Replace the Magic Ball with a sound Asset Allocation Plan

Thanks to FinanceBuff for pointing out the Chris Farrell column over at publicradio.org. His recent article responding to a question about the Market Turmoil was straightforward and right on target. A reader asked what should one do in this market crisis? Should we ride it out or sell stocks and buy safer investments? It's the usual magic ball question. “What does your magic ball say about the future of the market?”

Farrell simply advised that one should:

take advantage of this time by figuring out whether you're comfortable with your portfolio. Are you too much in stocks? Bonds? International? How do you wish your portfolio was constructed? Once you've figured that out, then I would create that portfolio over time.

That is excellent advice. Do not allow yourself to be whipsawed around by the market. Get a plan together and stick with it.

To that end, I have been reviewing my bond allocations. I know that they are too low, however, I am not quite as conservative as some investors. For example, the rule of thumb put forth by John Bogle is that the allocation of bonds in your portfolio should be about 10 percentage points less than your age. So if you are 40 years old, aim to have 30 percent in bonds.

“As you get older, you want more bonds; bonds produce income and time is less on your side to recoup losses,” he said.

Once you settle on an allocation amount, it’s essential to be aware of some other significant aspects concerning bond ownership. For instance, most bonds distribute income, and it is important to shelter that income from taxes, if possible. You will want to select a different type of bond depending on what type of account you are wanting to fund. Starting with

Taxable Accounts:

“For taxable accounts, municipal bonds are extraordinarily attractive compared to Treasury bonds,” Mr. Bogle added. He suggests half short-term bonds (one to two years) and half intermediate-term bonds (six to seven years). When interest rates go up, so will the income on the short-term bonds.

To purchase municipal bonds, you will need to have a brokerage account. It helps to have a broker, who will notify you of new issues. But, you can also research and purchase existing munis from brokerages.

Non-Taxable Accounts:
For retirement accounts, like IRA’s, “inflation is a big, big worry,” he said. “Everybody should consider a significant holding of U.S. Treasury inflation bonds or TIPS.”

So what are TIPS? Treasury Inflation Protected Securities, known as TIPS, are securities whose principal is tied to the Consumer Price Index. As inflation grows, the principal increases, while with deflation, it decreases. When the security matures, the US Treasury pays the original or adjusted principal, whichever is greater.

Here is an informative article by The FinanceBuff about purchasing TIPS at auction. You can also acquire TIPS in a mutual fund, such as VIPSX, which is a low expense, Vanguard fund.

As part of my 2008 financial resolution, I want to increase my bond holdings in my retirement accounts. I plan to accomplish that in two ways 1) Convert some existing shares in my traditional IRA to VIPSX and 2) Add the $5000 IRA contribution allowed for 2008 to VIPSX.

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