In past articles, we introduced the Master Mutual Fund Portfolio and then showed how to adjust it for a young person just getting started in investing for retirement. Today we’ll shift to the other side of the spectrum and talk about how someone who was getting close to retirement could adjust the Master Portfolio to suit their situation. Note that most people are investing for retirement, so that is the normal event that investing planning is targeted towards. But it could really be any event in your life where you will start using your investment portfolio as your main way to pay for expenses and therefore can not afford to suffer a serious decline in portfolio value.
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The basic, master portfolio is composed as follows:
20% General Large-Cap US Stock Index Fund
20% General Small-Cap US Stock Index Fund
20% International Stock Index Fund
20% General US Bond Index Fund
20% US Real-Estate Investment Trust (REIT) Fund
As one gets closer to using the portfolio for living expenses, the focus shifts from growth vehicles such as stocks to income generators such as bonds and REITs. To understand the difference, let’s look at these options.
Stocks
The first three elements in the Master Portfolio are stock investments, which is where you are taking ownership stakes in companies. If a company does well and grows, the value (price) of your investments grows. This means that the price of your mutual funds will increase and the number at the top of your brokerage statement will increase. This growth is somewhat unpredictable. While you can predict, using past history, that you will probably get somewhere between an 8% and 12% return if you hold a set of stock mutual funds for 15 years or longer, you don’t know when that growth will occur. It could grow steadily, it could shoot up in the first few years and then languish, or it could languish for years and then grow rapidly at the end of the period. It is unpredictable, which makes stocks unsuitable if you need the money within a few years.
This does not mean that you should not hold any stocks if you are near retirement. First of all, you should own some stocks since they do provide growth in your portfolio value. While you might need to start collecting some income from your portfolio, if you will be retired for twenty years or more, you still need your portfolio to grow somewhat to keep up with inflation. Without a stock component, your spending power will decrease and you see your income drop as you get into your later years. By having a portion of your portfolio in stocks, your portfolio value will grow over time, allowing you to shift more money into income investments later and increase your income to keep up with inflation.
Companies also eventually start to pay the investor some of their profits in what is called a dividend. This is a payment made to shareholder four times per year out of the profits the company makes. Companies that are growing quickly usually pay small dividends or no dividends at all. This is because they need all of the money they can get to grow the company.
Companies that are well established and generating a lot of cash from operations, however, typically start to pay a dividend. At first, the returns that you can receive from dividends will be small compared to those that you can receive from stocks. Dividends are typically a small percentage of the price of a stock (values of 1-2% are common). Over time, however, companies tend to increase their dividends. Dividends can grow by 10-15% per year, meaning that they will double every four to six years. As the dividends grow, the effective rate-of-return you receive on your investment grows.
Even though after several years you may still only be receiving 1-2% returns from dividends based on the value of the stock positions you own, because the value of your stock portfolio has doubled or quadrupled in price over the period, you’re receiving an effective 4-8% return on your investment. This means that while you might be able to get a 4% return from a bond portfolio today but only a 1% return from a stock portfolio, if you invest equal amounts in each and hold both for twenty years, both will be paying you the same amount of money. Hold another twenty years and your stock portfolio will be paying you four times as much as your bond portfolio. Bonds are therefore for income today, but stocks are for income tomorrow.
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Bonds
Bonds are loans made to companies, which in exchange pay you interest each year until they eventually repay the loan. As an investor, you then make new loans to other companies (or your bond mutual funds does so). Bonds are a good source of income since the amount of cash you can collect in interest will be greater than the amount you can collect from dividends. When you buy a bond (or a bond mutual fund), however, you are pretty much setting your income level from that investment in stone. Think of buying a bond as renting out an apartment to someone who will then pay you the same rent forever. Unless you take some of that rent and use it to buy other apartments that you can then rent to other people, your income will never increase. In fact, it will your spending power will decrease over time as the cost of things increases.
Bonds do have the advantage that they tend to pay interest payments consistently, regardless of market conditions. The price of your bond portfolio can (and will) fluctuate, but the amount of income you receive will stay relatively fixed, assuming no event where lots of companies go out-of-business like the Great Depression occurs. Dividends are also relatively fixed, but companies may cut them if financial conditions start to deteriorate.
REITs
Real-Estate Investment Trusts, or REITs, are mutual funds of rental properties. They tend to generate a good deal of income since they rent out properties, but they also see some growth in value since the values of the properties they own increases with time. They therefore are a good addition to a retirement portfolio. They also tend to not move up and down in price with stocks and bonds, so holding some REITs tends to help stabilize the value of a portfolio.
The Adjusted Master Portolfio:
Here, finally, if the new Master Portfolio for someone near retirement:
15% General Large-Cap US Stock Index Fund
15% General Small-Cap US Stock Index Fund
10% International Stock Index Fund
40% General US Bond Index Fund
20% US Real-Estate Investment Trust (REIT) Fund
(This is part of a series of articles to teach those who are new to investing how to invest. To find other articles in this series, choose “Beginner Investing Class” under “Investing” in the menu at the top of the page. If you have questions or you’d like a topic to be covered, please leave a comment at the bottom of the post.)
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.