by Archie M. Richards, Jr., CFP^®
May 27, 2002

Michael writes that his 74-year-old mother-in-law recently inherited 10,000 shares of Torchmark and 1,000 shares of Waddell & Reed. Social Security is her only source of income. She's worried about the stock market. What should she do?

She should diversify, Michael. Her risk of loss is higher than it needs to be.

Like all stock investors, she has market risk. If the market falls significantly, her two stocks would probably fall with it.

Market risk she should accept. The economy is not falling apart. With improving productivity from new technologies and 3 billion people released from Communism only a decade ago, the world markets will recover. I expect the U.S. stock market to rise slowly at first and faster as time goes on.

But your mother-in-law also has "specific" risk. Even if the market goes up, her two stocks may fall. Specific risk she doesn't need. Her stocks should be sold.

The taxes would be insignificant. The income-tax costs of the two stocks are the values at the death of the person who owned them before. The death having occurred recently, the date-of-death values are probably close to the current values. Your mother-in-law would pay little or no capital gains tax when she sells them.

I suggest she diversify to index funds. An index measures the performance of a certain kind of security. For example, Standard & Poor's keeps track of an index that reflects the performance of America's 500 largest stocks. As those stocks rise or fall by a certain percentage, the S&P 500 Index changes by the same percentage.

An index fund endeavors to track an index by holding the very same stocks that are included in the index. An S&P 500 index fund, for example, holds all 500 stocks chosen by Standard & Poor's for its index.

Index funds don't try to beat the index they're following; they just try to equal it. The operating costs of such funds are very low. So are the capital gains distributions.

I recommend that your mother-in-law acquire Vanguard index funds of bonds, real estate, domestic stocks, and international stocks. (See www.Vanguard.com or call 800-662-7447.) The following funds and proportions I consider ideal:

20 percent: The Long-Term Bond Index Fund

20 percent: The Real Estate Investment Trust (REIT) Index Fund

30 percent: Total Stock Market Index Fund

30 percent: Total International Stock Market Index Fund

By spreading her money among different investment groups, weakness in one is partially offset by strength in another. The risk of the whole is reduced.

Results will improve if she rebalances the portfolio every 13 months. (Holding for more than a year results in long-term capital gains, which reduces taxes.) Any fund whose percentage of the entire portfolio is then 30 percent higher than the percentage originally assigned to the fund should be partially sold. For example, if a fund that started at 20 percent of the portfolio is now above 26 percent, it should be cut back to 20 percent. The proceeds should be added to funds that have underperformed. Rebalancing causes sales at relatively high prices and purchases at relatively low prices - the opposite of what most investors do.

The dividend payouts from all four of the index funds above would be 2.6 percent. Your mother-in-law's portfolio should amount to about $430,000. Her income would be $11,000.

The dividend payouts from the bond and REIT index funds are fairly high. The payouts from the other two funds are low. If she draws her dividend income primarily from the bond and REIT funds, the 20, 20, 30, 30 percentages would be thrown off. She should therefore request Vanguard to pay out distributions from all four funds - 2.6 percent of the value of each.

If your mother-in-law needs income higher than 2.6 percent, she should take it. Withdrawals of even 5 percent of each fund would still enable the portfolio to grow.

If she has difficulty with all this, Michael, you could help her. Or you might seek the assistance of an accountant.

By adopting this diversified investment program, your mother-in-law's financial future would no longer depend on just two companies. Her money would be invested in over 5,000 of the world's business enterprises. Her long-term gains would probably improve. Her risks would certainly diminish.