The model portfolio tracked in this blog is quite aggressive, seeking to hold 3-5 sector funds that give the portfolio the best chance for growth in coming months.  Although the holdings in the model portfolio are desirably not strongly correlated with one another, they lack the diversity of a traditional portfolio.  A monthly chart plotting movement of the model portfolio relative to the S&P 500 is therefore also typically provided, graphically illustrating efforts to keep the portfolio’s volatility reasonable relative to the S&P 500.

Although model portfolio volatility has been modest over the past several years given the increased performance realized, many investors have a longer time horizon for investment, and seek more diversified investments that can be held for longer periods (such as a year) between portfolio reviews.  A diversified portfolio (not including bonds, which may constitute up to 30% of such a portfolio for retirees or those wishing to further minimize volatility) is therefore provided here as a reference, such that it can be reviewed and compared against this blog’s more aggressive model portfolio.

The diversified portfolio (Feb 1, 2014) includes:

Ticker             Value             Shares
ARTJX          $100,000      3776.4          Artisan International Small Cap
DODGX        $300,000      1836.9         Dodge and Cox Stock
OAKIX          $200,000      7874.0         Oakmark International
PRSVX          $200,000      4133.9         T Rowe Price Small Cal Value
VASVX          $200,000      7352.9         Vanguard Select Value

Although the fund appears on its face that it may be biased toward international (30%) and value (40%) stocks, use of a portfolio analyzer tool such as Morningstar’s professional portfolio manager indicates the this combination of funds is 57% large cap, 24% mid-cap, and 18% small-cap, with 33% value, 36% core, and 32% growth stocks.  The diversified fund is 62% North American and 22% European, with only 2.25% in riskier Asia emerging markets and .5% in Latin America.  There is nearly no stock overlap between funds, with DODGX and VASVX both holding Capital One Financial (COF) at 1.6% total the only significant duplicate.

A diversified fund such as this is suitable for most passive investors with a long-term time horizon, and can be supplemented with a bond fund (such as PTTAX – Pimco Total Return) in an amount up to 25% or so for those wishing to further reduce volatility (note that increasing bonds beyond about 30% or so in such a portfolio has been shown to reduce portfolio returns without meaningful reduction in volatility).

Through the last year, the S&P 500 is up from 1462 to 1832 (25.3%), while the Morningstar value portfolio is up 21.2%.

Of the stocks in the original portfolio, Facebook nearly doubled (99%), Amazon was up by 55%, and Applied Materials was up 50%.  Other significant gainers included Microsoft, John Wiley General Dynamics, Amgen, and Bank of New York.   Unfortunately, Potash lost 21%, and Weight Watchers lost 40% over the same period.

The portfolio as a whole slightly underperformed the S&P 500 in a relative bull market, suggesting that blindly purchasing a portfolio of stocks meeting Morningstar’s value criteria may not be an optimal investment strategy, at least in the bull market of the past year.

Through the first six months of the year, the S&P 500 is up from 1462 to 1606 (9.8%), while the Morningstar value portfolio is up 6.6%.

Applied Materials (+28%), Berkshire Hathaway (+23%), Microsoft (+26%), and Western Union (+23%) stood out as winners, but the portfolio had double-digit losers in Weight Watchers (-14%) and CH Robinson (-12%) as well.  As before, many companies in the portfolio remain good values, but simply are not among the more popular or trendy stocks currently.

Although the portfolio may remain a quality long-term investment short-term performance has been mixed so far.

As it turns out, buying the “unloved” stock examples Blackberry and Netflix would have dramatically outperformed the Morningstar stock portfolio of 20 undervalued stocks through the first quarter, as the portfolio returned only 1.4%.  Note the S&P 500 was up 7.4%, and our unloved examples of BBRY and NFLX (very risky/volatile) would have been up 60%.

Although the Morningstar value portfolio did well with a few picks such as Berkshire Hathaway and Excelon (+15%), it also had poor picks like Weight Watchers (-23%) that weighed down the portfolio.  The performance difference between the hand-picked stock examples and Morningstar’s portfolio of undervalued wide-moat stocks is largely due to earnings and product announcements from BBRY and NFLX, as well as somewhat broader interest in these names than in most companies in the Morningstar portfolio.

Many of the Morningstar portfolio stocks remind me of another holding I have – China Gueri (CHOP), a Chinese specialty metal producer that is tremendously overvalued but isn’t on many people’s radar.  The price of a stock is based both on the free cash flow of the underlying company and on market sentiment, and it seems market sentiment may change with less-known stocks relatively slowly.

I’m not inclined to rebalance the Morningstar portfolio given the few changes and poor performance through the first quarter, but will revisit its performance in coming quarters.

So far, the fund has bought mutual funds and ETFs, but no stocks.  This is in part to minimize transaction costs and management complexity, and to benefit from the relative diversity offered by holding low numbers of mutual funds relative to low numbers of stocks.

While it’s tempting to buy unloved stocks such as Netflix or Blackberry hoping they’ll break out, or buy Apple based on its historic market leadership and low price/earnings ratio, building a stock portfolio can be perilous.  Many investors buy “hot” stocks once they’ve become hot, often capturing the common fall back to Earth rather than further price appreciation.  Investors who do not research stocks full-time also often hold too few stocks to build a portfolio having tolerable volatility, and tend to not dedicate the weekly time needed to follow each stock (much less to scout for potential new purchases).

I’ve recently started tracking a stock portfolio based on long-term performance of undervalued stocks selected by formula, proposed by Morningstar and said to return 17% on average.  The new stock portfolio tracks 20 stocks Morningstar estimates to have the best price/fair value estimate, and that have a “wide moat”, or significant barrier to competition.  The portfolio started the year with $500,000, equally distributed among the following stocks, and will re-evaluate quarterly:

AMGN AMZN AMAT BK BRK-B CHRW CMP EXC EXPD ESRX FB GD INTC JW-A MLM MSFT NOV POT WTW WU

Wall Street investors often say “diversification is the only free lunch”, meaning that having a diverse mix of assets in a portfolio can reduce volatility while still producing acceptable returns. Volatility is often equated with risk, reasoning that a more volatile asset or asset class will have more significant variations in price than an asset with less volatility, and therefore be more risky.  Combining assets that are not correlated with one another into a portfolio can therefore be desirable to reduce or manage risk, as long as the returns of the uncorrelated assets are acceptable.

For example, while bonds are generally believed to have lower volatility and to be less risky assets than stocks, a modified portfolio of 75% bonds and 25% stocks is less risky than a portfolio of 100% bonds due to diversification and the lack of correlation between stocks and bonds, the two asset classes in the modified portfolio.  The modified portfolio of 75% bonds and 25% stocks produces a higher return than the portfolio of 100% bonds, though, due to stocks’ historically higher returns relative to bonds.

Similarly, an investor who is OK with the risk of a 100% bond portfolio can enhance overall returns by assembling a portfolio of 50% bonds and 50% stocks, which has roughly the same risk as a portfolio of 100% bonds but substantially higher returns.  Increasing the percentage of stocks further results in even higher returns, but with a risk or volatility greater than the risk of the bond portfolio alone.

These examples illustrate how combining two assets, or asset classes, results in returns that are an average of the returns of the proportionate asset classes, while risk can be reduced to less than that of any one of the combined asset classes alone.  This only holds true for assets or asset classes that are not strongly correlated, though, as it should be no surprise that combining two portfolios having similar volatility and returns that are 100% correlated with one another simply produces a bigger portfolio with the same volatility and returns as the constituent portfolios.

The funds in the model portfolio presented here therefore desirably represent asset classes that are not strongly correlated with one another.  For example, a portfolio of energy, natural resources, energy services, and precious mineral funds or ETFs would be expected to have significant overlap, and strong correlation in price movement between the funds.  The current model portfolio of housing, biotech, and emerging markets dividend stocks does not have any such obvious correlation between asset classes, and is likely to have lower volatility than any of the constituent funds alone.

Because the return of an evenly weighted portfolio of uncorrelated funds is the average of the return of the independent funds, we can therefore produce a portfolio having a return that is the average return of the individual funds while experiencing lower volatility than the average volatility of the individual funds.  Average returns + lower than average volatility = Free Lunch!  The task for the investor remains choosing few enough funds for the portfolio to produce the expected higher returns of more favored asset classes or funds while having enough uncorrelated funds or asset classes represented to reduce risk to acceptable levels.

For the model portfolio, that’s three to four funds not strongly correlated with one another held at any one time, depending on whether four diverse asset classes having expected high returns can be found at the same time.

Now that we know we’re seeking a return greater than 7% per year (and hopefully much greater), and can bear the volatility imposed by market cycles that typically last around seven years given the relatively long retirement horizon, we’re left to construct a portfolio that pursues high returns while managing volatility. We know that stocks have returned 11-12% per year on average, and bonds have returned an average of 5.5% over time.  We will therefore seek a diverse mix of stocks, bought using mutual funds and ETFs to reduce transaction costs and research needed to maintain a diverse portfolio.

High volatility is often associated with high returns, but we will seek to pursue high returns with a diverse mix of mutual funds or ETFs (which are themselves typically each less volatile than stocks due to the diversity of stock holdings within a fund) to manage volatility, being careful to spread assets among three or four high-performing funds that are desirably not strongly related or correlated with one another.  The relatively small number of funds reduces the risk of diluting returns from strongly performing funds with poorer performing funds, while diversity among funds helps reduce volatility of a portfolio that may have only a few relatively narrow asset classes represented.

Funds are sorted based on a few criteria – no sales loads or excessive fees for selling within a few months of purchase, and recent performance over the past year.  Preference is given to funds that have stronger performance over recent months, in an attempt to identify funds that are near the beginning of a positive cycle rather than near the end of a cycle of outperforming the market.  We therefore use a weighting of 1, 3, 6, and 12 month returns, similar to what is employed in the No-Load FundX newsletter, with additional attention given to diversity among funds, market conditions and events, and other factors.

Milton Friedman noted that “Inflation is the one form of taxation that can be imposed without legislation”, while polar opposite Vladimir Lenin observed that “The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation”.  Inflation is simply the result of increasing the supply of money, such that things cost more in the future than today.  While this seems entirely undesirable on its face, governments print money and willfully cause some inflation to stabilize declining economies, to reduce the cost of paying back previous debt, and for other such functions.  But, this comes at the expense of the average taxpayer, who loses some percentage of the value of their dollar-denominated assets every year to inflation.

Even a modest 3% inflation will eat away a quarter of a dollar’s buying power every ten years, or halve its buying power every 24 years.  Although the Federal Reserve has only two mandates, the first of which is to control inflation and the second to minimize unemployment, we’ve seen double digit inflation twice in my lifetime – from 1974-1975 and from 1980-1981.  The Fed’s stated target of 2-3% inflation target therefore cannot be considered a guarantee, or even a likelihood, given our tremendous debt and faltering economy.  The temptation to cut the cost of our debt in half by inflating the dollar 100% is strong, and politically more palatable to many politicians than raising income taxes, although the net result is similar.

Is the standard 3% assumption a reasonable one?  I sure hope so, but it may be too low.

We know that our estimated 7% yearly return in retirement minus 3% inflation gives us about 4% per year to withdraw as retirement income using the standard model, and have discussed whether 4% is reasonable for income, but what about our estimated 3% for inflation or 7% for returns?  This example shows that inflation is just as relevant to the effective value of retirement income in present-day dollars as rate of return or amount withdrawn per year.  If one guesses that inflation may average a percent or two above 3%, as I believe is possible, this must be reflected in either a rate of return higher than 7%, or a rate of withdrawal lower than 4%.  I’ve already determined that 4% withdrawal per year is unlikely to be a high estimate, which leaves me chasing returns higher than 7% per year.

We’ve determined that our goal is to save enough to withdraw at least 4% of retirement savings per year in retirement, while maintaining approximately the same standard of living.  Although average returns in retirement are often estimated at a conservative 7% rather than 4%, this includes an estimated 3% inflation per year.  In determining whether the same dollar amount per year in retirement is reasonable for my situation, it makes sense to consider other factors that may affect income or expenses:

Taxes: I fully expect my taxes will be higher by the time I retire, whether income is 70% or 150% of what it is now.  The government seems to have no shortage of ideas on how to spend my money, and I expect this problem will likely define our government for the next 30 years, much as we are starting to see in Europe. One can dodge some of this by paying taxes now using a Roth IRA or Roth 401(k) – more on this later.

Expenses: My two biggest expenses are currently my home mortgage, and saving for retirement.  These will both be gone once I retire, along with other significant expenses, such as my student loan.  Related costs such as property tax, insurance, utilities, and the like will not go away.  Some expenses like transportation and food are likely to remain similar to current levels as well, but may vary with the cost of resources.  Other expenses are likely to rise in retirement, such as money spent on travel, hobbies, and medical care.

Other Income: I already have enough work history to qualify for social security on retirement, and if I work until my mid 50s, I should receive noteworthy social security income at 67 (or whenever I elect to take social security).  I do not expect to work in retirement with the goal of generating income, but some hobbies on the horizon may produce modest income, reducing the burden on my retirement savings.

Lake home, boat: I’ve always thought this sounded like a nice way to retire, and if it’s economically feasible I’ll likely try to find a place on water to live in retirement.  I may downsize, but expect that with transaction costs, property taxes, etc., such a move will not be inexpensive.

Conclusion?  My expenses in retirement will not likely be significantly below what they are today (adjusted for inflation), and are likely to be similar if not somewhat higher.  I’m therefore saving to replace my entire income, and trying to save more to give me some additional freedom to live near water.   So, using the hypothetical current income of $100,000, my goal is to have an income of greater than $100,000 per year in retirement.

Most families that take summer trips wouldn’t dream of setting out without a destination in mind, but the same people will work and save for retirement for decades without even a vague set of goals. How then does one set a goal for retirement savings, and develop a plan against which to measure one’s progress?

Certified Financial Planners have long used a rule of thumb that one should plan to withdraw 4% of their retirement savings per year to have a sufficiently low (10%) chance of running out of money during an average 30 year retirement, reasoning that post-retirement investment will return about 7% and inflation will average perhaps 3%.

But, we’ve had abnormally low stock market returns over the past 10 years – low enough to throw a wrench in such a plan. Plus, I may wish to be retired longer than the typical 30 or so years, and may travel or pursue other hobbies that make yearly expenses somewhat greater than expenses during my working years rather than the 70-80% of pre-retirement income typically estimated by financial planners. I therefore wish to save more aggressively than this 4% rule dictates, enabling both a higher standard of living in retirement and the ability to weather potential volatility of post-retirement investments while seeking a rate of return higher than 7%.

Using a hypothetical yearly income of $100,000, the 4% rule suggests a retirement savings of $2.5M to retire. My goal is to surpass this percentage by a safe margin, using a fairly aggressive investment portfolio illustrated by the model portfolio associated with this blog.

Note I use fictional, round numbers for purposes of this example, which is not likely to directly mirror anyone’s exact situation. I’m 40, but my income and savings have been arbitrarily selected as $100,000 and $500,000 – a ratio more typical of an active saver nearing 50. It is my goal to bring that hypothetical $500,000 savings to an amount exceeding $2.5M, or multiply it by another five times before retirement in 10-15 years.

Next, how to get from here to there…