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Smart Advice for the HuffPost Investor

I am thinking of calling my next book. Some of the questions I answer in this week's column reflect similar gloomy sentiments.
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I am thinking of calling my next book The Smartest Doomsday Prediction You'll Ever Read.

After all, if you want to write a best-selling book, predicting disaster for the U.S. economy seems like a sure bet.

It worked for Howard Ruff. His book, How to Prosper During the Coming Bad Years, racked up huge sales in 1979. Ravi Batra's, The Great Depression of 1990 topped the best seller list in 1987. These are just a few of many examples.

Some of the questions I answer in this week's column reflect similar gloomy sentiments.

Please ask questions for consideration in next week's column by adding a comment to this blog. I appreciate all of your questions and will continue to do my best to answer as many of them as I can.

Question From DavidJames


I understand your approach to diversification. Why do you only put 30 percent of your example portfolio's equity investments in overseas investments?

Wikipedia indicates that 75 percent of the world's assets are outside the U.S.

Shouldn't the portfolio's distribution of assets mirror the world's, for ideal diversification?

Right idea but wrong benchmark.

Instead of assets, you want to look at "global equity capitalization." This is a far more accurate measurement of economic size.

Market capitalization is computed by taking the share price and multiplying it by the number of shares outstanding in a public company.

The total global market capitalization is approximately $51 trillion. Domestic (U.S.) stocks currently account for 44 percent of the total global equity capitalization.

You could make an argument that your allocation of domestic versus foreign stocks should mirror these numbers. If so, you would increase your foreign exposure to 56 percent. However, I would not recommend it.

Some studies have shown that you can achieve maximum diversification benefits from exposure to foreign markets by allocating between 20 percent and 40 percent of your assets to those markets. As you increase your foreign exposure, these benefits diminish.

The same studies show that allocations above 30 percent - 40 percent do not reduce volatility by any significant amount and may even increase volatility during certain time periods.

Finally, most advisors recognize what could be called a "regional bias" towards the domestic economy. For this reason, they generally recommend overweighting domestic holdings. For example, when I wrote the Canadian Edition of The Smartest Investment Book You'll Ever Read, I recommended that Canadian investors invest 10 percent of their assets in Canadian stocks, even though Canada accounts for only about 2 percent of the world's economy.

If you recognize these issues, and believe you can cope with them, it might indeed make sense for you to increase your exposure to foreign markets to reflect their increasing dominance in the world's economy.

Question From MamaRage:

My question is: I often see advice that in the couple of years before retirement, one should move one's investments away from equity funds into bonds. But, I am a very healthy 60 with both parents still living (83 and 82 years) and Dad's still working just for the fun of it! Shouldn't I be more concerned about inflation over the next 30 years? Thank you

You are absolutely correct. Not all those nearing retirement should be heavily invested in bonds. Each situation is different. And you are very wise to be concerned about the ravages of inflation, which could seriously affect the quality of your life by reducing the purchasing power of your retirement nest egg.

Take the asset allocation questionnaire here or the Risk Capacity Survey. It will tell you what an appropriate asset allocation should be for you. Then proceed accordingly.

Question From Fewkes

I am retired and have an account with a broker that I like. My retirement IRA is in a fund that has been performing well for the 1 1/2 years that I have been in it and the broker says it has been averaging a conservative 6 to 8 percent a year. How do I tell if it is diversified?

A diversified portfolio has exposure to the domestic stock market, the foreign stock market and the bond market.

Specifically, the Russell 5000 is a benchmark that gives you broad exposure to the domestic stock market. The MSCI EAFE Index measures the performance of the international equity markets. The Lehman Aggregate Bond index measures the performance of high quality bonds in the U.S. bond market.

The best way to achieve this diversification is through low cost index funds, either individually or using a balanced fund or a life-cycle fund.

Unfortunately, few brokers recommend index funds. If your broker is an exception, hold on to him. If he isn't, consider investing directly with Vanguard, Fidelity, Charles Schwab or T. Rowe Price, but be sure to request their index funds that use these benchmarks, and not their actively managed funds.

Question From twgbonehead


I have a question. What is the rationale behind "rebalancing" your portfolio? I have always felt that you should balance your contributions, and then let them ride (slowly transferring funds from stocks to bonds as you get closer to retirement).

The market doesn't tend to go in one-year cycles; it tends to move over multi-year cycles, and therefore annual rebalancing tends to move funds from overperforming areas to underperforming areas. (For example, look at the slide from '01 onward - I cringed every time the talking heads said "Don't forget to rebalance" as the market continued it's long-term slide.

At the very least, could you run a comparable analysis of this "set-it-and-forget-it" strategy vs. one that includes rebalancing?

I can understand your confusion since rebalancing can be counter-intuitive. After all, who wants to sell an asset class that is going up and buy more of one that is going down?

However, rebalancing is a critical part of portfolio management. When you determined your asset allocation, you took into account your tolerance for risk, your time horizon and your investment objectives.

Because stock and bond returns vary over time, unless you rebalance, you may find that you are taking too little or too much risk. Both scenarios can cause big problems.

Most experts advise rebalancing at least once a year. You don't want to rebalance unless your percentage of stocks or bonds deviates by more than 5 percent. Remember, rebalancing may involve both transaction costs and tax consequences, so you should only do it when it is necessary.

You can avoid rebalancing by investing in life-cycle funds (sometimes called "target funds") or in balanced funds. The fund managers of these funds do the rebalancing for you. However, if you decide to go this route, be sure that the underlying funds are index funds and not actively managed funds. Vanguard is a good resource for these funds.

Question From Mr. Fitz

Invest in an index fund? That's old news. What's so special about Vanguard?

Everyone is always looking for something that correlates directly with returns. Here it is: low costs.

Vanguard has historically been the lowest cost provider of index funds. However, competition is heating up. You should consider Fidelity, Charles Schwab, and T. Rowe Price as well.

Your final decision is really very simple. If two index funds have the same benchmark (like the Wilshire 5000), pick the one with the lowest expense ratio.

As for "old news", you are right. Unfortunately, given the hype of the securities industry and the financial media, this "old news" is lost on most individual investors (but not on institutional investors!).

Any objective review of the long term historical data that compares the returns of a properly diversified portfolio of index funds to a comparable portfolio of actively managed mutual funds or a portfolio of stocks and bonds, would demonstrate superior returns from the index fund portfolio. Yet, millions of investors ignore this data. Why? Because brokers steer them towards high commission, expensive and underperforming actively managed funds.

If index funds were high commission items, 90 percent of the investing public would own them.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

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