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Mutual Funds
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The perfect portfolio of funds
Financial planners can be wildly optimistic about returns. Lets get real. Heres what to save and an ideal portfolio of indexed funds for safety in the long-haul.
By Timothy Middleton
Economists say the personal savings rate in this country is too low, with the result that America wont have enough capital to fuel future national wealth.
Yadda, yadda, yadda. Heres what really matters: Your personal savings rate. That will determine whether you are comfortable in retirement. Save too little and you simply wont have enough. And the fact is, you are probably saving way, way too little.
Conventional financial planning allows you to assume a certain rate of return -- say 11%, the historical average for stocks -- going forward in a straight line. Reality isnt like that. Remember the bear market? Surprise is normal: Did you expect a year ago to be paying $3 a gallon for gas?
There is a massive amount of uncertainty that youll get exactly that rate of return going forward, says Frank Armstrong III, president of Investor Solutions, a financial planning firm in Coconut Grove, Fla. In fact, Armstrong figures your odds of getting returns like that are roughly zero.
A portfolio to beat the odds
Using a mathematical model called Monte Carlo analysis, he says theres only a 50/50 chance that $100,000 of todays dollars will be worth four times as much 30 years from now, adjusted for inflation. Conventional planning would put that figure between $1 million and $2 million.
I asked Armstrong to create what I call a mutual-fund smoothie. This is a blend of investments designed to deliver the best returns with the least risk. His recipe allows you to whip one up for yourself. You can put this thing in the freezer and take it out years later, and it will still be fresh.
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You can be highly confident youll get a satisfying financial treat -- but only if you put in enough ingredients.
| Here is Armstrongs ideal portfolio: | | Fund | % of assets | | Vanguard Total International Stock Index (VGTSX) | 31 | | Vanguard Short-Term Bond Index (VBISX) | 30 | | Vanguard Small-Cap Value Index (VISVX) | 9.25 | | Vanguard Value Index (VIVAX) | 9.25 | | Vanguard REIT Index (VGSIX) | 8 | | Vanguard Small-Cap Growth Index (VISGX) | 6.25 | | Vanguard 500 Index (VFINX) | 6.25 |
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Source: Investor Solutions
Armstrong says this is as close to an ideal portfolio as you can get using widely available index funds. He could do better with funds from Dimensional Fund Advisors, but theyre only available to institutions and financial advisers like him. You and I cant buy them.
This portfolio is designed to protect as well as enhance capital, so its 38% fixed income, including real-estate investment trusts. It may sound conservative, but remember, if you lose 50% of your money you have to earn 100% to be back where you started.
The portfolio uses index funds because they eliminate manager risk or the likelihood that some of todays top funds will be tomorrows goats.
It has a strong value tilt, because academic theory predicts that, over very long periods, the style of investing that stresses beaten-down stocks will do better than the high-flying growth approach. It overweights small-cap stocks because historically theyve outperformed large caps.
Because of all these things, the portfolio has a risk profile, or standard deviation, about one-quarter less than world equity markets. Its annual expense ratio is 0.14%, or 14 basis points. One of indexings chief appeals is its low expense. Even a thrifty actively managed fund charges 50 to 80 basis points annually.
Theoretically, the mix of indices these funds represent could be expected to deliver annualized returns of 11.02%. Armstrong says that it is impossible to achieve in real life, because indices dont have expense ratios and other friction costs of securities ownership, such as taxes on dividends.
Therefore, he subtracts two points from this ideal return and bases his forecasts on an assumed return of 9.02%. He also adjusts the results for an assumed average inflation rate over the period of 3%. Finally, he rebalances the portfolio every January to maintain these exact percentages, selling a fraction of funds that have gone up the most and buying more of the cheapest.
Save now or pay later
How much can you expect this portfolio to return? There is no single answer. Monte Carlo analysis produces forecasts expressed as probabilities. Here are the probabilities that result from investing $25,000 a year in this mix of funds:
| Inflation-adjusted portfolio returns | | Odds | 15 years | 20 years | 30 years | | 25% | $595,741 | $904,718 | $1,811,161 | | 50% | $489,258 | $722,829 | $1,307,580 | | 75% | $405,770 | $579,898 | $977,220 |
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Source: Investor Solutions
This is a sobering table. It demonstrates that even if you save more than some Americans earn, youve only got a 50/50 chance of accumulating $1.3 million if you retire 30 years from now. The odds are only one in four youll come close to a million in 20 years.
Do you want to base your planning on a 50/50 chance youll succeed? Armstrong asks. His answer: No. You want at least a 75% probability of success. That forecast is less than half a million dollars in 15 years and just under a million in 30.
(Not adjusted for inflation, the 30-year total would be $2,371,969. Even a 3% inflation rate takes a big bite out of the greenback.)
Conventional portfolio planning is much more optimistic -- and people who retired between 2000 and 2005 paid a terrible price for that error. With stock prices tumbling 30% to 80% in those years, many substantial nest eggs were all but wiped out. The next great bear market could come three years before you expect to retire.
And while a million dollars sounds like a lot, consider this: At 5%, it would provide you with an income stream of $50,000. If you can afford to save $25,000 a year, youre probably accustomed to living on a lot more than that.
So the odds are that unless youre rich, serious saving for retirement is going to require lifestyle changes. After all, $25,000 is nearly one-fifth of an annual income of $150,000, after taxes. Take that much out of current spending and maybe that Lexus in the driveway ought to be a Toyota. That McMansion ought to be a three-bedroom house. That $8 lunch should be replaced with a brown bag.
Because the worst thing that can happen to you if you are thrifty is that youll end up with a lot more money than you expected. None of my clients has ever complained to me about having too much money, Armstrong says.
The worst that can happen if youre happy-go-lucky is that youll end up broke.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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