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How to Diversify Your Retirement Portfolio


Hey everyone, it’s DIY weekend at our rental. I’m going to replace a cracked sink, install a new toilet, clean the gutter, and fix the fence latch. That’s what you have to do when you manage your own 125 year old rental… Anyway, we have an article from Mike Lewis today. Next week, I’ll share the details of our DIY weekend.

By Mike Lewis

The key to a happy retirement is to have enough income to enjoy your life without undue stress and hassle. For most people, reaching that point will require access to funds beyond Social Security and Medicare. Of course, the total amount of income needed depends upon the lifestyle you choose once retired, whether you will have continuing responsibilities to others, and your probable lifespan. Regardless of whether you will need a little or a lot of extra income at retirement, it is almost certain that you need to save money today to have it for tomorrow – the accumulation of your savings is your retirement portfolio, and will be the source of your discretionary income.

If you imagine your portfolio today as an empty pail of water, your first step is to fill the pail as full as possible until you need to start draining it. The fuller the pail, the more often and the deeper you can drink; the greater your portfolio value, the more likely you can enjoy retirement without worry or hardship. The following keys can help you maximize the benefits of the contents.

Building to Retirement – Growth

During the first 20, 30, or 40 years of your working life, you will be building value upon which you will draw over your retirement span. It is to your advantage to invest as much as you can as often as possible, to build up your investments, and limit your losses.

1. Invest Regularly

Developing the habit of saving is difficult for most people, especially when you’re starting a family, buying a home, and educating children. As a consequence, many people don’t invest seriously until they are in their 40s, forgoing the advantage of compound earnings in their early years. Spending less than you earn, making wise decisions about your expenditures, and being able to differentiate between your “wants” and “needs” is critical if you are going to be a successful investor. Controlling your lifestyle helps you save money when you are young, and get the biggest bang for your buck when you are retired.

2. Maximize Tax Advantage

Over your lifetime, you are likely to pay hundreds of thousands of dollars in various taxes. You have no choice in the payment of some, but others can be eliminated or reduced with a little forethought and strategic planning. Since your goal is retirement savings, you should be participating in an IRA or 401k, both of which allow you to invest money on a tax-deferred basis. Long-term capital gains are taxed at half the rate of short-term gains. Employing a health savings account or medical savings account minimizes the after tax cost of healthcare. There are dozens of tax deductions and credits for federal income tax, some of which may be available to you. Take the time to understand taxes and minimize the bite on your current income and asset accumulation.

3. Focus on Technology & Biology ETFs

Study after study has questioned whether an individually managed portfolio of common stock can out-perform an unmanaged exchange-traded stock index fund (ETF), especially when management and transaction fees are included. Equities have historically been one of the best vehicles for long-term growth, combining liquidity, choice, and consumer regulation to be the foundation of most retirement funds. Picking individual winners among the thousands of securities traded worldwide is a difficult (if not impossible) task for the average nonprofessional investor. As a consequence, an ETF is the perfect vehicle for retirement plans.

At the same time, we are in the midst of a technological and biological revolution driven by an increasing pace of new discoveries with the capacity to transform every aspect of human life. Investing in a broad selection of companies in these industries increases the chance that investors have a stake in the specific companies that will be super-successful. Technology and biotech ETFs can provide this opportunity.

4. Diversify to Reduce Risk

There have always been two theories of financial success: Invest in a basket of opportunities (securities, for example), thereby reducing the risk of missing out on winners, or concentrate your investment in onesituation and carefully monitor it. Most investors lack the expertise, as well as the time, to select the optimum investment or watch its performance closely. Since picking the wrong investment can be catastrophic, it makes no sense for most investors to rely on a single investment for their retirement security. Diversify your retirement portfolio by different companies, different industries, different investment vehicles, even different country economies. Eliminate losses as much as possible, and let the magic of compounding interest work in your favor.

After Retirement – Income

When you finally reach the point at which you wish to retire, you should alter your investment strategy and transform your portfolio to a defensive stance where losses are less likely and regular income is probable. Losses once you’ve quit building your assets are much more difficult to overcome, if for no other reasons than that you’re unlikely to add to the corpus from income, and the balance is likely to be depleted over time with regular withdrawals.

1. Balance Your Portfolio

The most popular advice given to new investors is to invest when stocks are low, and sell them when they are high. Clearly, this strategy would be effective if it could be followed, but as investors quickly find out, it is difficult to put in practice. Balancing your portfolio is a sure way to implement this advice, selling only when you have profits and buying when the new investments are out of favor. For example, if you are pursuing an aggressive investment strategy, your $100,000 portfolio might be comprised of 70% equities, 20% fixed income, and 10% cash-equivalents.

Over time (and you should check your portfolio at least once per quarter), your portfolio due to stock appreciation will have grown to $115,000 and is comprised of 74% equities, 17% fixed income, and 9% cash. As a consequence, you would sell $5,000 of your equities and invest $3,000 of the proceeds in fixed income and $2,000 in cash-equivalents, restoring your portfolio to the desired 70-20-10 mix – or $80,000 in equities, $23,000 in fixed income, and $12,000 in cash. If the fixed income proportion had grown out of balance, you would sell bonds and buy stocks to restore the desired portfolio proportions.

2. Utilize Fixed Income Ladders

Fixed income securities should be a portion of every portfolio, and the use of a bond “ladder” reduces the risk of interest rate fluctuations. Bond prices move in according to interest rate movement and the time remaining until maturity. In other words, a bond’s value moves up or down in an opposite direction of interest rate movement, the extent of price movement based on the remaining term.

A bond ladder is simply proportioning your bond portfolio into a series of annual maturities so that one bond (or portion of your portfolio) matures at the end of year one, a second portion matures at the end of year two, and so on. A 10-year ladder would have 10% of the bonds maturing each year and reinvested in a new bond with a 10-year maturity; an eight-year ladder would have 12.5% of the bonds maturing each year and the proceeds invested in a new bond with an eight-year maturity. Using a bond ladder protects your portfolio and ensures a constant cash flow.

3. Add Real Property Investments for Higher Income

Historically, real estate investors have enjoyed a combination of asset growth, steady income, and tax advantages. Though results have been lackluster in recent years due to speculation and over-building, real estate ownership remains attractive. Investors in or nearing retirement should consider placing a portion of their investment portfolio into direct ownership of rental property, either commercial or residential.

Joe of Retire By 40, purchased a duplex in 2014 and expects to make about $5,000 per year on this investment. Joe is actively involved in managing his investment, a responsibility not everyone is capable of or desires to assume.

Investors looking for a passive investment should consider:

  • Triple net leases of commercial property such as a McDonald’s restaurant property, a Kindercare nursery facility, or a Walgreens. These properties are owned by the investor and leased to a major company, which has total financial responsibility for all of the costs (taxes, insurance, maintenance), as well as rent during the term of the lease. At the end of term, the property reverts to the owner and can be either released or sold. Income during the lease term is usually sheltered from taxes due to depreciation, and the property, in a good location, will escalate in value. The drawback is that each investment is a single, specific property so there is no diversification.
  • Real estate investment trusts (REITs) own and manage real estate properties such as apartments and commercial buildings. They must distribute at 90% of their income each year to trust holders as dividends, a portion of which is attributed to return of capital (depreciation) and not taxed. Yields historically have generally been higher than for stocks. Their shares are sold on stock exchanges, and are very liquid. REITs also have little correlation with the stock market, so they reduce risk in an overall portfolio.

4. Include Royalty Income Trusts in Your Portfolio

Royalty trusts generate income from the production of natural resources such as coal, oil, and natural gas. The income and distributions each year depend upon the price of the underlying energy asset. For example, if the price of oil goes up, the income from the trust also increases.

The trusts have no physical operations and no management – simply the ownership of the underlying physical assets which are produced by other companies. The yields are unusually high, since all income received by the trust must be distributed to trust holders less an administrative fee. There are tax-advantages, such as no corporate income tax (so no “double taxation”), as well as deductions for depreciation and depletion. In addition, a portion of the distribution is considered a return of capital and not taxed at all. The single drawback is that the underlying assets are finite so that the total amount of assets is reduced as the asset is produced.

Final Thoughts

Retirement is the Holy Grail for most workers. However, the latest report from the National Institute of Retirement Security released recently suggests that 45% of families have no savings, and that the median retirement savings for households between the ages of 55 and 64 had only $14,500 in their retirement accounts. Clearly, what we want and the actions we take to achieve our wants lack correlation.

Track Your Investments

Lastly, here is a way to easily track your investments – sign up for Personal Capital. Personal Capital is a great free site for investors. They have many tools that can help you keep track of your investments including the 401k Fee Analyzer and the Retirement Planner. I log on to Personal Capital almost every day and they have been extremely useful. (This is an affiliate link and we may receive a referral fee if you use this link to sign up with them.)

Are you saving at a rate that will allow you to retire comfortably? 

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Joe started Retire by 40 in 2010 to figure out how to retire early. He spent 16 years working in computer design and enjoyed the technical work immensely. However, the job became too stressful and Joe retired from his engineering career to become a stay-at-home dad/blogger at 38. Today, he blogs about financial independence, early retirement, investing, and living a frugal lifestyle.

Passive income is the key to early retirement. This year, Joe is increasing his investment in real estate with CrowdStreet. He can invest in projects across the U.S. and diversify his real estate portfolio. There are many interesting projects available so sign up and check them out.

Joe also highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help DIY investors analyze their portfolio and plan for retirement.

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{ 6 comments… add one }
  • Ali @ Anything You Want August 21, 2015, 10:47 am

    These are great points. I save as much as I can towards retirement, but at 27 I feel that retirement is just too far away for me to know if I am really saving “enough.” My best is all that I can do though.

    I think your point about diversity is particularly important when investing for retirement. When you have such a long time horizon, you just want to make sure you’re going up with the overall market, not beholden to any specific winners or losers.

  • Steve Miller August 21, 2015, 9:13 am

    Great article. I was wondering why you suggest investing in a bond ladder. Why not just purchase a bond fund (like FSITX or VBTLX), that way you don’t have to deal with the maturities.

  • Marco August 21, 2015, 9:05 am

    Hi Mike – Thanks for the timely article. The markets have been getting slammed lately and I’m appreciating your 70, 20, 10 allocation. I’m having a hard time figuring out the right allocation for me, since I own a rental condo outright and it’s a big chunk of my net worth. With the condo, my allocation is: Condo 39.54%, cash 26.18%, stock funds 30.21%, Bond funds, 4.07%. If you remove the condo from the equation, it changes drastically to cash 43.30% stock funds 49.97%, Bond funds 6.74%. I know these are good problems. Any tips would be much appreciated. Cheers.

  • Bryan @ Just One More Yearb August 21, 2015, 8:01 am

    We have already saved at a rate that will allow us to retire comfortably. We did this through a combination of retirement accounts invested in stocks and bonds, personal savings, and rental real estate.

    I plan to branch out in the future to a couple other passive income areas, the first being peer to peer lending.

  • Justin @ Root of Good August 21, 2015, 7:49 am

    We’re in the retirement income phase of life now. Diversification and keeping a cash buffer of a few years is how we keep sane and keep long term growth coming!

    As for real estate, we don’t want the hassles of rental real estate so stick with owning our own primary residence outright plus holding 11% of our portfolio in REITs (US and international).

  • Dave in Sunny FL August 21, 2015, 5:18 am

    An excellent, excellent article! Much appreciated. If the author is up for it, a follow-up on retirement strategies would be fantastic (the glide paths, the ramp-up, etc.). What a wonderful job! One element of real estate investing I wanted to mention that is not in the article is leverage (Other People’s Money). You get to use it, buying real estate, but not in buying REITs. I would categorize REITs as a commodity investment (like an oil company ETF), rather than a true investment in property.

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