by Archie M. Richards, Jr., CFP^®
October 11, 2004

Ralph writes, "My wife and I, nearing 60, want to retire in a year or two. Our investments are worth around $800,000, all in index funds. We hold 30 percent in a total U.S. stock market fund, 30 percent in an international stock fund, 20 percent in real estate investment trusts (REITs), and 20 percent in bonds. We rebalance every thirteen months. Are these percentages appropriate for us, so close to retirement?"

Age shouldn't matter in an investment portfolio, Ralph. Assume that the younger of you and your wife will attain 100. That's more than 40 years off. Why invest differently than a youngster who has 40 years of employment ahead? Your need for income in retirement shouldn't affect your investing for the best possible returns with the least possible risk.

I like your allocation to 60 percent stocks (half U.S. and half foreign) and 40 percent income producers (half REITs and half bonds). The price fluctuations of the REITs and the bonds don't match those of stocks. This reduces the volatility of the whole portfolio, and this in turn eases anxiety, helping to avoid selling the stocks during bad times.

Rebalancing cuts the risk even more. You sell a portion of the index funds that have moved up a lot and buy those that have moved down a lot, bringing the portfolio back roughly to the original percentages. Rebalancing automatically sells high and buys low - no judgment needed. Generally, the less often we exercise investment judgment, the better the results.

You can even rebalance in 12 months and a day. As long as you wait the extra day, you avoid high-taxed short-term capital gains.

You could cut your risk further by dividing the U.S. stocks into big growth & big value stocks (10 percent each) and small growth & small value stocks (5 percent each), totaling 30 percent. Also, divide the international sector 10 percent each in European, Far Eastern, and Emerging Market funds.

All of this means a portfolio of 9 index funds: 4 for U.S. stocks, 3 for foreign stocks, 1 for REITs, and 1 for bonds. The more diversification, the better.

If you need income during retirement, withdraw up to 6 percent a year. More than this risks outliving your capital.

To receive income, don't direct the mutual funds to pay you dividends and interest. The REITs and bonds pay income at a higher rate than the stocks. If the funds all pay out dividends and interest, the REITs and the bonds would draw down faster than the stocks. Your income stream would also be uneven.

Instead, direct the funds to reinvest both income and capital gains into the purchase of additional shares. For rebalancing purposes, you want changes in the proportions of the funds to be caused solely by the fluctuation of values, not by income withdrawals.

Let's say you want income of 5 percent a year, payable quarterly. Assume you have 10 percent of your portfolio ($80,000) in big growth stocks. Five percent of $80,000 is $4,000. You would direct the fund to pay you $1,000 per quarter.

In the next year, after rebalancing, let's say the fund's value has risen to $90,000. You'd raise the quarterly income to $1,125 (5 percent of $90,000, divided by 4). Do this calculation each year for each fund.

Never mind your age. Use index funds, diversify widely, rebalance annually, and in retirement take out up to 6 percent income a year.

Oil drilling partnerships are becoming popular. Stay away from them. Drilling is risky. Plus, the price of oil will fall from the current $53.31.

Think of the pricing this way: You're in a rowboat, leaning way over to starboard. The boat tips far to the right. You then lean way over to port. The boat tips far to the left. Your movement subtracts your weight from the starboard side and adds it to port. The effect is doubled. The boat pitches a lot in each direction.

The high price of oil also has a double effect: It lessens the desire of consumers to use oil, and it increases the desire of companies to produce it. As a result, the price will fall from its current height. Avoid oil-based investments.