Although written for the U.S. investor, this Morningstar post written by jdmartin ( El Toro) is a worthwhile read for any investor.

This post was initially written as a response for a new investor on a Morningstar forum and was previously titled "Getting started for the new investor" but the scope has since been greatly expanded and includes many additional planning and retirement topics. This revision has several new sections along with more examples and more extensive use of web links to pertinent material. I'd especially like to thank the Morningstar community members who contributed to either the content review or HTML format of the material.

The following post will be broken down into 11 separate parts:
Part I - Development of an investment planPart II - Establishment of accumulation goalsPart III - Age adjusted asset allocation & Rates of ReturnPart IV - Fund selection process using Morningstar toolsPart V - Fund analysis in portfolio designPart VI - Portfolio analysis & examplesPart VII - Funding College expenses (new section)Part VIII- Retirement investing & withdrawal strategies (new section)Part IX - Dynamic risk & age-adjusted portfolio strategy (new section)Part X - Long-Term Care Planning (new section)Part XI - URLs of interest (expanded)Part XII - Summary

Investors unfamiliar with any of the investment terminology used in this document should refer to one of the following on-line glossaries for a definition:

InvestorWords.com

New investors should seriously consider reading an introductory book like "Mutual Funds for Dummies" by Eric Tyson and/or Vanguard's free introductory booklets "Investment Planner" and "Facts on Funds" that can be downloaded from their website. Suggested reading for more advanced investors would include:

"Bogle on Mutual Funds" by John Bogle

"Investment Strategies for the 21st Century" by Frank Armstrong

"What Wall Street Doesn't Want You to Know" by Larry Swedroe

"The Bond Book" by Annette Thau

Additional on-line information about mutual fund investing and asset allocation can be found at Vanguard University, Morningstar University and MaxFunds University. Another web site for good unbiased mutual fund information and educational material is the Mutual Fund Education Alliance.

One of the most critical decisions confronting a new investor will be that of determining his or her own tolerance for risk. Portfolio diversification can help reduce but not eliminate risk. New investors would be wise to read the Morningstar series "An Investment Risk Primer" to better understand the risks of investing. Some of the risks that confront investors are:

Loss of capital (market risk)

Loss of purchasing power (inflation risk)

Interest rate risk

Credit quality risk

Prepayment risk for callable assets

Liquidity risk

Political risk

Currency risks

After years of a bull market in domestic equities, many investors became complacent and reduced or abandoned their less risky and less volatile assets in the hopes of instant wealth. Investors who became excessively aggressive were punished through large capital losses in their portfolios during the sharp market drop and found that they needed to reassess their asset allocation decisions.

Serious consideration should be given to using one or more of the on-line asset allocation planners, discussed in more detail later, to aid in the determination of the correct stock/bond/cash investment mix which can be adhered to, even during down markets. To better determine your tolerance to risk, consider taking a risk tolerance quiz like MSN MoneyCentral Risk Tolerance Quiz or the "Investor Questionnaire" in Vanguard's "Investment Planner" or "Facts on Funds" booklets that are available for free by calling Vanguard at 1-800-662-7447.

Remember; it's your money and your choice!

1. Part I - Development of an investment plan:

The single most important endeavor investors undertake is the establishment of a long-term investment plan consisting of:

Goals and objectives

Time horizon (ability to take risk)

Age-adjusted risk tolerance (willingness to take risk)

Required rates of return (realistic need to take risk)

Asset allocation

Accumulation and withdrawal philosophies

Monitoring and rebalancing philosophy

A portfolio's return is NOT determined by what funds are chosen but by the asset allocation of the portfolio. Asset allocation differences between portfolios typically account for as much as 90% of the variations in returns. A larger percentage of stock exposure may be appropriate for investors in the early accumulation phase of their plan but as they age, the investment plan should provide for a moderation in risk as they near their objective. It's imperative to use realistic expected rates of return for planning purposes.

Once an asset allocation is determined, the investor can begin the development of the portfolio. Investors should use as few funds as possible in the creation of a diversified portfolio to allow ease of management. Index funds make excellent core holdings within a portfolio, providing exposure to several asset classes and investment styles. For example, a Total Stock Market fund as a core holding provides exposure to domestic small, mid and large cap stocks as well as growth and value styles. However, a Total Stock Market fund may not offer the assets classes in the desired proportions. A better methodology might be to use a combination of an S&P 500 and extended market (Wilshire 4500) fund to allow better control of your asset allocation within the U.S. stock market. Investors using only TSM allow the market to determine their asset allocation rather than making the investment decision themselves in accordance with their plan. Many decisions made during the fund selection process include:

Load vs. no-load funds

Passive vs. active investments

Growth vs. value

Taxable vs. non-taxable assets

Fund expenses

Diversification

Asset class correlations

When possible, an investor should choose no-load and low expense funds as expenses do matter and affect the portfolio's long-term rate of return. When the option exists, highly tax efficient assets like stocks, index funds, I-Bonds and tax-managed funds should be held in taxable accounts. Tax inefficient assets like TIPS, bonds, taxable fixed income instruments and REIT funds should be held in tax-deferred accounts. Actively managed funds should also be held in tax-deferred accounts as these funds can generate large capital gains distributions. A highly diversified portfolio could contain the following asset classes maintained in accordance to your age-adjusted risk tolerance:

Domestic stocks (Small, Mid & Large Cap)

International stocks (Small, Mid & Large Cap)

Emerging market funds

Real Estate funds

Bonds (Short term, Corporate, I-Bonds, Int'l ...)

Money market or annuities

An investor's risk tolerance will (to some extent) dictate their exposure and allocation to various asset classes. For example, because of the increased volatility of small cap stocks, many investors maintain their large cap to small cap ratio in the 2:1 to 3:1 range during their accumulation years, but switch to a ratio of as much as 3:1 to 5:1 range during retirement. When considering a specific fund for inclusion in the portfolio, the investor should consider:

Fund expenses

Fund's turnover rate

Fund's long term return (3, 5 & 10 year avgs when available)

Fund's volatility and correlation statistics (Using Beta & R-squared)

Tax efficiency

Lastly, rebalance annually or when one of the asset classes is out of the acceptable allocation range as per the investment plan. When possible, rebalancing activity should be restricted to tax deferred accounts due to tax implications. Rebalancing can either be accomplished with new cash or transferring of assets between funds. The rebalancing process forces an investor to adhere to the "buy low and sell high" philosophy by selling a portion of the better performing and possibly over-valued asset classes and adding to under-performing assets classes at possibly bargain prices. This will capture and retain unexpected gains and take advantage of unexpected declines by moving money back into under-performing asset classes closer to market bottoms.

2. Part II - Establishment of accumulation goals
El Toro| 05-15-01 | 10:18 AM
To establish realistic accumulation goals for retirement, it's imperative to analyze and understand all sources of income available during retirement:

Pensions

Qualified retirement plans

Savings

Part-time employment

Social Security

Social Security benefits are calculated from a worker's earnings history with full benefits dependent upon date of birth but can commence as early as age 62 at a reduced rate. An estimate of your benefits can be found in the Personal Earnings and Benefits Estimate Statement (PEBES) mailed annually or can be obtained by calling the Social Security Administration at 1-800-772-1213 and requesting form SSA-7004.

Information on Social Security can be found at:

Benefits overview

Spousal benefits

Widow & survivor benefits

Benefits calculator

A serious consideration when determining your accumulation goal is:

Will the social security system remain solvent and/or how will benefits change?

Currently, the approximate percentage of pre-retirement income replaced by the Social Security benefits is:
Final | Income Salary| replacement $ 30K | 40% $ 60K | 30% $150K | 15%

Inflation can gradually erode the purchasing power of a portfolio without your being aware of it. The table below represents the amount needed to have equivalent projected purchasing power assuming various levels of inflation over time.
yr\% 3.0% 3.5% 4.0% ---| 1000 1000 1000 5 | 1159 1188 1217 10 | 1344 1411 1480 15 | 1558 1675 1801 20 | 1806 1990 2191 25 | 2094 2363 2666 30 | 2427 2807 3243

Therefore, time horizon and inflation affect the accumulations needed to maintain a standard of living during retirement.

A long-term plan should utilize reasonable macro-economic assumptions. If you live in a state where salary reductions for retirement contributions are subject to state and local taxes during working years, retirement distributions may be exempt from those taxes during retirement years, thus making this a concern if relocation is a consideration during retirement. The example below utilizes the following assumptions:

3.0% inflation

The social security system remains solvent with minimal changes
15.0% salary reduction for retirement contribution* +7.5% social security taxes (subject to earnings limits) +5.0% state tax rate* +2.5% local tax rate* 30.0% total salary reductions

* Prospective retirees should utilize parameters specific to their situation and contribution limits.

EXAMPLE:

Assuming a 3% COLA, a couple of age 50 earning $65K will have a combined estimated salary of about $100K at age 65. Their final combined salary, less appropriate reductions, should be used in determining the retirement accumulations needed to maintain their standard of living during retirement. Other expenses projected to be eliminated prior to retirement (mortgage expenses) will reduce the annual withdrawal and should be taken into consideration. Click here for an income worksheet for retirees.
$100.0K Combined pre-retirement salary - $15.0K 401K Contributions (subject to limits) - $ 7.5K Social security taxes (subject to earnings limits) - $ 5.0K State taxes - $ 2.5K Local taxes $70.0K - $24.0K Estimated social security benefits $46.0K Starting 401K withdrawal
Note: Special care should be given by couples with respect to reducing final pre-retirement income by their combined estimated Social Security benefits because, at the death of the first spouse, the surviving spouse will lose that portion of the income stream resulting from the deceased spouse's benefit.

The Trinity study, which analyzed portfolio survivability using various rates of withdrawal, concluded that a 4% inflation adjusted withdrawal rate has a high probability of surviving withdrawals during retirement for most portfolios. Therefore, the minimum goal for retirement savings for the above couple should be $1.15M, calculated by dividing $46K/0.04. On-line retirement calculators can be found at SmartMoney and Money.

A "Rule of Thumb" formula to estimate target accumulations by age for tracking purposes for retiring at age 65 is:
Target= (Age - 25)*salary (3+($30K/salary))

3. Part III -Age adjusted asset allocation & ROR
El Toro| 05-15-01 | 10:19 AM
Past performance can only be used as a guide on how best to invest for expected future returns. Asset classes drift in and out of favor over time and your best bet is to own a highly diversified portfolio of all asset classes in appropriate proportions, depending on your "age-adjusted" risk tolerance. You can review the historic returns for various equity asset classes at

Callan Associates

When determining the rate of return necessary to meet your objectives, the investor should consider inflation, fund expenses and taxes as the three worst enemies of success. The latter two can be controlled through planning and choice. But inflation will sneak up gradually and eventually decimate the spending power of your portfolio without your being aware of it. The Moral: Beware and be aware of inflation!

There was a previous discussion on the "Improving Your Portfolio" forum that resulted in Morningstar's reporting their estimate of expected future returns for various asset classes. IMO, their estimated future rates of return were a bit conservative but work well for planning purposes and in summary are:

Inflation rate assumption of 3.0%

Nominal returns using Morningstar forecasts for various asset classes are:

Large-cap U.S. stocks 5.5+3.0=8.5

Mid/small-cap U.S. stocks 6.5+3.0=9.5

International stocks 6.0+3.0=9.0

Bonds 3.0+3.0=6.0

Cash 1.5+3.0=4.5

Historic multi-year annualized returns for comparative Benchmarks can be found at Mutual Fund Education Alliance.

One of the most critical decisions confronting new investors will be determining his or her own tolerance for risk. An important step when developing an investment plan is to analyze your goals and long-term employment situation carefully and then determine what rate of return will be needed to meet your objectives. An investor's circumstances, willingness or need to assume risk to market volatility may dictate that they assume a portfolio of lesser return than others in their age bracket having a higher risk tolerance or need to take risk. One way to determine an appropriate stock/bond asset allocation that takes into consideration your personal circumstances is to use one of the many on-line planners available on the web such as Vanguard's Online Investment Planner, Fidelity's Asset Allocation Planner or the M* Goal Planner. No matter how you derive your initial asset allocation, your investment plan should provide for a moderation in risk as you age, because your ability to take risk is reduced.

Caveat: The various on-line planners should be viewed as optimistic projections of expected accumulated wealth because:

most do NOT use an age-adjusted asset allocation

most use a specified wage growth rate until retirement

The following table represents hypothetical well-diversified "age-adjusted" portfolios for demonstration purposes ONLY, along with the annual expected rate of return (ROR) for each:
..........................Portfolio Objectives.............. Asset Class..... Wealth ... Aggr . Growth . Conserv. Preserve ................ Builder . Growth &Income . Growth . Capital Stock/Bond Ratio. 100/0 .. 80/20 .. 60/40 .. 40/60 .. 20/80US Large Cap..... 40.0% .. 35.0% .. 30.0% .. 25.0% .. 10.0% US Mid Cap....... 10.0% ... 7.5% ... 5.0% ... 2.5% ... 0.0% US Small Cap..... 10.0% ... 7.5% ... 5.0% ... 2.5% ... 0.0% REITs............ 10.0% .. 10.0% ... 5.0% ... 5.0% ... 5.0% Int'l............ 25.0% .. 15.0% .. 10.0% ... 5.0% ... 5.0% Emrg Mrkts........ 5.0% ... 5.0% ... 5.0% ... 0.0% ... 0.0% Inter. Term Bonds. 0.0% ...10.0% .. 10.0% .. 15.0% .. 15.0% Short Term Bonds.. 0.0% .. 10.0% .. 20.0% .. 30.0% .. 50.0% Money Market...... 0.0% ... 0.0% .. 10.0% .. 15.0% .. 15.0% Estimated ROR..... 9.0% ... 8.5% ... 8.0% ... 7.5% ... 7.0% Volatility & Risk. Very .. High .. Moderate . Low ... Very ... Tolerance .... High ............................. Low RISK PROFILE \ AGE Aggressive ....... 20-35 .. 35-50 .. 50-65 .. 65-75 .. 75+ Average ................... 20-35 .. 35-50 .. 50-70 .. 70+ Conservative ....................... 20-50 .. 50-65 .. 65+ Risk Adverse ................................ 20-60 .. 60+
Again, these are hypothetical "age-adjusted" portfolios and should only be used as a guide for designing a portfolio that meets your age and risk profile in accordance to your long-term plan.

4. Part IV - FUND selection process
El Toro| 05-15-01 | 10:20 AM
When the rate or return analysis and asset allocation decisions are complete, the investor can then contemplate selecting funds for the portfolio. Constructing a portfolio from funds that track different indices will minimize stock overlap and maximize diversification. For demonstration purposes ONLY, the asset class table below will be restricted to Vanguard funds for simplicity.
Asset Class..... Symbol | tracking Index US Large Cap .... VFINX | S&P 500 US Small/Mid Cap. VEXMX | Wilshire 4500 Int'l............ VWIGX | MSCI World ex US Emerging Markets. VEIEX | MSCI Emerging Markets REITS............ VGSIX | Wilshire REIT Intermediate Bond VBMFX | LEH Brothers Aggregate Short Term Bond.. VBISX | LEH Brothers Short Term Money Market..... VMMXX | Short Term Treasury
Domestic equity funds are differentiated by investment style such as: growth, value or blend as well as by size as follows:
Size | Median mrkt capSmall| < $1.0B Mid | $1.0B - $5.0B Large| > $5.0B
Small & mid cap equities have historically provided slightly higher returns but with more volatility. Frank Armstrong's Asset Class Investing Series recommends having a value-biased portfolio.

When considering bond funds for inclusion in a portfolio, it should be noted that bond fund volatility is influenced most by average duration and credit quality of the bonds it holds. The value of a bond fund moves inversely to changes in interest rates. As interest rates rise, the value of bonds falls and vice versa. In general, for each 1% change in interest rates, there is a corresponding inverse 1% change in the value of a bond fund for each year of average duration. Therefore, short-term bond funds are less volatile than intermediate or long-term bond funds. Historically, there has been a high correlation between prevailing interest rates and the rate of inflation. However, Treasury Inflation-Protected Securities & Inflation-Linked Bonds, commonly referred to as TIPS & I-Bonds, react differently than traditional bonds to changes in inflation, as part of the their return is linked to inflation and therefore provides an inflation hedge.

International equity and bond fund returns are more closely correlated to economic conditions in their local economies. International investing also exposes an investor to political and currency risks. Emerging market and Int'l small cap equities have a lower correlation to domestic equities than Int'l large caps because of the large cap's reliance on exports to the global economy. However, before investing in an Emerging Market or Int'l small cap fund, an investor must decide whether they are adequately compensated via higher expected returns and lower correlation to more than offset the increased risks and higher fund expenses.

Numerous tools are available on the Morningstar website to aid the investor in distilling the voluminous amounts of information during the fund selection process. The "Fund selector" tool will select by criteria such as:

load vs. no-load

minimum initial investment

manager tenure

style (growth vs. value)

multi-year annualized returns

portfolio turnover

fees & expenses

median market cap

Funds identified for possible inclusion into the portfolio should undergo further scrutiny during the final selection process. The "Quotes&Quicktakes" tool allows investors to do in-depth research and analysis on a fund-by-fund basis and provides fund data such as:

multi-year annualized returns

# of stocks and/or bonds per fund

median market cap

P/E & P/B

sector weightings

bond quality & avg. duration

asset correlation

as well as other pertinent data to be analyzed during the final fund selection process. In addition, every fund or asset class will typically have a tracking index which represents its benchmark for comparison purposes. When comparing funds, only compare funds with like characteristics that track the same index and use the same investment style such as growth or value investing. If more than one fund for an asset class is identified during the selection process, the investor can use the "Fund comparison" tool to decide which fund would be the better choice for inclusion into the portfolio. There are thousands of funds from which to choose so the use of appropriate tools can expedite this process.

5. Part V - Fund analysis in portfolio design
El Toro| 05-15-01 | 10:20 AM
A premise of Modern Portfolio Theory (MPT) is that including asset classes having a low correlation to existing portfolio assets can reduce risk and lower volatility. Dr. Paul Kaplan, Director of Quantitative Research at Morningstar, was gracious enough to provide the following data in response to a query in the "Improving Your Portfolio" forum.
............................ Correlation With ...... Asset Class.. StdDev| (1) ... (2) ... (3) ... (4) . Large-Cap Stk 16.34 | 1.000 Mid-Cap Stk.. 18.83 | 0.798 . 1.000 Int'l Stk.... 21.83 | 0.533 . 0.447 . 1.000 Bonds........ 8.00 | 0.515 . 0.404 . 0.233 . 1.000 Cash......... 2.60 | 0.481 . 0.264 . 0.265 . 0.700
A fund-by-fund correlation for Vanguard funds can be found here.

Morningstar provides many other statistics that can be useful in evaluating funds for inclusion in a portfolio. Data that reflects operating costs, valuation, volatility, correlation and size worth considering are: expense ratio, P/E and P/B, Std. Dev., R-squared and median market cap.

A comprehensive fund-by-fund analysis should be done for each asset class to be considered for inclusion in a portfolio. For demonstration purposes only, the following analysis is limited to evaluating the fundamentals of Int'l equities with respect to portfolio diversification. Int'l equities trade on the fundamentals of their local economies and therefore have a lower correlation to domestic equities. A few of the Int'l funds available for possible inclusion in a portfolio are:
Median Ticker|Mrkt.| Exp | S&P | #of | ------| Cap | Ratio|RSqrd|Stcks| P/E | P/B | Mutual Fund Name VWIGX |21.0B| 0.53 | .52 | 119 | 27. | 5.2 | Vangrd Intl Gr. TIINX |27.8B| 0.49 | .27 | 909 | 34. | 8.5 | TIAA-CREF Intl ARTIX |13.4B| 1.27 | .35 | 90 | 26. | 5.5 | Artisan Intl FDIVX |20.0B| 1.18 | .48 | 459 | 30. | 5.4 | Fid. Div. Intl HAINX |27.9B| 0.94 | .53 | 68 | 23. | 3.8 | Harbor Intl OAKEX | 0.3B| 1.79 | .27 | 39 | 15. | 1.6 | Oakmark Intl Sml ACINX | 2.3B| 1.11 | .26 | 151 | 34. | 7.5 | Acorn Intl ISCAX*| 0.6B| 2.03 | .17 | 255 | 37. | 9.6 | Fed. Intl Small PNVAX*| 1.2B| 1.59 | .20 | 162 | 33. | 9.4 | Putnam Intl Voy VEIEX | 4.7B| 0.58 | .51 | 472 | 21. | 4.7 | Vangrd Emrg Mrkt WPEMX | 7.0B| 0.79 | .43 | 118 | 25. | 4.3 | WarburgPincus Em

* denotes load funds

The above table is divided into three distinct asset classes: Int'l large cap, Int'l small/mid cap and emerging markets. Emerging markets and Int'l small cap funds have a lower correlation to domestic equities than Int'l large caps and are, therefore, better portfolio diversifiers. However, before investing in an Emerging markets or Int'l small cap fund, an investor must decide whether they are adequately compensated via higher expected returns and lower correlation to more than offset the increased risks and higher fund expenses.

Of the five Int'l large cap funds analyzed, the TIAA-CREF Int'l fund (TIINX) provides a low cost, low correlation alternative having good diversification with 909 equities. Investors preferring a more value-oriented fund could choose Harbor Int'l due to the lower P/E and P/B statistics or Vanguard Int'l Growth because of it's lower expense ratio. Investors preferring a fund with a broad market cap exposure can do further analysis by comparing the market cap composition of the available choices:
------| VWIGX | TIINX | ARTIX | FDIVX | HAINX Giant | 17.81 | 32.49 | 13.86 | 29.97 | 28.83 Large | 58.94 | 43.75 | 37.26 | 31.65 | 40.99 Medium| 22.07 | 17.10 | 47.34 | 21.55 | 27.69 Small | 1.18 | 5.35 | 1.54 | 11.64 | 2.49 Micro | 0.00 | 1.31 | 0.00 | 2.47 | 0.00
then decide which fund best meets their criteria.

Of the four Int'l small/mid cap funds analyzed, most have considerably higher expense ratios than the Int'l large cap funds. Acorn Int'l would be the better choice of the four because it has the lowest expense ratio. Investors preferring a more value-oriented fund would chose Oakmark Int'l due to the lower P/E and P/B statistics.

6. Part VI - Portfolio analysis & examples
El Toro| 05-15-01 | 10:21 AM
When the fund analysis process is complete, the investor can do the portfolio analysis step which is to enter the chosen funds into the "Instant X-ray" tool in the desired proportions, according to the investment plan. Characteristics of the portfolio, easily gleaned from the data displayed by the "Instant X-ray" tool, include:

asset allocation

style box diversification

world equity exposure by region

overall fees & expenses

equity sector breakdown

portfolio stock statistics

YTD return statistics by fund

By evaluating each asset class individually, such as domestic equity funds, the investor will ensure that the desired proportion of each asset sub-class or category has been attained. For example, when evaluating the chosen domestic stock funds, such as the S&P 500 Index used in combination with an extended market fund, closely examine the Style Box for proper diversification (with the four corners being most important), making alterations as necessary until satisfied. Then begin analyzing the other asset classes of the portfolio.

The following simple portfolios, for illustration purposes ONLY, demonstrate the usefulness of the data provided by the "Instant X-ray" tool. A hypothetical simple but aggressive three fund Vanguard portfolio for a young investor with very high risk tolerance during their early accumulation phase might be:
% | Fund | Description 35 | VFINX | S&P 500 35 | VEXMX | Extended market index 30 | VWIGX | Int'l Growth 100%

Entering the above portfolio into the "Instant X-ray" tool yields the following style box diversification:
Size 32 9 25 | Large cap 9 2 11 | Mid cap 6 1 5 | Small cap Value Blnd Growth Valuation

The above simple three-fund portfolio can be improved by including a small percentage of the Vanguard REIT index, Vanguard Emerging markets and Acorn Int'l because of the very low correlation of these funds to the S&P 500 index. Acorn Int'l was chosen because Vanguard does NOT offer an Int'l small cap fund.
% | Fund | Description 30 | VFINX | S&P 500 30 | VEXMX | Extended market index 10 | VGSIX | REIT index 15 | VWIGX | Int'l Growth 10 | ACINX | Acorn Int'l 5 | VEIEX | Int'l Emerging markets 100%

which yields the following style box diversification:
Size 25 4 21 | Large cap 15 4 12 | Mid cap 10 3 6 | Small cap Value Blnd Growth Valuation

The addition of VGSIX, VEIEX & ACINX to the portfolio provides additional exposure to the small/mid cap asset classes and enhances the value bias of the portfolio.

A hypothetical TIAA-CREF portfolio comparable to the three fund Vanguard portfolio would be:
% | Fund | Description 70 | TCEIX | Equity Index 30 | TIINX | Int'l fund 100%

which yields the following style box diversification:
Size 30 12 39 | Large cap 8 1 6 | Mid cap 3 0 2 | Small cap Value Blnd Growth Valuation

The ONLY problem with the TIAA-CREF fund family regarding a highly diversified portfolio is that TIAA-CREF equity funds provide minimal exposure to the domestic small/mid cap asset class which is easily observed in the above Style box. However, this shortcoming can be easily overcome by including an appropriate small/mid cap fund from another fund family.

The above hypothetical portfolios should ONLY be considered by the most aggressive young investors during their early accumulation phase, having a very high tolerance to risk and market volatility. Investors with a lower risk tolerance would add an appropriate portion of bond funds to their portfolio to reduce risk and volatility.

Morningstar analysis tools

Goal planner
Fund selector
Fund compare
Instant X-ray
Quotes&Quicktakes

7. Part VII - Funding educational expenses
El Toro| 05-15-01 | 10:21 AM
Funding college expenses represents a major but worthwhile investment as individuals with college degrees on average make upwards of 80% more than individuals with H.S diplomas. The most commonly used alternatives for reducing overall costs of college expenses are:

Grants & scholarships

Public colleges

Tax incentives

Deductible student loans

Financial aid

Financial aid is available to fund a portion of educational expenses by filing a Free Application for Federal Student Aid, or FAFSA, which is used by states and many colleges to award needs-based aid. Financial aid offices use formulas that analyze a family's financial circumstances, such as income, family size and assets, in determining the family's ability to fund expenses, commonly referred to as the "Expected Family Contribution" (EFC). Many on-line calculators are available for calculating a family's EFC. Families should plan carefully with respect to what assets are placed in a child's name as such assets reduce eligibility for financial aid. Strategies for maximizing eligibility for financial aid should be considered.

The Tax Relief Act of 1997 provided numerous educational tax incentives some of which are mutually exclusive. For example, you cannot withdraw from an Educational IRA in the same year you utilize the Hope Scholarship or Lifetime learning credit. Additionally, you cannot fund both an Educational IRA and a 529 plan in the same year. The most notable tax incentives are:

Hope Scholarship
Lifetime Learning credits
Educational IRAs
IRA withdrawals for Educational expenses
Student loan interest deduction
Qualified State Tuition Programs (Section 529 plans)
Govt. educational bond program

Section 529 plans provide the most liberal mechanism for saving for educational expenses with higher annual contribution limits and fewer restrictions. However, assets in Section 529 plans may reduce eligibility for financial aid because gains withdrawn from 529 plans are treated as beneficiary income. It should be noted that the comparative ratings differ for each state sponsored plan, which ultimately has control over the asset allocation and investment manager along with non-resident eligibility. In general, asset allocations for funds contributed to such plans automatically adjust to a more conservative investment portfolio as the beneficiary approaches college age. Some of the Section 529 plan benefits are:

assets grow tax deferred

high contribution limits

529 Plan assets are controlled by the account holder

no income limitations on participants

educational expense withdrawals are taxed at beneficiary's rate

withdrawals are possibly exempt from state and/or local tax

remaining balance is transferable via beneficiary change

account balances can revert back to owner at 10% penalty

Prior to making a final decision, the above items should be double-checked with the chosen state's plan as 529 plan options differ from state to state. Two low cost providers of Section 529 plans are Vanguard, which manages plans for Iowa and Utah, and TIAA-CREF, which manages twelve state programs: California, Connecticut, Idaho, Kentucky, Michigan, Minnesota, Mississippi, Missouri, New York, Oklahoma, Tennessee, and Vermont.

Articles and web sites with information on funding college expenses:

Guide to Financial Aid
Educational tax incentives
College funding overview
College funding guide
Comparing college savings plans
Savingforcollege.com
529 plans as estate planning tool
529 plans offer alternatives
529 plan FAQs

8. Part VIII-Retirement withdrawal consideration
El Toro| 05-15-01 | 10:22 AM
There are no certainties with respect to retirement other than more accumulations is better as are lower withdrawal rates. IRS Publication 590 contains information and rules governing Individual Retirement Arrangements, commonly referred to as IRAs, complete with life expectancy tables for one or two people. Retirement is typically funded partly through systematic withdrawals from qualified plans.

Terms frequently used in retirement discussions are:

Recalculation method - distributions recalculated annually on life expectancy

Term Certain - distributions based on life expectancy when initiated

MRD - Minimum Required Distribution & proposed changes

RBD - Required Beginning Date for a traditional IRA is April 1 of the calendar year following the year at which age 70 1/2 is reached

MDIB - Minimum Distribution Incidental Benefit for joint non-spousal distributions in accordance with the MDIB table in IRS Pub. 590

NOTE: Substantial penalties result when inadequate amounts are taken after RBD

Articles on retirement investing

Making it Last Forever

Investing during retirement

Not relying on "The Averages"

Retirement planning tools

new MRD calculator

Life expectancy calculator

Early retirement considerations

Early retirement is fraught with peril and should ONLY be considered after fully understanding the risks associated with such a decision which are:

Inflation

Sustainable withdrawal rates

Prolonged down markets

Health care insurance and prescription drug costs

The IRS permits penalty free withdrawal from qualified employer plans for anyone separating from service after attaining age 55. Additionally, IRS code section 72(t) allows for penalty free withdrawals from IRAs and other qualified plans prior to age 59 1/2 through distributions which are part of a series of Substantially Equal Periodic Payments, commonly referred to as SEPP, made at least annually for the life expectancy of an individual or the joint life expectancy of an individual and a designated beneficiary. These distributions must continue for the greater of 5 years or until age 59 1/2, which ever is longer, and are essentially fixed for the entire withdrawal period regardless of inflation. The three accepted SEPP withdrawal calculation methods are:

Annual recalculation - calculated annually using minimum distribution rules

Amortization - amortize account balance using life expectancy

Annuity factor - account balance divided by an annuity factor

The amortization and annuity factor methods require the use of a reasonable interest rate in the range of 80% to 120% of the Applicable Federal Rates, which the IRS has deemed acceptable. An on-line 72(t) calculator can be used to compute the distributions via any of the three methods. Another good web resource for learning more about 72(t) withdrawals is 72t.net.

Withdrawal strategies

There have been many studies performed on sustainable withdrawal rates using various asset allocations some of which are:

Trinity study on portfolio survivability
Jarrett & Stringfellow study on Withdrawals

These studies conclude that a 4% withdrawal rate has a high probability of surviving withdrawals during retirement using a 50/50 stock/bond asset allocation. A "Rule of Thumb" percentage for sustainable withdrawal rates by age is:
3.5+((age-55)/10)
Additionally, portfolio survivability at various withdrawal rates is very dependent upon the chosen asset allocation.

Commonly used withdrawal strategies:

Fixed income - withdrawal of a fixed amount each year irrespective of inflation

Inflation adjusted - annually adjusted withdrawal according to the prior year's inflation rate irrespective of portfolio performance which could suffer the perils of higher withdrawal rates

Endowment Principle or Fixed % - adjust the annual dollar amount withdrawn relative to the value of the portfolio at year end. In theory, retirement funds will last indefinitely using this method, which provides a fluctuating income stream irrespective of inflation

9. Part IX - Dynamic risk adjusting portfolio
El Toro| 05-15-01 | 10:23 AM
This portfolio management strategy should NOT be used by investors during the accumulation phase of retirement investing! Retirees should consider what initial Rate of Return (ROR) is required from their portfolio as that represents their need to take risk with respect to exposure in the equity markets. It's also generally accepted that as one ages it's desirable to reduce exposure to equities and thereby reduce portfolio volatility and likewise risk. After the required ROR for the portfolio is determined, the retiree can then develop a diversified asset allocation having a high likelihood of generating the necessary ROR. Using said asset allocation and the value of the portfolio, determine the fixed "$" exposure to the various equity asset classes as components of the portfolio. From that point in time on, that fixed "$" amount represents the exposure to the various equity markets during retirement. For example, if an initial 8.0% ROR is required, the following hypothetical asset allocation represents a portfolio with a high likelihood of generating the desired ROR assuming an inflation rate of 3.0%.
-- Asset class -------- Nominal ROR Asset | Asset ------------------------------------ Alloc | class ------------------------------------------ | yield U.S. Large cap stocks. 5.5+3.0= 8.5 | 20.0 | 1.7% U.S. Mid cap stocks... 6.0+3.0= 9.0 | 7.5 | 0.675% U.S. Small cap stocks. 6.5+3.0= 9.5 | 7.5 | 0.7125% Int'l large cap stocks 6.0+3.0= 9.0 | 10.0 | 0.90% Int'l small cap stocks 7.0+3.0=10.0 | 2.5 | 0.25% Emerging Markets...... 8.0+3.0=11.0 | 2.5 | 0.275% Diversified REIT index 5.5+3.0= 8.5 | 10.0 | 0.85% Mortgage backed sec... 4.0+3.0= 7.0 | 10.0 | 0.7% Corporate bonds....... 3.5+3.0= 6.5 | 10.0 | 0.65% I-Bonds............... 3.5+3.0= 6.5 | 10.0 | 0.65% Government bonds...... 3.0+3.0= 6.0 | 10.0 | 0.6% Money market funds.... 1.5+3.0= 4.5 | 0.0 | 0.0% -------------------------------------------- 7.9625%
Here's the dynamic risk & age-adjusted portfolio management strategy for a hypothetical age 65 retiree starting with a $1M portfolio using an initial 60/40 stock/bond allocation maintaining a fixed "$" amount of equity exposure while utilizing a 4.5% inflation adjusted withdrawal.
.................. Fixed .. Inflation Portfolio Portfolio ....... Equity .. Income .. Adjusted . Balance .... ROR ... ROR . 9.0% .... 6.5% . Withdrawal Year.................................. 1000000 2000 .. 600000 .. 400000 ... 45000 ... 1032075 ... 8.00% 2001 .. 600000 .. 432075 ... 46350 ... 1064797 ... 7.95% 2002 .. 600000 .. 464797 ... 47741 ... 1098165 ... 7.91% 2003 .. 600000 .. 498165 ... 49173 ... 1132177 ... 7.87% 2004 .. 600000 .. 532177 ... 50648 ... 1166829 ... 7.82% 2005 .. 600000 .. 566829 ... 52167 ... 1202114 ... 7.79% 2006 .. 600000 .. 602114 ... 53732 ... 1238027 ... 7.75% 2007 .. 600000 .. 638027 ... 55344 ... 1274557 ... 7.71% 2008 .. 600000 .. 674557 ... 57005 ... 1311693 ... 7.68% 2009 .. 600000 .. 711693 ... 58715 ... 1349422 ... 7.64% 2010 .. 600000 .. 749422 ... 60476 ... 1387727 ... 7.61% 2011 .. 600000 .. 787727 ... 62291 ... 1426590 ... 7.58% 2012 .. 600000 .. 826590 ... 64159 ... 1465989 ... 7.55% 2013 .. 600000 .. 865989 ... 66084 ... 1505898 ... 7.52% 2014 .. 600000 .. 905898 ... 68067 ... 1546291 ... 7.50% 2015 .. 600000 .. 946291 ... 70109 ... 1587134 ... 7.47% 2016 .. 600000 .. 987134 ... 72212 ... 1628392 ... 7.45% 2017 .. 600000 . 1028392 ... 74378 ... 1670025 ... 7.42% 2018 .. 600000 . 1070025 ... 76609 ... 1711988 ... 7.40% 2019 .. 600000 . 1111988 ... 78908 ... 1754230 ... 7.38% 2020 .. 600000 . 1154230 ... 81275 ... 1796697 ... 7.36%
It should be noted that other withdrawal strategies, such as the endowment principle, also work well using this methodology. Using the above ROR assumptions, which are fairly conservative, this scenario implements the desired behavior, which is to systemically decrease equity exposure as you age. Strict discipline and periodic rebalancing is necessary to maintain the fixed"$" amount of equity exposure. This methodology enforces the "buy low and sell high" philosophy by reducing equity exposure as a percentage of your portfolio during periods of extreme market valuations and increasing equity exposure as a percentage of your portfolio after steep market declines. Retirees desiring a lower initial equity exposure should reduce their withdrawal rate accordingly and determine if this scenario works for their chosen asset allocation and withdrawal rate.

10. Part X - Long-Term Care Planning
El Toro| 05-15-01 | 10:24 AM
A common misperception is that Medicare provides long-term care coverage, when in fact, it provides only very limited coverage for skilled nursing and home care coverage and ONLY under certain conditions for less than 100 days. The annual cost of long-term nursing home care now averages more than $40,000 and varies greatly between states and type of care required with state-by-state average LTC costs available at LTCQ.net. State insurance departments typically have consumer affairs divisions to help answer questions.

Insurance companies offer Long-Term Care policies to cover medical assistance expenses required by individuals unable to care for themselves. These services are usually provided pursuant to a plan of care prescribed by a licensed health care practitioner for services not covered by MediCare and other health insurance products. Consumers unfamiliar with any of the terminology should refer to GE Financial's LTC Glossary or E.F. Moody's LTC Glossary for a definition. An overview of articles on Long-Term Care information can be found at Health Insurance Association of America and Long-term care insurance library. Another good source for basic information about when to buy LTC, how much coverage and LTC policy features can be found at insure.com.

Tips on Buying Long-Term Care Insurance

The most crucial factor when choosing a long-term care policy should be the criteria that trigger benefits, which are the conditions that must exist before receiving coverage. The best policies allow you to receive benefits if you suffer from a cognitive impairment such as Alzheimer's disease. However, some policies require an acute medical condition and a hospital stay that requires skilled nursing care before your benefits commence. Most policies require that conditions must exist such that the individual need "substantial" assistance with 2 or 3 ADLs (Activities of Daily Living).

Whether or NOT you need LTC insurance depends largely on the size of the estate. Families with a relatively large estate may choose to self-insure against long-term care expenses while Medicaid will most likely cover families having minimal estates. However, families with modest estates are most at risk of impoverishing a surviving spouse as a result of long-term care costs and should consider consulting an estate planner and/or purchasing some amount of LTC coverage. If you can afford the LTC premiums and have assets you want to protect against long-term care costs, you should seriously consider purchasing some amount of long-term care insurance.

LTC policy premiums can be controlled by judiciously choosing the waiting period, benefits period and maximum daily benefit but it is advisable to get policy premium cost estimates from several high-quality insurance providers such as GE financial, TIAA-CREF, UNUM, CNA, John Hancock and others. Another good source for price quotes is from an insurance broker site such as LTCQ.net or QuoteSmith.com. It is highly recommended you research the financial strength of the insurance provider prior to purchasing a policy, as it may be several decades before the benefits are needed. Therefore, the use of good un-biased rating services, such as Standard & Poor's or A.M.Best Insurance rating service, to evaluate the financial strength of the chosen insurance provider should be considered.

LTC policy benefits & riders

Information on LTC Features&benefits and LTC products and policy riders can be found at GE Financial and Insure.com. Some of the more notable features and riders to consider are:

Maximum Daily Benefit

Benefit period

Elimination or waiting period

Reimbursement or indemnity (per diem) benefit

Shared-benefit rider (for couples)

Home health care rider

Inflation rider

Ten-pay rider

Guaranteed renewable

11. Part XI - URLs of interest
El Toro| 05-15-01 | 10:24 AM
General interest websites

Social Security Administration
Social Security benefits calculator
401Kafe.com
403Bwise.com
Thrift Savings Plan for Federal Govt. employees
457 retirement plans for public-service employees
Wills & Trusts

Tax related information

Tax burdens by state
Estate taxes levied by States
State-by-State individual tax rates
State-by-State sales tax rates
IRS Tax Publications
Marginal Federal tax rate table
Federal & state tax forms & publications
Tax Guide for investors
Complete online Resource for tax information
U.S. Treasury I-Bond tax reporting guide

Mutual fund investing

Mutual Fund Education Alliance
Investment Company Institute
ScottBurns.com
Coffeehouseinvestor.com
Standard&Poors Index Services
Exchange Traded funds

Bond fund investing

Federal Reserve saving Bond Wizard
The Bond Market Association
BondResources educational library
I-Bond Tutorial

Funding educational expenses

Educational tax incentives
College funding overview
Hope scholarship & lifetime learning credits
Savingforcollege.com
College funding 529 plans offer better alternative
529 plans as estate planning tool

Insurance tools & rating services

QuoteSmith.com quote service
Standard & Poor's Insurance rating service
A.M. Best Insurance rating service
States' Dept of Insurance
Insurance web learning center & toolbox

Annuities

SEC guide for variable annuities
All about annuities
1035 tax-free annuity exchange

Long-Term Care provider & policy information

LTC Glossary
State-by-state average LTC costs
LTC insurance provider directory
LTC insurance library
Basics of LTC
LTC features & benefits
LTC policy riders
Customizing your LTC policy

Historic data, risk analysis&charting

Federal Reserve historic rate data
Historic price quotes
RiskGrades.com Measurement tools
Callan Associates' historic return data
S&P/BARRA charting
Historic returns

12. Part XII - Summary
El Toro| 05-15-01 | 10:25 AM
New investors would be wise to consider ONLY no-load and low expense fund families and use index funds as core holdings. Two popular and well-run fund families that fit those criteria are: TIAA-CREF and Vanguard. Investors with low initial amounts of money to invest would do well to consider the TIAA-CREF fund family, given the low initial minimums of ONLY $250 or $25/month to get started. Other funds offering low initial minimum investments can be found at Mutual Fund Education Alliance.

The most critical decisions confronting a new investor are determining his or her own tolerance for risk and choosing an asset allocation. It is widely accepted that the biggest long-term determinant of a portfolio's performance is asset allocation. Each investor must decide on an investment strategy and asset allocation with which one is comfortable with and can adhere to, even during down markets.

Remember, higher risk does NOT necessarily equate to higher returns!

Investors should develop an investment plan specific to their risk tolerance, age, marital status, family situation, stability of earnings, etc. There is more to long-term planning than just picking mutual funds.

If you think Estate planning is unnecessary because your Estate is under the
Unified credit limit for federal estate taxes, Think again! Families with modest estates are most at risk of impoverishing a surviving spouse as a result of long-term care costs. If the above circumstances apply to your family situation, consider reading Long-Term Care vs. Estate & taxation planning.

Lastly, other topics that should be included as part of a truly long-term plan, consider including (but not limited to):