Portfolio Housekeeping

Dear Readers —
In his annual State of the Union Speech, President Bush officially opened what will surely be an emotional and protracted debate concerning how to “fix” Social Security.

Thanks to ever-increasing numbers of retiring baby boomers, the latest estimates predict that starting around 2018 Social Security is going to begin collecting less in tax than it is scheduled to pay out in benefits.

For the next 25-35 years (it depends upon the assumptions you make) the shortfall will be covered by the extra tax that’s been collected since the 1980s (mainly from baby boomers during their work lives) plus the interest that this money is earning. Then around 2042 (according to the Social Security trustees) or 2052 (according to the Congressional Budget Office), the surplus in the Trust Fund will be completely used up.

Whenever the day finally arrives, Social Security will find itself collecting less tax than it is scheduled to pay in benefits. According to the projections made by the number-crunchers at the Social Security Administration, beginning in 2042, 73 cents will be coming into the agency for every dollar that’s supposed to be paid out.

So the question is, do you reduce Social Security benefits by 27 percent so that you’re only paying out what’s actually taken in? Should you suddenly raise the Social Security tax rate (by one estimate to eventually 18 percent from its current 12.4 percent) and take more from the paychecks of those working at that time in order to pay those who are due benefits? What about increasing the income tax rates we all have to pay in order to make up for this shortfall?

There are literally dozens of proposals about what we could do to avoid such a drastic day of reckoning — from private investment accounts (a favorite of President Bush’s), to increasing the current Social Security tax rate (something AARP has proposed), to raising the age of “full” retirement to 68 or older, to changing the way benefits are calculated, to (believe it or not) doing virtually nothing.

I’m not going to get into this now. Trust me. I know I’ll be tackling this issue in more than one column in the months ahead. But the fact is, it’s too early to know what might be done to “save” Social Security. And, frankly, it’s out of our hands. So let’s worry about the things we can control with regard to retirement. Believe me, that’s a big enough job.

For starters, do you know whether you’re saving enough to retire at the age you want with the income you’ll need? When is the last time you took a good hard look at the way your retirement money is invested? Are your investments properly diversified? Is it better to own stocks in a tax-deferred accounts such as an IRA, 401(k), 403(b) and hold bonds in a non-retirement account or vice versa? How much can you safely withdraw from your investment accounts and not run out of money in retirement?

Feeling overwhelmed already? Don’t throw in the towel just yet. My goal is to make this 1) simple, and 2) free. A combination I happen to like.

As you may know, there is plenty of free help available on the internet. The problem is, if you head off into the great expanse of www-land without a clear idea of what you’re looking for and where to go, you can quickly get overwhelmed with information.

This leads to a debilitating financial condition called “Analysis Paralysis.” The most prominent symptom is that your investments languish for decades in the same mutual funds you chose when you were 20-something and landed your first job. For all you know, that tech fund you dumped 50 percent of your 401(k) contributions into went out of existence! So let’s boil this down to some easy steps:

STEP 1. Collect the end-of-year statements you just received from your IRA custodian, your broker, your company retirement plan, and anywhere else you have investments. Doing this now should be a cinch; trying to find this information 5 months from now will be a pain.

STEP 2: Log on to http://www.morningstar.com. Click on the tab labeled “Tools.” Morningstar, known for its “star” system of rating mutual funds, has a wealth of handy, easy-to-use calculators that you can use for free. If you want to go a deeper, you can subscribe to their service. But for now, let’s stick to the free stuff.

If you’ve done any reading about investing you know that there is virtually unanimous agreement that “asset allocation” is the most critical aspect of assembling a portfolio — one that can get you where you need to be in the timeframe you’ve allotted.

Asset allocation refers to the mix of investments you own — if you keep too much in cash, the return on your portfolio will be too low. As a result, you’ll fall short of your next egg goal and will have less income available when you retire. However, as many people found out in March 2000, if an overly large portion of your money is riding on high-flying growth stocks, you can get burned in a different way. These tend to be more volatile than other sectors of the market. To paraphrase, when you’re talking about growth stocks, “What goes up, can come down — with a vengeance.”

So what’s the answer? You’ve got to reach a balance between low risk/low return investments and higher risk/higher return investments. There’s no magic formula. A lot of it has to do with your goals, your time horizon, and your temperament.

Accumulating a certain sum of money by a certain time is akin to taking a trip to Grandma’s. If she lives 800 miles away and you’ve got 5 days to get there, you can drive a lot slower than if you have to get there today. But if today is grandma’s birthday and she’s threatened to cut you out of her will unless you make it by the stroke of midnight, you’re going to have to put the pedal to the metal. This strategy, of course, is riskier because 1) you could get a speeding ticket (or two), and 2) driving at excessive speed is in and of itself risky.

But there are alternatives. For instance, if the goal (Grandma’s house) is more important than the timeframe and it doesn’t matter exactly when you arrive, you can just set the cruise control on “55” and take a more leisurely drive. Or, you can switch your mode of transportation and take a plane. Then again, if you get a thrill out of testing your car’s radar detector, you might just decide to drive, anyway.

So these three variables — your goal, i.e. the dollar amount you want to end up with, the time you have to accumulate this, and your willingness/ability to accept some risk — will determine your asset allocation.

The problem is most of us aren’t quite sure what kind of investments we own. In particular, we don’t really know if a certain mutual fund is in the “high risk/high return” category or the “low risk/low return” category. (I’m going to stick with mutual funds in this article because that’s what most people have in their company retirement plans and IRAs, but the same principles apply to individual securities such as stocks and bonds.)

So let’s begin there.

From the “Tools” page of the Morningstar.com site, click on “Instant X-ray.” Here’s where you will list every single investment you (and your spouse) own, regardless whether it’s in your 401(k), IRA, brokerage account, or anyplace else. You’ll need to enter each fund by using its “ticker symbol,” which refers to fact that in the good ol’ days, a ticker tape reported the changing prices of stocks on the New York Stock Exchange by abbreviating each security’s name. This tradition carried over to mutual funds.

Don’t worry: a search box on the page will enable you to get the symbols you’ll need by typing in the name of the fund. (If you’re not sure whether you own the “A” shares or the “B” shares, etc. choose “A.”) In the left hand column you enter the symbol for each fund; across from this enter the value of that fund as of the end of last year.

There are additional pages so be sure to include every mutual fund you own. If you’re married, include the investments in your spouse’s name and those you own jointly. This is important! You don’t want to just look at, say, your company retirement plan in isolation. Christine Benz, Associate Director of Fund Analysis at Morningstar says, “It helps to look at all the pieces together — your 401(k), IRAs, and those of your spouse, especially if the target date for this money is the same.” When you take this type of holistic approach you’ll have a sense of whether your [total portfolio] is pulling its weight.

In addition, when you see how all the pieces- yours and your spouse’s — fit together, you can optimize your investment choices. For instance, let’s say you have 20 percent of your 403(b) in a bond fund. It’s a lousy bond fund but, hey, it’s the only one your plan offers and you figure you ought to have some money in bonds. However, the stock funds in your plan have been solid performers.

On the other hand, your spouse has a terrific bond fund through his employer’s plan, but only mediocre stock funds. When you’re running your retirement money as a couple instead of individually, you can divvy up your money based on the spouse who’s got the best investment options. In our example, if you decide that 60 percent of your total portfolio should be in U.S. stocks, then it makes sense for you to own these in your 403(b) and let your spouse invest in the bond portion, since he’s got better choices there.

Step 3: “Save” your portfolio and then click “Show Instant X-ray.” You will probably be surprised at what you see. Start with the pie chart. Morningstar’s software doesn’t just label a stock fund as “100 percent stocks.” Instead, according to Benz, “it actually drills down and looks at how the fund is invested. If it owns cash, this will show up in the ‘cash’ allocation of your total portfolio.” In other words, you get to see what you’re really invested in, not just what the name of a fund suggests you’re invested in.

Under “Stock Sector” you’ll see a breakdown of your holdings by industry and allows you to compare your portfolio to the weightings in the S&P 500 Index. While you may want to be more or less exposed to certain market sector than the index is, at least, says Benz, “you know where you’re making large bets.”

The section called “Style Box Diversification” will give you another view of where your portfolio might have unintended concentrations. “Growth” stocks refer to companies whose earnings are increasing at a faster rate than the market average; they also tend to experience bigger and more frequent price swings. Think “technology.”

In contrast, “Value” stocks tend to be older, more established companies. While these don’t usually offer as much upside or downside in terms of a price increase, they often have another important attribute: many value stocks pay a dividend. Think: consumer products companies.

The important thing to recognize is that neither “value” nor “growth” is better. Your portfolio should have both and also include large, medium (“mid cap”), and small companies in each category. That’s because growth stocks and value stocks tend to trade places in terms of performance. From 1995 through 1998 large companies in the “growth” category beat the pants off every other market sector. In 1999, small cap growth stocks were the stars. Then growth stocks of all sizes got hammered and value stocks took the lead for the next two years. But since you can’t predict when this rotation is going to happen, it makes sense to have exposure to both categories.

The important thing to understand is that the allocation you make to growth versus value stocks will determine the potential return of your portfolio as well as its risk, i.e. how much it will fluctuate in price. To use the grandma analogy, growth stocks have the potential to get you there faster, but the ride is likely to be bumpier. Having some of both should smooth things out. As I like to say, value stocks reduce the Maalox moments.

Back to the “Instant X-ray” page... Don’t overlook the world map. This shows you at a glance what parts of the world your investments come from. In other words, how geographically diversified your portfolio is. While you probably want the majority of your equity investments to be in domestic corporations, it’s a mistake to limit yourself to only U.S. stocks.

According to Ibbotson Associates, international stocks (as measured by the Morgan Stanley EFA index) delivered twice the return of the S&P 500 Index last year: 20.7 percent versus 10.9 percent. In fact, international equities out-performed U.S. stocks in 2003, as well. And in 2002, when the S&P 500 lost more than 22 percent, foreign stocks were down less than 16 percent.

This is a lot to digest. Next week we’ll move on to phase two and look at the chances that your existing portfolio will deliver the nest egg you’re planning on by your target retirement date and how to make adjustments if it looks as if you’ll fall short. If you’re already retired, you’ll learn how to estimate the potential for your portfolio last as long as you will.

All the best,

The folks at Morningstar have several books to help you navigate the sometimes confusing world of investing. Next week I’ll tell you how some lucky readers will get a complimentary copy of “Find the Right Mutual Funds.” But please don’t write me yet. Early entries will not be considered.

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