most investors don't need to own both the
Vanguard 500 Index
the Vanguard Total Stock Market Index. Because the 500 Index is a subset of the Total Stock Market Index, you wind up just adding an emphasis on the large-caps.
Additionally, investing in the
Gabelli Blue Chip Value AAA fund, a large-cap value fund, and
Spectra N fund, a large-cap growth fund, adds to the emphasis on large-capitalization stocks. If your preference is for large-cap stocks, buy the Vanguard 500 Index and then use specialty funds to give you some exposure to the mid- and small-caps.
We haven't discussed MA's household budget, but she should review that, too. To the extent that she can reduce her need for current income from the portfolio, it will help the portfolio to regain some flexibility and better meet her needs for future income.
Send In Your Portfolio
If you would like to submit your portfolio for a makeover, send it to email@example.com. Give us enough details -- dollar values or percentages -- so we can determine how your assets are allocated. Also tell us a little about yourself and your investing goals, and let us know how we can contact you if we have further questions. Though we'll use only your initials publicly, please include your full name so we can verify your identity. Unfortunately, we cannot guarantee your portfolio will be selected for a makeover, nor can we promise to respond individually to everyone who submits a portfolio.
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. At the time of publication, he owned shares of the Vanguard Growth Index fund, though positions can change at any time. 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