Makeover Finds High Price for Peace of Mind

By Christine Benz, Morningstar

CHICAGO ( Morningstar) -- Ernesto, a 63-year-old former engineer, is looking forward to a long and happy retirement with a peace of mind most retirees and pre-retirees would find enviable. Having retired seven years ago and still earning some income through periodic consulting work, he relies on a pension that more than covers his day-to-day living expenses. His children are grown, and he owns his home outright. In addition, he has managed to set aside more than $1 million in investment assets.

His investments' conservative positioning meant minimal losses during the bear market. But with more than two-thirds of his portfolio sitting in cash, Ernesto acknowledges he's very likely playing it too safe. "I am uneasy about the opportunity costs I might be incurring," he wrote.

Given that his main goal for his investment portfolio is to leave a legacy for his children rather than fund near-term living expenses, he recognizes that a larger share of his portfolio should be in investments that have the potential to earn a higher return and outpace inflation. At the same time, he's not sure how to execute the shift into longer-term assets, particularly given the stock market's two-plus-year run-up. "The question for me is how to avoid buying high and selling low," he said.
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The before portfolio
Ernesto's portfolio is streamlined and conservative to the hilt, and his long-term investments are all favorites of Morningstar's ( MORN) fund analyst team.

In addition to holding $837,000 in a money market fund and certificates of deposit earning just 2%, he holds another 17% of his assets in bonds, including Vanguard Inflation-Protected Securities ( VAIPX) and Vanguard Intermediate-Term Tax-Exempt ( VWIUX). Vanguard Wellesley Income ( VWIAX), a conservative-allocation fund, also includes a sizable fixed-income stake.

Equity assets, by contrast, consume just 12% of the portfolio, according to Morningstar's Instant X-Ray tool. Ernesto's sole pure equity offering is Vanguard Dividend Appreciation ( VDAIX), which is itself fairly conservative for a stock fund. It focuses on firms that have increased their dividends in each of the past 10 years. Most such names are very large companies, and Morningstar has assigned wide-moat ratings to many of the fund's holdings.

Given the limited equity stake and heavy cash position in Ernesto's portfolio, its recent returns have also been muted, gaining about 4% during the past year, while the S&P 500 gained about 17% during that stretch. With inflation rearing its head of late, Ernesto is wise to worry that higher future prices could gobble up an outsized share of any return his investments are able to generate.

The after portfolio
Retirees such as Ernesto, who don't have to rely on their portfolios to pay for day-to-day living expenses, are a dwindling group. In general, such retirees' portfolios can be more stock-heavy than those of folks who expect to tap their assets for living expenses on an ongoing basis. And though most retirees will want to hold one to two years' worth of living expenses in cash, large cash holdings are also usually unnecessary for people such as Ernesto, apart from an emergency fund to cover unanticipated or extra purchases. In that vein, Ernesto noted that he'd like to keep some cash on hand to pay for one of his hobbies within the next few years. (I won't get into specifics here to protect his identity.)

For someone of Ernesto's age and general situation, an equity position of 60% of the total portfolio would be a reasonable starting point, allowing for far greater growth potential without extreme gyrations in principal value. (Ernesto could reasonably nudge his equity weighting even higher if he wanted.) Vanguard Dividend Appreciation is a terrific core equity holding, but it's almost entirely domestic and is focused on mega-cap stocks. Positions in Vanguard Total International Stock Market Index ( VTIAX) and Vanguard Extended Market Index ( VEXAX) help diversify a larger equity portfolio by giving it exposure to foreign and small- and midcap U.S. stocks, respectively. (Ernesto notes that a key priority is to keep his investment-management costs down, and these two funds fill in some portfolio holes at a very low cost.)

On the fixed-income side, Vanguard Intermediate-Term Tax-Exempt is a superb core holding for someone in Ernesto's income bracket. The firm's TIPS fund is also a solid way to pick up a direct hedge against inflation. Yet given that Treasury Inflation-Protected Securities are quite tax inefficient, they're usually best held in a tax-sheltered account such as an IRA or 401(k). If Ernesto has earned income in a given year, he could invest up to $6,000 per year in a Roth IRA, and TIPS would be a good receptacle for that money.

The Intermediate-Term Tax-Exempt and Inflation-Protected Securities funds are both actively managed, but their managers don't engage in active interest-rate positioning or venture beyond their namesake securities. For retirees who would like a more active bond manager navigating what could be a shaky bond market during the next few years, one idea would be to steer a portion of their assets to a more flexible, truly active fund. One of Ernesto's current holdings, Vanguard Wellesley Income, fits that description nicely: Though its duration has typically been on the long side, bond manager John Keogh has recently been shortening up. Wellesley Income also holds income-producing stocks, though. Those who would like dedicated exposure to a flexible fixed-income fund might consider Harbor Unconstrained Bond, a no-load version of Pimco Unconstrained Bond ( PUBAX). Its expenses are on the high side given currently meager yields and the threat of higher interest rates, but its flexible strategy and experienced manager are an appealing combination right now.

Given that stock and bond markets aren't exactly cheap right now, it's crucial to engineer any shifts into those markets slowly, making regular purchases during a period of several years rather than investing the cash all at once. Doing so will help avoid a shift into long-term assets that in hindsight could be ill-timed.

-- Written by Christine Benz, director of personal finance for Morningstar in Chicago. Benz is also editor of Morningstar Practical Finance, a monthly personal-finance newsletter, and writes a weekly column on
Please note that the information above is not intended to be personalized portfolio advice for the makeover subject or any other investor. It is meant to illustrate a common investor dilemma and offer general portfolio ideas for consideration by investors in similar circumstances. Every investor's situation is distinctive and may include several important variables not accounted for in this makeover.

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