Here are the recent and cumulative returns of some major market sectors.  As noted in my earlier musings, I prefer to use index funds to measure returns (including dividends and trading costs) rather than the indices themselves.  These are the returns you actually would have received investing in these funds, rather than hypothetical index returns.

Total Returns (including dividends) Through September 30, 2006			Third	Year To	5 Year	10 Year
			Quarter	Date	Average	Average
Sector	Vanguard Fund	Ticker	2006	2006	Annual	Annual
Large Cap U.S. Stock Index	500 Index Fund	VFINX	5.62%	8.42%	6.85%	8.51%
Broad U.S. Stock Index	Total Stock Market Index Fund	VTSMX	4.50%	7.91%	8.45%	8.56%
Broad International Index	Total International Stock Index	VGTSX	3.97%	13.88%	15.42%	6.80%
Real Estate Investment Trust Index	REIT Index Fund	VGSIX	9.39%	23.84%	21.71%	15.21%
Long-Term Bond Index	Long-Term Bond Index Fund	VBLTX	6.81%	1.42%	6.93%	8.09%
Mid-Cap U.S. Stock Index (Medium size companies)	Mid-Cap Index Fund	VIMSX	1.30%	5.79%	14.41%	NA
Small-Cap U.S. Stock Index	Small-Cap Index Fund	NAESX	-0.26%	6.61%	14.08%	9.70%

Note that large stocks (particularly U.S. stocks) outperformed small and mid cap stocks this quarter.  Perhaps the most surprising return this quarter is that of Real Estate Investment Trusts which continued to trounce the other asset classes.  Remember REITS represent commercial property, hotels, apartments, etc., – not your local personal residence or the condominium market.  You need to be careful not to chase returns using this data.  History has shown that the best performing investment next year is unlikely to have been the one that performed best last year.  REITs have had a good run and many are very high priced at this point.  I would not expect the coming quarters to have any where near these returns, in fact, I think buying opportunities may occur in the future, especially if long term interest rates rise. 

Remember, a diversified portfolio with representation of many asset classes (types of investments) reduces risk and can help you sleep better at night.  Don’t put all of your eggs in one basket (but if you do, watch that basket very closely).

Let’s assume that:

• You have accumulated $1,000,000 in tax-deferred retirement accounts
• Long-term stock returns are expected to be 9% per year - a little lower than the average return during the past 80 years or so (with a standard deviation of 20% - a measure of the volatility of returns)
• Long-term government bond returns are expected to be 5% per year (with a standard deviation of 9%)
• Long-term inflation is expected to be 3%.

If you invest 100% of your portfolio in stocks and desire to withdraw enough each year such that the remaining funds are reinvested to increase future payments by the rate of inflation, you might assume that you could safely withdraw $60,000 (9% minus 3% inflation) the first year, $61,800 the second year, and so on, without ever running out of money.  Unfortunately, this is only possible if stocks had a return of 9% every single year with no variability.  In reality, stock returns are variable and several years of consecutive losses can occur – impairing your ability to maintain withdrawals at the planned level.  Using historical volatility, the above assumptions and software which permits running many possible scenarios reveals that if you invest 100% of your portfolio in stocks you actually have about a 50% probability of running out of money within 30 years (withdrawing $60,000 each year adjusted for inflation).

A 50% probability of running out of money is not very attractive.  Using the same software we can determine that the maximum “sustainable” withdrawal amount which would reduce the probability of running out of money in 30 years to 10% is about $27,500 adjusted for inflation! 

What if we had invested in long-term government bonds instead?  The maximum “sustainble” withdrawal amount (keeping the probability of running out of money within 30 years at 10%) is about $29,000.  

While stocks have historically had higher returns they are more variable, bonds provide a higher sustainable withdrawal amount.  However, while the sustainable withdrawal may be higher for bonds the average wealth accumulation in the event you don’t run out of money is expected to be lower (less money on average to leave to your heirs if that is one of your objectives).

As noted in earlier posts, diversification is important.  It is especially helpful during  retirement.  Using the above assumptions, consider the following portfolios and the maximum sustainable, inflation-adjusted withdrawal (keeping the probability of running out of money within 30 years at 10%):

            70% Stocks/30% Bonds                      $32,000

            50% Stocks/50% Bonds                      $34,000

            30% Stocks/70% Bonds                      $34,000

By diversifying between stocks and bonds you can improve the sustainability of your retirement withdrawals!  Once again this demonstrates the benefits of investing in different asset classes that do not always move in the same direction rather than putting all of your eggs in one basket.  This example only considers two assets classes (stocks and bonds).  Further improvement can be made by including other assets classes such as real estate investment trusts and international securities.  Sustainable withdrawals can also be enhanced by using risk reducing techniques such as a covered call strategy (more on this on a later date).

As always, your asset allocation will depend on your risk tolerance, current market conditions and expectations.  Also your asset allocation during your pre-retirement (accumulation) years is likely to be different that your asset allocation during retirement (distribution) years.  During pre-retirement years more volatility can be tolerated as annual distributions are not being made.

This has changed with the proliferation of exchange traded funds in recent years.  An exchange traded fund (ETF) is a mutual fund that trades throughout the day like a stock.  ETFs have been available for many years in various international sectors (for example a Japan ETF) and types of investments (growth stocks, value, stocks. short term bonds, long term bonds, etc.).  Recently new ETFs have become available which invest in gold, silver, currencies and baskets of commodities.  It is now easy to achieve even greater diversification by investing in these types of assets.  An commodity ETF representing a basket of six commodities (light sweet crude oil, heating oil, gold, aluminum, corn and wheat) became available in early 2006.  More recently, two exchange traded notes (ETNs) have become available representing an even broader basket of commodities (over 20 commodities).  ETNs are a little different than ETFs.  ETNs are notes (like a loan) backed by the commodities, so it is essential that they are issued by a reputable firm to minimize credit risk.  The two recently issued ETNs are issued by a prominent financial firm which is also a large issuer of ETFs.

In addition to diversification, ETFs can be used in other investment strategies such as hedging a portfolio.  For example, if you own stocks in oil and gas companies but feel that oil and gas prices may fall you could take a short position on a commodity ETF concentrated in oil and gas.  If you are concerned about the falling dollar, you can purchase a currency ETF on foreign currencies (there are now several available). These currency ETFs also earn interest which can more than offset underlying expenses and provide income in addition to the currency exposure.  Stock options are available on some ETFs so that options strategies such as covered calls can be  implemented. 

As with any investment, investments in individual ETFs must be considered carefully.  While diversification is desirable, some commodities are at record high prices and it may be wise to wait for a suitable entry price.

“Friday, the Dow Jones Industrial Average fell 40.58 points to 11150.22, leaving it up 0.4% for the quarter and ahead by 4% for the year. It was the fourth straight quarter the blue-chip average has posted an advance.

The Standard & Poor's 500-stock index fell 2.02 to 1270.85, leaving it down 1.9% for the quarter and up 1.8% year-to-date. The Nasdaq Composite Index shed 2.63 Friday to 2172.09. The tech-heavy index fell 7.2% in the second quarter and is down 1.5% for the year.”  Online.wsj.com, “Rocky First Half for Stocks,” June 30, 2006, 9:19PM.

First the good news – they got the numbers wrong (or more precisely they got the wrong numbers).  Now the bad news – they were pretty close.  Business journalists tend to focus on the price performance of the market indices which gives an incomplete picture of the actual performance of the market.  The stock indices such as the S&P 500 are a weighting of the stock prices of the underlying stocks (500 stocks in the case of the S&P 500).  When you invests in securities there are two components to your return; periodic income (such as interest and dividends) and appreciation in price (or as in the case of the quarter just ended - depreciation).  The price indices discussed in the WSJ article only include the price portion.  It is more relevant to focus on the total return, including the periodic income received.  Dividends (and interest in the case of bonds) are an important component of returns. 

Unfortunately, total return indices are not easily accessible to the average investor.  An easily accessible alternative is to look at the actual performance (total returns) of index mutual funds.  This has a second advantage over the price indices.  Investing has costs associated with it (trading and sometimes management fees).  The total returns of index funds, from fund families such as Vanguard and Fidelity, include not only income but also a reasonable amount for trading costs and management.  These are a better proxy of returns that are actually available in the market.  As an example, here is the performance through June 30, 2006 from a sampling of Vanguard index funds:

Note that the year to date return on the Vanguard S&P 500 Index Fund through June 30, 2006 was 2.64% versus the 1.8% reported by the WSJ.  This is not a stellar return, but gives you a better picture of what you could have achieved in this market.

Lets focus on what this data tells us:

·        The markets have been volatile this year with very strong returns in the first quarter (other than for long-term bonds) and poor returns in the second quarter.  Volatility like this occurs when there is uncertainty, which we have a lot of right now.  There is uncertainty as to inflation, interest rates and IRAQ.  The Federal Reserve Board has been steadily increasing interest rates to head off inflation, but there is uncertainty as to when they will stop and concern that they might raise interest rates too far.  Volatility is likely to continue until some of these uncertainties are resolved.

·        Broad U.S. market indices (as opposed to the S&P 500 which represents large stocks) have outperformed for all periods shown above except the second quarter.  The broad market index includes small and mid cap stocks which have outperformed large stocks in recent years, but which can be more volatile.  Also in times of distress there is often a “flight to quality” – large well known stocks.  Note, however, that investing in these broader market indices provides greater diversification than limiting your investments to one sector.

·        Broad international markets have outperformed the U.S. stock markets for the last five years, but not over the last 10 years.

·        Real estate in the form of Real Estate Investment Trusts or REITS (these are real estate businesses such as commercial property, hotels, apartments, etc., – not your local condo market) has continued to outperform the stock markets.

·        Long-term bonds, considered by some to be a bastion of safety, have been a lousy place to be.  This is not surprising since long-term bonds are expected to do poorly in a rising interest rate environment.

The bottom line is diversification, diversification and diversification.  No one can predict future returns.  By having an adequately diversified portfolio including U.S. stocks, international stocks, REITs and other assets you can obtain a satisfactory return while reducing risk.  With the introduction of many new Exchange Traded Funds (ETFs) which invest in asset classes such as commodities you can achieve even greater diversification while hedging against inflation.  Don’t put all of your eggs in one basket (but if you do watch that basket very closely).

If you want to learn a little more about the benefits of asset allocation (investing in different types of assets) – see that topic on my other blog (www.financial-education.com). Asset allocation involves selecting what percentage of your overall portfolio goes into stocks, bonds and other assets.  This does not necessarily mean, however, that you always keep these percentages the same - your asset allocation should also consider current market conditions.  For example, I don’t know what is going to happen to long-term interest rates in the future – but if interest rates continue to rise long-term bonds will suffer more.  You can currently obtain a rate of return on certificates of deposit, money market accounts and short-term government bonds which is not much less than investing in long-term bonds.  Why take the risk of investing in long-term bonds at this time?  It might be advisable to wait until long-term bonds returns are paying a sufficiently higher return to compensate you for the risk.