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April, 2013

SIMPLIFYING PORTFOLIO MANAGEMENT
by LARRY

The truth is that for many, actually most, amateur as well as professional investors, the returns are insufficient to justify their efforts or expenses. Unfortunately, 80-90% come up short, taking larger risks but accumulating fewer gains than if they had simply purchased exchange traded funds that mirror the performances of the major stock averages. Yet there are mixes of just a few assets which tend to pump out returns at lower than those averages' chances of loss of principal and/or that offer levels of return superior to the indexes. Unless one genuinely enjoys investing as a hobby, why not try strategies, then, which are simpler than researching individual stocks and also that more reliably yield adequate if not superior profits?

In my own experience, for example, while I like an investing avocation a lot, the same cannot be said for my spouse. I turn 70 this year. Chances are, at some point I shall want an easier way of managing our nest egg and/or she may be called on to take over. Whether one manages one's own finances or assumes that role from someone else who (perhaps due to recent disability or death) is no longer able to oversee them, the notion here is to simplify the administration of liquid holdings, obtain good risk-adjusted nest egg returns, avoid a steep learning curve for the individual now controlling a portfolio, and limit one's cost in time away from preferred activities.



The easiest stance may be to leave well enough alone, assume the creator of the portfolio knew what he or she was doing, and allow the accumulated holdings to merely stay in the accounts for the long-term. These assets likely will provide a decent overall total return in days ahead. One might therefore do better to resist one's own impulses or calls by others to cull from or cut down all of a still abundantly fruit-bearing financial orchard. Contrary to popular notions, when it comes to one's equities, doing nothing can frequently be the best solution. Suppose one already had in that nest egg, for instance, strong holdings like Berkshire Hathaway (BRK/A or BRK/B), Coca-Cola Company (KO), or International Business Machines Corp. (IBM). These would likely provide good growth of earnings and hence, sooner or later, of market price going forward. Were these coupled with 3-4 dozen good dividend providers acquired when among the better values for their yields, equities such as Aegon, N.V. (AEG), Apollo Investment Corp. (AINV), AstraZeneca, PLC (AZN), AT&T (T), Kohlberg Kravis Roberts and Company, L.P. (KKR*), Royce Value Trust (RVT), and Templeton Emerging Markets Income Fund (TEI), the combined portfolio might well offer all one could wish in terms of low maintenance performance as well as income. So why change it?

There may be good reasons, though, for redeeming some or all of those assets. Cash might need to be raised, an estate might have to be settled, the cost basis may have favorably changed at the death of one's spouse (so it is appropriate now to weed out long held and profitable shares that hitherto needed to be kept lest the sales add to taxes), one-time or ongoing gifts to relatives or friends could be desired, holdings might better be converted into more income producing investments, etc.

*Please note that KKR is a limited partnership, so if investing in it one may prefer to avoid some extra tax forms by holding this security in a tax-deferred account.



Assuming one intends to sell individual assets from a portfolio of stocks or mutual funds and has planned as well to keep a prudent reserve, what is one to do with the balance? If part or all of the original nest egg has been converted to cash reserves, here are six viable choices, ranging from least to most potentially lucrative:


1. Place all the funds in Vanguard Balanced Index Fund (VBINX), preferably dealing with Vanguard directly so as not to need to pay extra costs to an intermediary, and arrange for a regular monthly check from the gradual sale of one's shares, not to exceed 5% of the total annually. (While there may be down years, on average this fund has provided reasonably low risk and low fee total returns of about 8% a year, so the 5% limit should assure both an emergency reserve and regular income as long as needed.)


2. A bit farther up the complexity and return ladder, is the "Permanent Portfolio" pioneered by Harry Browne. With this method, one merely invests an equal amount (25%) in each of four categories: cash reserves, gold, U.S. stocks, and U.S. bonds, then rebalances the portfolio account once a year. The average annual return from this technique over the past 40 years is reported to be 9.5%, and the biggest loss in any one year was 5%. (Some question, however, if this type portfolio could do as well after gold has recently been on such a tear or in periods of low to rising interest rates, such as they see ahead.) At a compound rate of 9.5% and excluding taxes, after ten years $500,000, left fully invested, would be worth $1,239,150.


3. An easy approach is the following one-fifth each portfolio made popular by Mebane Faber, to be rebalanced and returned to 20% per allocation, as I understand it, whenever one or more of the categories are 10% under or over their target ratios, not to exceed once a year: domestic stocks (investing for this category in VTI, an exchange traded fund); foreign stocks (VEU); bonds (BND); real estate (VNQ); and commodities (DBC). Over the years, this kind of strategy has had returns averaging about 10.7% a year, yet with lower risk than for the S&P 500 Index. A similar portfolio, analyzed since 1972 and rebalanced yearly, had a maximum drawdown of slightly more than 31% (in 2008), or about 75% that of the S&P 500 Index. At a compound rate of 10.7% and excluding taxes, after ten years $500,000, left fully invested, would be worth $1,381,000.


4. Next up is a method that combines domestic and international funds and so is more complex, but the annually rebalanced results of such a portfolio since 1985 would have averaged a little better than 11% a year. The worst decline in any one year (2008) would have been 20%, about half what the major market averages lost then. Here are the assets and their percentages for this strategy, also to be rebalanced once a year:

  1. 25% in a money market account;
  2. 25% in Vanguard Small-Cap Value Fund (VISVX), a domestic equity mutual fund;
  3. 12.5% in Templeton Emerging Market Fund (EMF), a value oriented foreign closed-end stock fund;
  4. 12.5% in Templeton Dragon Fund (TDF), a value oriented China equities closed-end fund;
  5. 12.5% in Vanguard Total Bond Market (BND), a domestic bond exchange traded fund;
  6. 6.25% in Templeton Global Income Fund (GIM), a global closed-end bond fund; and
  7. 6.25% in Templeton Emerging Market Income Fund (TEI), an emerging market closed-end bond fund.

At a compound rate of 11.0%, excluding taxes, after ten years $500,000 left fully invested would be worth $1,420,000.



5. Combining simplicity, relatively low risk, and competitive returns, my personal favorite, like the Permanent Portfolio, is a four-asset blend, rebalanced annually, with 25% allocated to each of:

  1. Domestic equity small-cap value (VISVX);
  2. Emerging market (VEIEX);
  3. 5-Year T-Bills (VFITX);
  4. Global bonds (PIGLX).

Since 1985 (global bond assets not having been widely available before that), backtests have shown that a portfolio like this would have had an average rise of 11.8% a year with a maximum drawdown (2008) of 18.6%, less than half the maximum drawdown for the S&P 500 Index in the same period.

At a compound rate of 11.8%, excluding taxes, after ten years $500,000 left fully invested would be worth $1,525,000.



6. Finally, here is a simple yet aggressive portfolio, one potentially with higher rewards, yet it is also a more volatile alternative. This allocation is perhaps most appropriate for the younger investor. He or she likely will have plenty of time to wait out periods of greater losses and so take full advantage of the eventually greater gains this mix has to offer. A portfolio similar to this had average annual backtest returns since 1985 of 12.9%. Its worst year performance was in 2008 when it lost 28.6%, roughly two-thirds what the major averages declined that year. This five-asset portfolio includes both foreign and domestic funds to be rebalanced annually:

  1. 20% in Vanguard Small-Cap Value Fund (VISVX), a domestic equity mutual fund;
  2. 20% in Templeton Emerging Market Fund (EMF), a value oriented foreign closed-end stock fund;
  3. 20% in Templeton Dragon Fund (TDF), a value oriented China equities closed-end fund;
  4. 20% in Templeton Global Income Fund (GIM), a global closed-end bond fund; and
  5. 20% in Templeton Emerging Market Income Fund (TEI), an emerging market closed-end bond fund.

At a compound rate of 12.9% and excluding taxes, after ten years $500,000 left fully invested would be worth $1,682,500.



Meanwhile, back to the original choice of keeping one's nest egg, consider at least retaining the dividend providing stocks already in one's accounts. Chances are they will grow enough to keep up with inflation while also adding income. And, more often than not, stock shares which are sold go on to perform as well as if not better than the major market averages.

Yet in case it is necessary to harvest a portion of an estate for extra income, a viable choice may be to make a contribution of the shares or cash in question to a fiscally sound non-profit foundation which returns part of the donation annually in the form of a charitable remainder annuity trust (CRAT).

Revenue available from the charitable giving of stock shares or of other parts of one's estate can vary both by the foundation and by the prevailing federal rates. The charitable annuity idea is not recommended when the income return from a CRAT is low. In my opinion, one could do better then by following any of the above approaches.



If required, advice on such matters can be sought from a fee-based certified financial planner. Assuming, though, that a sufficiently large annuity can be obtained through one's generosity, often it is possible to deal with well established charitable foundations directly. Many have the forms ready which one might need, and one could just check with a trusted and/or well recommended lawyer to be certain one's interests are adequately protected before signing and sending them in, hopefully assuring a sufficient income stream for the remainder of one's days.

While there are no guarantees of the indicated portfolio management returns noted above and one will certainly wish to do further research to see which approach fits his or her situation, hopefully this summary usefully introduces to the topic.



DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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