By JACK HOUGH
Year-end financial planning might feel a bit like trying to fit an alligator for a suit. The S&P 500-stock index provided a year's worth of typical gains this past week after losing nearly a year's worth the week before. How can investors hope to put such an unruly beast to work?
The good news is that three of the most important determinants of portfolio growth are under the direct control of investors: fees, asset allocation and new contributions. Each deserves a fresh look.
Mutual funds won't disclose their 2012 returns ahead of time, uncooperative as that seems. But all will say what they charge. And although fees have broadly declined over the past two decades, most investors are paying too much, especially considering that bond yields are meager and that stocks have had a stingy decade.
The Investment Company Institute tracks costs by lumping yearly fund expenses and sales charges into a single measure, weighted for the money investors have in each fund. It finds that stock funds charge 0.95% and bond funds, 0.72%.
That means stock fund holders pay one-third of what the S&P 500 has returned per year over the past decade. Bond fund holders pay one-third of the 10-year Treasury yield.
Over a lifetime of savings, fees can gobble a Mercedes or two. A 25 year-old with merely median pay who saves 9% a year in a half-stock, half-bond portfolio can expect to have $510,000 by age 65 if he pays 0.25% a year, according to a recent Vanguard study. With a 0.75% fee his stash grows to only $456,000, and with a 1.25% fee, just $410,000.
Of course, a savvy fund manager can earn his fee and then some by picking winners, but studies have long shown that most fail to do so.
For cheap open-end mutual funds, the Vanguard Total Stock Market Index fund (VTSMX) costs 0.18% a year and the Fidelity Spartan Total Market Index fund (FSTMX) is 0.10% a year. For an exchange-traded fund, the Schwab Total Stock Market Index fund (SWTSX) costs 0.06% a year. Each company has low-cost bond and international funds, too.
That leads to the second important factor investors can control today: how their assets are divided among stocks, bonds and other investments. Those who are sitting in cash and waiting for the market to calm down might be taking on more risk than they think. Most money markets yield much less than 1% a year and the latest reading on inflation is 3.5% over the past year.
"That creates a big risk that investors will lose spending power while they wait," says John Hailer, president and CEO of Natixis Global Asset Management, U.S. & Asia.
To re-enter the market, or to re-balance a lopsided portfolio, one old guideline calls for an investor to hold a percentage in bonds equal to his age. It's a good starting point, but flexibility is needed, says Scott Schermerhorn, chief investment officer with Granite Investment Advisors, a Concord, N.H., money manager.
"An 80 year-old who plans to leave most of his money to a young heir probably should have more than 20% in stocks," he says. "And a 40 year-old who's unemployed and living off his savings probably wants less than 60% in stocks."
Schermerhorn recommends thinking of allocations as ranges; rather than keep 50% in stocks, target 40% to 60% depending on whether stocks are broadly cheap or expensive relative to bonds. "Recently the S&P 500 has yielded more than the 10-year Treasury," he says. "That's rare and it suggests stocks are a much better deal than bonds."
Such active shuffling doesn't appeal to everyone. "The problem with tactical asset allocation is that most investors aren't good at it," says Fran Kinniry with Vanguard's Investment Strategy Group.
Mr. Hailer says most investors focus on holding stocks and bonds and ignore key asset classes, like real estate. "To control risk investors should use a broader set of tools," he says.
Investors should also beware hidden allocation bulges. For example, U.S. multinational companies have seen a sharp rise in revenues from emerging markets in recent years. That means that adding an emerging-markets fund to a U.S. fund could leave investors with more emerging-markets exposure than they think, according to Mr. Schermerhorn.
Finally, consider savings. More of it is better, of course, but it's worth considering the trade-off between finding extra money to invest and seeking higher returns through aggressive investing. Recall Vanguard's median-income investor who saves 9% a year and ends up with $510,000 after 40 years. If he instead saves only 6% but boosts his stock allocation from 50% to 80%, he can expect only $469,000 after 40 years, according to the same study.
In other words, one of the easiest ways to keep portfolio risk in check is to save enough to not have to reach for returns.
Many investors are already saving all they can. For them, one way to keep fresh cash coming into a portfolio is to add plenty of dividend-paying stocks, says Mr. Schermerhorn. Don't reach for the highest yields around, which might be attached to troubled firms, he says. Instead, look for a record of payment growth.
The Schwab U.S. Broad Market exchange-traded fund charges annual expenses of 0.06%. Last weekend's Upside column mistakenly identified the ETF as Schwab Total Stock Market Index, which is a mutual fund that charges 0.09% a year.