No one portfolio is suitable for all investors and no lifestyle or target date fund has a portfolio that is appropriate for all investors of the same age or projected retirement date. Building a portfolio that is tailored specifically to you is a better way to go.

Some Key Issues to Understand About Yourself:

When designing your own portfolio, you need to take into consideration at least these issues:

1. Your level of need for current income from your portfolio
2. Your tolerance for volatility based on requirements for capital withdrawals to pay for lifestyle or particular capital needs, such as college tuition
3. Your level of emotional tolerance for portfolio value fluctuation
4. Your ability to replace potential capital losses with earnings from work
5. Your other assets and sources or income, such as rents or pensions
6. Your ability, willingness, available time and self-discipline to research and manage your portfolio’s assets
7. The level of total return you seek and your time horizon for achievement of expected returns.

Lifecycle / Target Date Funds:

The lifecycle / target date funds concept is based on a simple principle that has some merit, but that must be tweaked for each specific investor. The principle is similar to Ibbotson’s ratio of “human capital” versus “financial capital” to describe the investor’s condition.

Human capital represents future earnings potential, whereas financial capital represents realized asset accumulation. Your total capital is the sum of the two.

When you are young and beginning your investments, you have 100% human capital and 0% financial capital. After you retire and reach the point that re-employment or operating your own business is no longer a reasonable option, you have 0% human capital and 100% financial capital.

The problem with lifecycle / target date funds is that different people do not reach the same points on the human capital - to - financial capital scale” (“HC-FC scale”) at the same ages or upon retirement from a career or upon selling a business.

Lifetime Capital Sufficiency:

We think it’s important to add another scale perpendicular to the HC-FC scale. Let’s call it the lifetime capital sufficiency scale (“LCS” scale). It is indexed to that point in life (whatever the chronologic age) that the amount of accumulated financial capital is just sufficient to supply all of the money you need for the rest of your life to maintain your lifestyle, and to fund any capital payments that are in addition to life style. That lifetime capital sufficiency would be rated 100%.

The two scales together on a chart make for an interesting plot of your condition as shown here.

You can see on the chart that the LCS scale goes from 0% when you have no financial capital to 100% when you have just enough to live all your remaining life on your assets without working again. The scale continues to amounts in excess of lifetime capital sufficiency.

Notice that chronologic age does not appear anywhere on the chart.

You could think of your “financial age as 0 to 100 on the “% Total Capital as Financial Capital” scale (the inverse of “% Total Capital as Human Capital”), but your chronologic age is only important in estimating the number of probable years of remaining life. Even then other factors come into play. Someone 80 years old could live for 20 years or more, while someone with a terminal disease at age 45 may have less than 3 years to live.

Problem With a Popular Maxim:

For those reasons, we find the old maxim, “Hold you age in bonds” (e.g. 50% bonds at 50 years of age) to be overly general and inconsistent with the diversity of conditions that one may be in, as suggested by the chart. Maxims may be born in wisdom, but cannot be applied blindly across the board to every person and situation. Lifecycle and target date funds are flawed in the same kind of way. They are overly general and do not recognize the myriad of conditions (including financial age and lifetime capital sufficiency) of specific investors.

If you reach 100% lifetime capital sufficiency at any age (G, F, H, C and D on the chart), you could retire then and there.

If you reach 0% human capital and do not have 100% lifetime capital sufficiency (E on the chart), you are in trouble.

If you reach the 0% human capital / 100% financial capital / 100% lifetime capital sufficiency condition (C on the chart), you are OK, but you have little room for mistakes. You may need to give capital preservation priority over capital appreciation to minimize the risk of outliving your assets due to the combination of regular withdrawals and portfolio volatility.

If you reach 100% financial capital (0% human capital remaining) and your lifetime capital sufficiency is well beyond 100% (D on the chart), you can reasonably choose between a capital conservation, low volatility, income biased portfolio; or a more aggressive pursuit of capital appreciation with attendant higher volatility and possibly less income bias.

Similarly, if you reach 100% lifetime capital sufficiency level, but have not yet reached 100% financial capital stage — more human capital remaining — (F on the chart), you do not need to be as conservative or income oriented as if you had no remaining human capital.

As you plan your portfolio, evaluate the seven issues listed above and try to place yourself in the chart of financial capital, human capital and lifetime capital sufficiency to orient yourself before you make your investment decisions.

Richard Shaw
QVM Group LLC

As you select asset classes and class weights for your portfolio, you should take into consideration, among other things, the mean return of those classes over different periods of time.

History is no guarantee of the future, but lack of understanding of the past may result surprising returns. It’s a good idea to do all you can to minimize surprises.

The chart shows the relative 1, 3, 5 10 and 15 year annualized returns for six major asset classes. The key feature to observe is the relative size of the return for each class within each year.

You can see bonds as a low return, but stabilizing asset class. You can see the US market has been weak relative to foreign markets. Commodities have been strong. Real estate did well, until it fell out out bed in a major way during the last 12 months.

A representative (but not exhaustive) list of index funds for those classes is:

• US Total Stocks: VTI, IWV and IYY
• Foreign Developed Market Stocks: EFA
• Foreign Emerging Market Stocks: EEM and VWO
• US REITs: VNQ and IYR
• Global Commodities: GSG and DJP
• US Aggregate Bonds: AGG and BND

Richard Shaw
QVM Group LLC

The wages of work have not been so great for most Americans in the last few years — barely keeping up with published inflation, which we all know is far below real inflation when energy and food are included.

The wages of ownership, however, have been much better. Over the past 45 years or so, dividends paid to investors by the S&P 500 index have risen by an average of about 6%.

Except for unusual 11+% dividend growth in the last 5 years, dividends have grown on average between 5.5% and 6.5% per year; depending on how many years you look back.

That’s good news for retirees with dividend oriented stock portfolios. Retirees face inflationary cost spirals just like everybody else, but all too often find themselves on fixed incomes from pensions or bond holdings or annuities that they purchased so they would not “outlive their assets”. The problem with fixed incomes is that inflation ravages them.

We think retirees need to include equity income (dividends) in their retirement portfolio mix. Each person’s situation is different, but dividend income should at least be considered for part of a retirement asset allocation.

While the price level of the S&P 500 index has been volatile, the actual number of Dollars paid by the index has not been volatile. It has risen rather smoothly over the years.

Dividends did decline slightly in 5 of the past 47 years, averaging -1.7% per decline, as follows:

• -1.54% in 1970
• -0.94% in 1971
• -0.12% in 1986
• -2.63% in 2000
• -3.26% in 2001

Those are miniscule in comparison to the declines seen in earnings or the index price level.

The index earnings declined in 11 of the 47 years, and averaged -9.1% for those declines, the greatest of which was a -14.9% decline.

The index price level declined in 12 of those 47 years, and averaged -13.3% for those declines, the greatest of which was -29.7%.

When you think about predictability of earnings, dividends and index price levels, it may be useful to take note of who controls the outcomes. Investors control the price level of the index. Management and company directors control dividends. Earnings are controlled by a combination of management, general economic conditions and customer decisions about the products or services provided by the companies in the index.

Clearly, investors are a more skittish and fickle group, making index price levels the most volatile. Management and directors are conservative in letting go of cash flow to pay dividends, and in creating precedents and expectations that they will be expected to repeat or beat in future years – that makes dividends non-volatile and most predictable. Earnings are controlled by multiple forces, only one of which is management, putting earnings between index price levels and dividends in predictability and volatility.

Most retirees with fixed amounts of capital need to think about predictability and volatility in their investments more than younger people. That’s why they tend to focus on bonds or fixed payout annuities — and why they tend to nervous about stocks.

However, if retirees looked at large-cap stock indexes instead of individual stocks, and at the dividend income more than the price level, they might give stocks more consideration.

Dividends are reasonably predictable, and unlike bond interest, they have a tendency to grow and overcome the ravages of inflation.

For example, if a retiree was earning $100,000 in dividends from a stock portfolio, and that was sufficient to cover the full cost of living for that retiree, how important would it actually be if the stock portfolio paying those dividends declined by 20% one year? Not really very much. If the retiree believes the dividends are secure, the price level of the portfolio isn’t a primary concern.

Virtually all of the media reporting, and the majority of the fund reporting is about price levels with comparatively little about dividend income levels.

We think people with income orientation are looking through the wrong end of the telescope if they focus on stock price levels. They should be looking first at their portfolio dividend income, and the dividend payout ratio from earnings – putting price level last, not first. If the payout ratio is reasonable and the dividend yield is attractive, then the price of the stocks can gyrate without harming the retiree.

If a retiree can live entirely on dividend income and not invade capital, then price level drawdowns aren’t as important in the question of outliving your assets as the dividend growth level versus inflation.

Of course, for retirees, who must utilize both income and capital to survive, price level is important, because multi-year price declines combined with fixed dollar consumption of capital can deplete a portfolio. Those investors are at higher risk of outliving their assets.

The S&P 500 index through proxy funds such as SPY and IVV pays a current dividend yield of about 2.1% ($21,000 in annual dividends per $1 million invested).

Of the 500 stocks in the S&P 500, fully 384 pay dividends (averaging 2.59% yield) and only 114 do not pay dividends. That provides strong protection against the inevitable stinker that pops up unexpectedly in most portfolios, such as Bear Stearns or Washington Mutual as recent examples. Diversification is key to reducing stock selection risk and to improving predictability of results.

The highest yielding portions of the S&P 500 index are financials (proxy XLF, 3.70%) with banks in particular paying high yields lately (proxy KBE, 6.44%), plus telecommunications (proxy VOX, 3.22%) and utilities (proxy XLU, 3.04%).

One way to increase portfolio dividend yield is to add some higher yielding sector funds to a core S&P 500 or other broad index portfolio. Alternatively, there are the high dividend stock funds (proxies DVY, 4.29%; SDY, 4.00%, as examples).

Be aware that any high dividend stock fund will tend to be biased toward the high yield sectors: banks, telecom, and utilities; but they can capture members of other sectors which pure sector funds will not do.

If you are retiree which ample capital, give some thought to a dividend oriented stock allocation in your portfolio along with your consideration of bonds and annuities.

Richard Shaw
QVM Group LLC