The war is over, the hummingbirds are back, the dogwood’s blooming white and pink. It’s spring, and, after a long, hard winter, it’s a refreshing and comforting change.
So it’s time to give your investment portfolio a thorough spring cleaning. Get rid of the mess, give to charity what doesn’t fit you, put the rest neatly in order. Here are my suggestions. . . .
The plan. The first step is to review your asset-allocation plan. If you don’t have one, get one. Hire a financial adviser or do it yourself. Simply write your objectives — the “whys” of your investing — on a sheet of paper, using first-person pronouns. “I need a comfortable retirement.” “We want to pay the college tuition for our three kids.” “We’re saving to buy a house.” For your long-term goals, own stocks; for medium-term (one to five years), own bonds; for short-term, cash (that is, money-market funds, Treasury bills, bank accounts, and certificates of deposit).
The list. Root around the house and find the latest statements (probably dated March 31, 2003) for all the financial investments you own. Write out all your holdings, including what you have in retirement plans, on a sheet of paper. Divide the assets into three categories: stocks, bonds, and cash. Total the amounts and see how the proportions conform to the original asset allocations of your plan. What you’ll probably find — unless you have been very conscientious — is that they are far out of whack.
The shift. Now, devise a strategy to bring your allocations back into line — quickly. Here’s what I mean: Say that you are now 40 years old and, at the start of 2000, you believed that a mix of 70 percent stocks, 20 percent bonds, and 10 percent cash would be right for the next 10 years. The past three years were rough on stocks but a boon to bonds. Now, even though you haven’t sold any of your assets, you find that your allocation has shifted to 50 percent stocks, 40 percent bonds, and 10 percent cash. If your total holdings are $100,000, you’ll have to sell $20,000 worth of bonds and buy $20,000 worth of stocks to get the amount invested in stocks to be 70 percent of your assets.
The gift. Before you actually start buying and selling, think about giving some of your holdings to charity. Yes, now, not in December. Do it all at once, with tax filing fresh in your mind. The tax code allows you to deduct the full market value of the stocks and bonds you donate, even if they have accumulated large gains. It’s true that gains aren’t as abundant as they were a few years ago, but, with a diversified portfolio, it’s likely that some of your stocks have gone up. Say goodbye to them now as part of the cleanup. Donating stocks and bonds whose value has declined, however, makes no sense at all. It’s better to sell them, offset the losses against gains on your tax return and donate cash.
The elimination. Get rid of the little odds and ends you have accumulated. I have a brokerage account, for example, composed totally of $176 invested in money-market funds. I get a monthly statement and a tax statement for a few bucks each year. I promise that this year I will close the account. Ditto, some miscellaneous mutual funds I own. Sell all the little stuff and convert it to cash immediately.
The simplification. Besides reallocation, the goal of spring cleaning is to make your financial life simpler. There is no need to own an index fund that tries to mimic the performance of the benchmark Standard & Poor’s 500-stock index, plus three conventional managed funds that hold S&P-like large-cap portfolios. For instance, eight of the top 10 holdings of Fidelity Magellan (FMAGX), the largest managed equity fund, are also among the top 10 holdings of Vanguard Index 500, the largest index fund. Do you really need both funds? Unfortunately, mutual funds are required to report their holdings only twice a year, so it’s hard to calculate the overlap precisely, but look at your statements or go to www.morningstar.com and you’ll find that the portfolio of a fund like T. Rowe Price Growth Stock (PRGFX), which by the way is excellent, differs little from an S&P index fund. In five of the past six years, the Price fund has produced returns that vary by no more than 2 percentage points (up or down) from the S&P. It’s fine to own the Price fund instead of an index fund, but not both. Nor do you need two or three small-cap funds. And, if you own the popular Nasdaq 100 exchange-traded fund (QQQ), you don’t need to own Intel (INTC), Cisco Systems (CSCO), and other large-cap tech stocks as well. You’re just compounding confusion.
The taxes. As you decide which assets to sell, remember our curious tax system. You can reduce your capital gains taxes by offsetting losers against winners. But also remember that taxes aren’t everything. If a stock has dropped below what you paid for it and you still love the company, don’t dump it — or else consider selling it and, after what the Internal Revenue Service considers a decent interval (at least 30 days before or after a sale, according to www.irs.gov), buy back more.
The changes. Now you’re ready to make the actual spring adjustments. Some people prefer feeding money into the stock market slowly, but that’s market timing — you are actually making a guess that stocks will decline in the short term. I prefer to make the changes all at once — especially if they involve moving into stocks, which, after inflation, have returned two to three times as much as bonds.
The subtleties. The spring-cleaning process is simply a matter of common sense. Remember the basics of stock investing: Diversify, do the research, keep expenses low, buy with the intention of holding for the long term. Understand that how you allocate your assets — not which stocks and bonds you choose — is the single most important factor in determining the risk and return of your investments. But also understand that one size doesn’t fit all.
For years, I have suggested that readers start moving out of stocks and into bonds as retirement approaches. But there’s another approach, and I am finding it more and more compelling. Its most passionate advocate is Charles Ellis, a financial adviser, teacher, and author. In his superb book Winning the Loser’s Game, first published in 1985 and now in its fourth edition, Ellis argues, “Don’t change your investments just because you have come to a different age.”
He points out, first, that if you plan to leave money to your children and grandchildren and to charity, then “the appropriate time horizon for your family investment policy — even if you are well into your seventies or eighties — may be so long-term that you’d be correct to ignore investment conventions,” such as shifting from stocks to bonds.
Second, of course, if you sell stocks that have gains, you’ll lose 20 percent of those profits to federal taxes.
Finally, and most important, “compounding is powerful.” Say that a baby is born in 1900 and his or her parents put $100 into a diversified stock account. By 1995, the $100 would have grown to $733,383. Incredible. But then Ellis poses an interesting question.
How much of the 95 years’ gain came in the last 20 years?
Nearly all of it. In 1975, the $100 had grown to only $75,000.
The point is that as a nest egg grows in total dollars, even small percentage increases lift its value enormously. Over the past three-quarters of a century, stocks have returned about 10 percent (including inflation) while Treasury bonds have returned about 5 percent. So a 50-50 stock-bond portfolio would return about 7.5 percent, or 2.5 percent less than an all-stock portfolio. That doesn’t sound like much of a difference, but. . . .
Assume you have accumulated $300,000 at age 50. If you keep all the money in stocks, then, if history is a guide, you will have $2 million by age 70. But if your allocation is half stocks, half bonds, you will have only $1.3 million. Stocks, in this example, produce a nest egg that’s more than 50 percent greater.
There are two reasons to shift from stocks to bonds: First, you may need income — or even capital gains from your investments — to make ends meet in late working or early retirement years. Second, stocks are far riskier than bonds in the short term, and you risk suffering the profound psychological shock of losing a big chunk of money on the brink of retirement.
I am not sure even these arguments hold up. First, over time, stock dividends rise while long-term bonds keep paying the same rate of interest. A solid mutual fund that emphasizes mid-to-high-yielding stocks — like T. Rowe Price Dividend Growth (PRDGX) or Strong Dividend Income (SDVIX) — can be a good substitute for bonds.
Second, critics often point to the 40 percent decline in the S&P 500 between the start of 2000 to the end of 2002 as evidence that you can’t rely on stocks for security in retirement. That sounds logical, but it’s not. When you examine every 20-year period since 1926, you find a remarkable consistency of returns for stocks: The annual average for each of the 58 periods ranges from a low of 3 percent to a high of 18 percent.
Overall, large-cap stock investments returned a total of 573 percent in the average 20-year period. But that 573 percent gain was not achieved the same way in every 20-year period. Sometimes there’s a spurt at the end, other times in the beginning. For example, the 20-year period that ended in 2002 — despite the huge drop in the last three years — produced a total return of 992 percent, an impressive figure.
So keep in mind, as you perform your spring cleaning, that a broadly diversified all-stock portfolio is not as wild and crazy as it may seem. But whatever asset-allocation plan you adopt, get going now. It’s why they call it spring.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. This column originally appeared in the Washington Post.