MONEY Markets

Unlocking a safer, smarter portfolio

With a few tweaks to your portfolio, you can still hedge against the risks that really matter. Illustration: Daniel Stolle

Building in portfolio safeguards can be easy with these common-sense moves.

RORO has made a mess of a lot of carefully designed portfolios.

RORO isn’t what George Jetson’s dog used to say. It’s trader jargon for “risk on/risk off.” Investors pile into risky assets — especially stocks, both U.S. and foreign — when the economic news is bright, and run for cover into Treasuries at the first whiff of trouble.

Even if you’re a steady buy-and-holder, RORO has left its mark in two big ways:

First, diversification is harder. A classic way to reduce your volatility is to own different kinds of assets, so that when one part of the market falls, something else may be going up — or at least falling less. RORO wrecks that. It first roared in the 2008 crisis, when not just U.S. stocks but foreign stocks, high-yield bonds, real estate, commodities, and you-name-it all crashed.

The HSBC RORO index, which tracks how closely assets correlate, or move together, kept rising from there. It stayed near historic highs through late 2012.

The mood-swing trade has tailed off this year, but that’s because U.S. stocks boomed as Europe and emerging markets dragged. So spreading your bets with international stocks didn’t help you in the crisis and isn’t boosting your returns now.

In any case, it’s too early to declare an end to RORO, says HSBC strategist Mark McDonald. With the global economy still vulnerable to crisis, a raised eyebrow from Ben Bernanke or a European finance minister may be enough to set off an undiscriminating tizzy. “Any market hiccup can cause correlations to spike again,” says McDonald.

Second, safety is getting risky. One investment that has smoothed your ride is the safe haven everyone runs to at “risk on” time: Treasuries. They’re now so popular that the yield on a 10-year note is down to less than 1.8% (When bond prices rise, their yield falls.)

That creates some problems: Yields have little room to go anywhere but up from here, which means you could experience sharp losses when interest rates, and thus yields, start to rise again. What’s more, holding bonds at these rates means you risk seeing your investment’s value eroded by even a moderate amount of inflation.

How, then, in this twitchy environment, do you build a portfolio safe enough to let you sleep at night, with returns that get you to your goals? MONEY dove into the best research on diversification and talked to some of the sharpest advisers. The big takeaway: With only a few twists, you can still hedge against the risks that really matter.

What follows are five key ideas to guide a long-term investor through a market where everything turns on the latest news flash.

KEY IDEA NO. 1

Forget the short-term, protect against generational risk

The idea that other countries’ markets will move out of step with the U.S. is an important part of the pitch for international mutual funds and ETFs. (“Diversification” is literally the first word on T. Rowe Price’s “International Investing Explained” web page.) This has become a harder case to make, however.

Consider the relationship between U.S. equities and an index of developed markets. A 100% correlation means markets always move together; zero is no relationship at all. Since the ’70s, correlations have shot up from 37% to 88%.

What happened? Globalization. “As the world becomes increasingly interconnected, macroeconomic events are more often driving market movements,” says Tyler Shumway of the University of Michigan business school. Companies in Europe or Asia do much of their business here, and vice versa.

Even the fact that you can easily diversify abroad with a mutual fund makes it harder, ironically, to reap the benefits of diversification. The anxieties of investors in Florida can feed through to stock prices in Frankfurt.

Step back from the short term, though, and diversification still looks powerful. William Bernstein, a Portland, Ore., investment adviser, says it protects against risks that play out over decades — like a slump long enough to blow out the gains of a generation of investors. That happened to Japanese investors after 1989.

To be blunt: Owning overseas is a hedge against the unlikely but real possibility that you’ll someday find yourself living in the next Japan. Research from AQR Capital Management shows that while countries often fall together in the short term, long slumps are something nations often do on their own.

In a decade in which Japan fell 40%, in fact, a global portfolio rose 130%. “Global exposure helps you cut out the risks of investing in a single country,” says Gregg Fisher of advisory firm Gerstein Fisher. And that includes your own country.

How to retool: Over five years foreign equities have lost an annualized 1.4%, vs. a 4.9% gain for the S&P 500. If disappointing performance led you to lighten up on foreign shares or to stay out, this year’s divergent markets may offer a window to get in. The stocks in Fidelity Spartan International FIDELITY CONCORD SPARTAN INTERNATIONAL IDX I FSIIX -0.4515% look relatively inexpensive, trading at about 13 times next year’s expected earnings, compared with 14.3 for the S&P. “Smart investors go fishing in troubled waters,” says Bernstein.

How much do you want to own? A third of your stocks is a baseline. Though the short-term diversification benefits of going abroad have declined, they haven’t disappeared. A report by Vanguard found you get most of that advantage with a 30% allocation.

The same report also revealed something surprising: “Emerging markets are almost as correlated with the U.S. as is the rest of the developed world,” says Vanguard’s Christopher Philips. These riskier markets might be attractive for their return potential, but there’s no need to add a lot just to be diversified.

A broad international fund with around 15% in such countries, like MONEY 70 picks Dodge & Cox International Stock DODGE & COX FDS INTERNATIONAL STK FUNDS DODFX -0.4064% or Vanguard Total International Stock VANGUARD STAR FUND TOTAL INTL STOCK INDEX FD VGTSX -0.3448% gives you plenty of exposure.

Key Idea No. 2: Some stocks beat others

KEY IDEA NO. 2

Markets may move in sync, but some stocks beat others

The demise of easy stock diversification (at least in the short run) means there’s one less obvious strategic edge available to individual investors. A bulwark against disaster is good — but is there any way to actually capture a better return along the way?

Research into the history of financial markets has found few strategies that offer a long-term advantage. Two that might: owning small-company and value stocks, or shares that trade at a deep discount to earnings or business value. Small-caps beat blue chips by an annualized two percentage points since 1927, according to Morningstar data; large value beat pricier large growth stocks by about as much. Stocks that are small and cheap won even bigger.

The idea of tilting your portfolio toward some corners of the market pushes against the idea of spreading yours bets as widely as possible.

However, Larry Swedroe of Buckingham Asset Management says you can use tilt as part of a strategy to lower your overall exposure to risky assets. He’s found that since 1970, a portfolio with 50% in bonds and the rest split evenly between an S&P 500 index fund and a U.S. portfolio of small value stocks would have matched the long-run return of a fund with all of its assets in the S&P, with less volatility.

Two big caveats: First, the future might not look like the past. Second, this approach takes guts, even with a bigger bond stake. The reason small caps deliver better performance is that they clearly are risky. And although value investing is often thought of as conservative, stocks are often cheap when the market sees trouble ahead.

Besides, when bull markets take hold and “go-go” growth stocks soar, being a value investor can make you feel like a chump. “Way more important than your specific mix of assets is your commitment to keep your money invested through thick and thin,” says investment adviser Rick Ferri of Portfolio Solutions.

Sticking to a tilted portfolio, which is bound to be out of step at times, requires extra commitment.

How to retool: You don’t have to go whole hog on this strategy. Adding even a style-focused ETF like Vanguard Small Cap Value VANGUARD INDEX FDS SMALL-CAP VALUE ETF VBR -0.4813% gets you some tilt. Or, says Daniel Solin, also a Buckingham adviser, you could add the value and small-cap factors separately, with Vanguard Value Index VANGUARD INDEX FDS VALUE PORTFOLIO VIVAX -0.2187% and Vanguard Small Cap Index VANGUARD INDEX FDS SMALL CAP STK PORTFOLIO NAESX -0.3651% .

If more than 50% of your overall stock mix is in value, and more than 10% is in small caps, you’re tilted. A similar strategy can also be applied to your foreign holdings using iShares MSCI EAFE Value ISHARES TRUST ISHARES MSCI EAFE VALUE IND EFV -0.3612% and iShares MSCI EAFE Small Cap ISHARES TRUST ISHARES MSCI EAFE SMALL CAP SCZ -0.3823% .

KEY IDEA NO. 3

Bonds are your frenemy

While correlations within the stock market have risen over the years, Treasuries, the core of many bond portfolios, are now negatively correlated with equities — they often move in the opposite direction. That would be great, if their sub-2% yields didn’t make them such unappealing investments.

“You’re not necessarily being compensated enough for the interest rate risk looming around the corner,” says Peter Palfrey of Loomis Sayles Core Plus Bond Fund, putting it mildly. The duration, or interest rate sensitivity, of a 10-year Treasury is 8.8 years, meaning a one percentage point spike in rates would cut its price 8.8%.

The lack of yield is a big enough worry that veteran investment adviser Charley Ellis, a longtime advocate of a passive buy-and-hold approach to investing, told MONEY in an interview last month that his best advice is to not own bonds.

The tough question is, What would you do instead? Adding a lot of equities can’t be the answer. As the Cyprus crisis earlier this year showed, the global economy is hardly out of the woods yet; bonds will probably still be a cushion in future stock shocks. Cash or CDs are an option for safety, but that means living with yields from barely over zero to 1%.

How to retool: Although not as safe from a rate spike as cash, Treasuries with durations below three years still offer a reasonable amount of protection from a rate turn.

Wealth manager Chris Cordaro of RegentAtlantic Capital also suggests that you diversify with some highly rated corporate bonds. They don’t add much risk of default, and the higher yields they pay give you an extra cushion against an interest rate move. Vanguard Short Term Bond VANGUARD BD IDX FD SHORT-TERM BOND BSV -0.0499% , a low-cost ETF, is mostly Treasuries, but keeps about 20% of its portfolio in high-grade corporate bonds.

Also look beyond the U.S. “Foreign bonds give you good value today, with better yields than Treasuries for income and protection against interest rate risk,” says Bohemia, N.Y., financial planner Ronald Rogé. He suggests that you make foreign bonds about 10% of your bond stake. Pimco Foreign Bon PIMCO FDS PAC INVT FGN BD A USD H PFOAX 0.0914% d is a solid choice that employs hedges against currency risk — the possibility that falling foreign currency knocks out some return.

Finally, if going shorter leaves you hungry for income, consider a change on the stock side of your portfolio. “Many good-quality stocks can get you 3% or 4% yields right now,” Rogé says. SPDR S&P Dividend SPDR SERIES TRUST DIVIDEND ETF SDY -0.2232% , an ETF, currently yields 2.8%; the Vanguard Value Index Fund’s yield is 2.5%.

KEY IDEA NO. 4

Inflation is worth fighting

Shortening-up addresses the interest rate risk in your bond portfolio. Another risk remains on the table: inflation.

Rising prices haven’t been much of an issue in this slow-growth economy — and many economic experts say they may not be for some time — but a diversified portfolio isn’t about protecting against what’s likely to happen. It is insurance against painful shocks.

Boston University economist Zvi Bodie notes that the long-run forecast for inflation is about 2.5% a year. “But I am highly uncertain,” he adds. “I would not be very surprised if it turns out to be 4% or 5%.”

The good news is that the U.S. Treasury sells really effective insurance against inflation in the form of bonds called TIPS, which adjust their principal value in line with rising consumer prices. The bad news is that the yields on them are really lousy — in fact, they are now -0.64%. In other words, you are guaranteed to lose a bit of money on them if you hold to maturity.

Who’d take the government up on an offer like that? You might, once you know that -0.64% represents the real, or after-inflation, yield. Buy a normal 10-year bond yielding 1.73% and you will lose just as much if inflation runs a moderate 2.37%. If it’s higher, you’ll lose more. Although TIPS can’t fix the fact that yields on all kinds of Treasuries are low, they do deliver truth in advertising and probably better real yields than savings accounts or CDs.

How to retool: TIPS are as vulnerable to interest rate risk as any Treasury, so for the most part short is the way to go. Pick the low-cost Vanguard Short-Term Inflation Protected Securities VANGUARD MALVERN F SH-TERM INFL PROTECTED ETF VTIP 0.04% or buy short-maturity TIPS directly at TreasuryDirect.gov.

As for how much you need to hold in TIPS, consider your life stage. “The average person might have half TIPS and half Treasuries,” says Swedroe. (So if you have a bond fund that’s mostly regular Treasuries, you’d dial back that investment to add a TIPS fund.) He adds that older people will want a bit more, since inflation poses the most serious threat to those dependent on investments for income. Younger people still in the workforce need fewer TIPS.

Unlike with regular Treasuries, there’s a case for owning longer TIPS, but individually, not in a fund. If you need to protect money with no chance of a surprise loss, a TIPS bond protects purchasing power (minus that negative yield). That’s provided, of course, you know for sure you will hold until maturity.

KEY IDEA NO. 5

The new diversification tools Wall Street sells are already rusty

Wall Street’s response to high correlations and lousy bond yields has been to sell “alternatives” — a mixed bag of everything from commodity futures to hedge fund strategies. Avoid these often expensive funds.

The diversification and return potential of alternatives is overstated, argues William Bernstein in the e-book Skating Where the Puck Was.

Commodities futures, for example, had amazing records a decade ago. They beat bonds and stocks, and correlated with neither. But new indexes, funds, and ETFs now mean that anyone can pile into futures — and they have. As the market has become crowded, returns have been lower, and correlations have risen too. When investors were running for the exits in 2008 and 2009, they dumped their futures bets along with their stocks. “The moment you securitize an asset, you begin to destroy its diversification benefits,” says Bernstein.

The same applies to hedge-fund-like strategies such as “absolute return” and “market neutral.” By the time such strategies get to retail, they may be too well-known to work.

There’s no magic combination of assets that will make you a winner every year. Cover the big dangers — a long slump, a rate turn, and inflation — and leave RORO worries to Wall Street’s hyperactive set.

MONEY Ask the Expert

Investing Beyond Your Target-Date Fund

Many investors combine their target-date fund with one or more other investments. illustration: paul blow

Q. “I already invest in a target-date retirement fund. What should my next fund be?”– Errick Chiasson, Baldwinsville, N.Y.

A. Target-date funds are designed to provide not only a fully diversified portfolio in a single fund, but also an investing strategy. Their mix of stocks and bonds gradually becomes more conservative as you age, protecting your savings as you near retirement. So in theory these funds work best if you put your entire 401(k) into one.

In the real world, however, many savers don’t take such an exclusive approach. A recent Vanguard survey found that just under half of target-date investors in its 401(k) plans combine target funds with one or more other investments, in some cases even another target fund.

While mixing another fund with a target fund can be a reasonable choice, you have to be careful that doing so doesn’t leave you with an unruly mishmash instead of a coherent portfolio.

Straying from the target

One good reason for going beyond a target fund is to adjust how much risk you’re taking.

Let’s say you’re a young investor who likes the target-date concept because it frees you from having to create a portfolio on your own, but you’re anxious about having 90% of your money in stocks, a typical allocation for investors in their twenties and thirties. Transferring, say, 20% of your target fund’s balance into a diversified bond fund would give you a considerably less volatile portfolio.

Conversely, you could make a similar shift into a total stock market index fund to boost your 401(k)’s growth potential. This add-on strategy is a more effective way to tweak risk than picking a target fund with a later or earlier retirement date.

Once you get beyond this sort of simple fine-tuning, however, things can get hairy. Some investors employ a “core and explore” strategy in which they use a target fund as a foundation and then add funds that focus on certain sectors, such as emerging markets or real estate.

Problem is, most target funds already spread their assets widely both here and abroad. So you could end up doubling down on niche markets.

Besides, you may not enjoy enough extra return to make up for the added time and trouble of monitoring and re-balancing a considerably more complicated portfolio.

If you do go that route, plug all your retirement investments, including those outside your 401(k), into Morningstar’s Portfolio X-Ray tool (available free at troweprice.com). That way you can see your overall allocation and make sure you’re not inadvertently overweighting any areas.

But once you’re investing in so many other funds that your target fund essentially becomes a bit player, you may be better off simply building a portfolio from scratch.

MONEY Ask the Expert

What’s Your Real Risk Tolerance for Investing?

Q. What’s my risk tolerance? I’m 31 and 90% in stocks, but I’m not willing to take a 50% hit. Craig Carlson — Omaha, Neb.

A. Considering how often the term “risk tolerance” is bandied about in the investment world, you’d be surprised how much confusion surrounds it.

Many people believe that your appetite for risk rises and falls — that is, you’re more willing to take on risk during bull markets, less so during bears.

Not true, says Geoff Davey, director of FinaMetrica, an Australian firm that creates risk-profiling systems.

You have a set amount of risk that you’re comfortable with. When you feel the urge to bail after a meltdown, your temperament didn’t change; you misjudged the risks you were taking.

“People underestimate risk when markets are booming and overestimate it when there’s a bust,” says Davey.

So how can you get a better handle on this crucial concept and develop an investing strategy?

For starters, think seriously about how much you could watch your savings drop before you panic.

From the market’s 2007 peak to the 2009 trough, stock values plunged more than 50%, while intermediate-term government bonds rose roughly 6%. A portfolio of 90% stocks and 10% bonds fell 45%; a fifty-fifty mix was down about 22%.

If you think 20% or so is the most heat you could stand, a 50% stock stake is probably close to your upper limit, even though that’s far less than what’s often suggested for someone your age.

You could also fill out one of the many risk-tolerance questionnaires available online. The problem is, most tend to focus on how much risk you ought to take with your investments, not the swings you’re prepared to handle.

A notable exception is FinaMetrica’s questionnaire (Cost: $45), which gives you a numerical risk-tolerance score on a scale of 1 to 100 that corresponds to the percentage of risky assets that’s appropriate for someone like you.

You may, however, discover a gap between the amount of risk you can tolerate and the amount you must embrace to reach your goals.

Say you prefer a fifty-fifty stock/ bond split but, given what you’re saving, you need upwards of 70% in stocks to generate the necessary returns. You could buy more stocks in hopes of higher gains, but investing too far outside your comfort zone could backfire. You could end up selling at a big loss during a downturn.

The better option: Adhere to a portfolio you can handle and make other adjustments, such as saving more, working longer, or scaling back your retirement lifestyle.

Finally, most people become less tolerant of risk as they age. But even if you’re okay with the same stock-heavy mix at 65 that you had in your thirties, you’ll probably still want to dial back. The same loss you shook off in your youth could so deplete your nest egg in retirement that it might never recover.

MONEY

Investing rules of thumb: Why they don’t always work

I’ve always heard that 100 minus your age gives you the percentage of your retirement portfolio that you should invest in stocks. Do you recommend that rule of thumb as a good way to invest? — John Noel

There’s no question that rules of thumb — or “heuristics,” as behavioral economists call them — can simplify activities many people find confusing, such as investing. Easy-to-follow rules can even sometimes produce better results than more sophisticated methods.

For example, researchers found that small business owners who were taught basic rule-of-thumb techniques for estimating profits and calculating revenues improved results more than those who were trained in the fundamentals of traditional financial accounting (which may come as no surprise to anyone who’s struggled through an accounting course).

Still, I’d be wary about relying exclusively on rules of thumb when it comes to investing, or for that matter, any other aspects of retirement planning, including the 70% rule for estimating how much income you’ll need in retirement and the 4% rule for gauging the amount you can safely withdraw from your nest egg after retiring.

One reason you need to be cautious about applying a rule of thumb is that many times there’s no real consensus about what the standard is. For example, when I arrived at MONEY Magazine nearly 30 years ago as a (relatively) fresh-faced writer who still had a full head of hair, 100%-minus-your age was the widely accepted gauge for determining how much stock one should have in a retirement portfolio.

But as investors became more enamored of stocks in the bull market of the late 1980s, you began to see references to a 110-minus-your-age benchmark. And by the time the “Stocks for the Long Run” culture really began to dominate, 120 minus your age was being touted as a more appropriate standard.

Related: Six secrets to a dream retirement

So if you were, say, 30 years old, you could end up with anywhere from 70% of your savings in stocks (100% minus 30) to 90% (120% minus 30), depending on which version of the rule you applied.

But even aside from the question of which benchmark is the accepted one, there’s the even more important issue of whether you should be basing your retirement investing strategy on any rule of thumb. After all, by its nature a rule of thumb is a metric that’s meant to apply to the average person or typical situation.

You’re not an average, though, and your finances may not be typical. You are you, a specific person who has distinct financial needs and preferences.

For example, if you’re age 65 and ready to retire, applying the 100-minus-your-age standard would give you a stock stake of 35% of your savings. That may be perfectly fine for many 65-year-olds. But if you have a relatively modest nest egg and you’re likely to bail out of stocks if the Dow drops 20%, then investing 35% in equities could be too racy for you.

If, on the other hand, you’ve got a huge pot of savings that can continue to throw off sufficient income even if the market tanks, or if Social Security and a pension cover enough of your expenses that large fluctuations in your retirement balances don’t faze you, then it may make sense for you to boost your stock holdings well beyond 35%.

So what do I propose instead of going with a rule of thumb?

Well, when investing for retirement you want to create a stock-bond allocation that can get you the returns you need without subjecting yourself to a level of risk that you can’t handle.

One way to arrive at an acceptable tradeoff between those two aims is to go to a good retirement calculator, plug in your financial information and test run a variety of stock-bond mixes. That will give you an idea of how your chances of achieving a secure retirement may change as you increase or decrease your exposure to stocks.

Related: Social Security’s role in your portfolio

Once you’ve arrived at a blend of stocks and bonds that seems appropriate, you can then go to Morningstar’s Asset Allocator tool to see how far that mix might drop over the course of three months if the market tanks. You could also do a quick back-of-the-envelope calculation to determine how large a loss a given blend might have sustained in severe downturns in the past.

From late 2007 to early 2009, for example, stocks lost roughly 50%, while the broad bond market gained about 15%. So an 80-20 mix of stocks and bonds would have sustained a loss of 37% vs. a setback of only 17.5% for a portfolio split equally between stocks and bonds.

Of course, there’s no assurance that the future will unfold exactly like the past. It probably won’t. But going through the exercises I just described can at least give you a sense of what the possibilities are for different allocations of stocks and bonds — and offer a much better guide for investing your retirement savings than any rule of thumb.

MONEY Investing

Where To Put Your Retirement Money

From the years you spend tending to your portfolio to the time when you finally get to enjoy sweet success, you face questions about what to do. Ace these and prosper.

This story is part of Money magazine’s story 5 retirement choices: Get ‘em right, live well which covers big decisions that can dramatically boost your income in retirement.

Once you determine how much of a saver you are, you have several more decisions to make — including how you invest your portfolio.

Decision No. 2: How should you divide up your money?

The decision: Once you’ve amassed a portfolio worth more than five figures, you may wonder whether you should branch out from plain-vanilla stock and bond funds.

To hear some advisers tell it, you can’t have a truly diversified portfolio unless you spread your money among virtually every asset class, sector, and subsector under the sun: hedge funds, currency, single-country funds, precious metals, exotic ETFs.

Why it’s important: You can capture more than enough of the benefits of diversification — solid returns while minimizing risk — with a relatively simple stocks/bonds mix.

Related: Betting your retirement on stocks

Start by making sure you own a broad swath of U.S. stocks and bonds. Then add developed and emerging foreign markets.

For inflation protection, you might pick up some real estate and TIPS. Adding more to this basic blend isn’t likely to appreciably boost your performance.

In fact, stocking up on a dozen or more different assets may work against you. One reason is the phenomenon that asset-allocation expert William Bernstein refers to as “overgrazing” — as more and more investors plow money into a newly discovered alternative investment, the lower its expected return.

Related: Investing in TIPS – Can retirees beat inflation?

“The first ones in get sirloin, but the latecomers get hamburger or worse,” says Bernstein. Many nontraditional assets also come with hefty fees.

As you pile on more investments, monitoring and managing them become harder.

“If you’ve got upwards of 20 different investments in 401(k)s, IRAs, and taxable accounts, you’re talking about a blizzard of trading every time you rebalance,” says Wealthcare Capital Management CEO David Loeper.

Best move: The simplest way to create this mix is by using index funds or ETFs from our MONEY 50 list. Aside from simplicity, they have the advantage of certainty: These funds strictly follow defined benchmarks, so you know exactly how they’ll invest.

Most important, though, resist the urge to jump onto the alternative investments bandwagon. Says Bernstein: “Wall Street needs to sell them, but you don’t need to buy them.”

 

MONEY Savings

5 Retirement Choices: Saving vs. Investing

From the years you spend tending to your portfolio to the time when you finally get to enjoy sweet success, you face questions about what to do. Ace these five and prosper.

Making better decisions can dramatically boost your income in retirement, a new study finds. That’s not exactly earth-shattering news. What may surprise you are which decisions matter most, according to researchers at Morningstar.

They are not the kinds of choices you may obsess about, like whether to buy Apple stock or where to find the next hot emerging market. Rather, the most crucial decisions involve more fundamental issues, like how you manage your 401(k) plan.

The idea of making savvy choices applies to all phases of planning. So, based on what I’ve learned writing my Ask the Expert column, I came up with these five big decisions you need to get right before and after you retire.

1. Are you a saver or an investor?
2. How should you divide up your money?
3. How much help do you really need?
4. What’s the best use of tax-deferred plans?
5. How much can you draw from your savings?

Decision No. 1: Are you a saver or an investor?

The decision: When you sign up for a retirement plan or use an online calculator to track your retirement progress, you must decide how much to save and how to invest those savings. It may seem counterintuitive, but your savings rate is by far more crucial.

Why it’s important: Even though history shows that tilting a portfolio toward equities generates higher returns, loftier gains are hardly guaranteed — witness the 3.4% annualized loss you would have suffered by investing in the S&P 500 index from March 1999 to March 2009. And investing too aggressively leaves you more vulnerable to downturns like the near 60% drop in the 2007-09 bear market. Ratcheting up the amount you sock away is a surer way to improve your chances of achieving a secure retirement.

Increasing how much you save every year has a much bigger impact on your eventual retirement security than investing more aggressively does. The reason: While shifting more savings to stocks enhances return potential, it also increases volatility, which dilutes the effectiveness of a stock-heavy portfolio.

Saving more has another benefit: You can afford to invest more conservatively. By saving 20% a year for 30 years — a high bar, for sure — you can trim stock holdings to 60% and still have the same high chance of success you would have with an 80/20 mix.

Best move: Aim to save 15% or more a year. You’ll improve your odds of retiring in comfort and be less vulnerable to the vagaries of the markets.

MONEY Ask the Expert

Betting Your Retirement: Stocks vs. bonds

Q. I’m 35 years old and a diligent saver. I’m torn, however, about whether someone my age should own bonds. If the stock market has never had a negative 10-year span, shouldn’t I invest 100% of my savings in stocks and keep it there until I’m within a decade or so retiring? — Mark N., Austin, Texas

A. With stocks on a roll in recent months, investors who were shunning equities just last year are feeling positively ebullient about them now. But before you plow all your retirement savings into stocks, I have two words of caution for you: Downton Abbey.

What, you may ask, could a soap opera set in England in the early 20th century possibly have to do with your retirement planning? Rather a lot, actually.

As viewers of Downton’s third-season premiere will recall, Lord Grantham’s lawyer informed him that the Canadian railway into which he had sunk the bulk of his wife Cora’s fortune stood on the verge of bankruptcy, jeopardizing the financial health of his estate.

Upon hearing this news, the Earl of Grantham thundered, “Every forecast was certain. Rail shares were bound to make a fortune…It wasn’t just me. Everyone said we couldn’t lose!”

I’m not saying that putting 100% of your retirement savings in stocks is as rash as Lord Grantham’s decision to invest so heavily in just one stock. But tying your retirement prospects to the performance of a single asset class — and a very volatile one at that — wouldn’t exactly qualify as a prudent move either.

One reason is that while losses in stocks over long stretches are rare, they do happen, despite your supposition to the contrary.

Related: Can retirees beat inflation?

For the 10 years from 1999 through 2008, for example, large-company stocks lost 13% of their value. There have also been a handful of 10-year and even 20-year spans during which stocks had positive returns yet still lagged bonds.

So while I think it’s reasonable to expect stocks to outperform bonds over the long term in most instances, there’s enough variation so that it pays to hedge. The investing world is too uncertain for all-or-nothing bets.

Besides, you shouldn’t be basing your investing strategy solely on expected returns. You’ve also got to consider your risk tolerance, or how you’ll likely react if the market tanks (as it inevitably will many times between now and when you retire).

It’s one thing to say you think you should be 100% in stocks because you believe that over long periods equities will rack up the highest gains. It’s quite another to stick to that strategy when a plunging stock market zaps the value of your 401(k) by 50% or more, and it’s anyone’s guess how long it will take for your account to bounce back.

My suggestion: Go to a good online retirement calculator and plug in such information as your age, when you think you might retire, how much you already have tucked away in retirement accounts and how much you plan to save going forward. Then run scenarios with different investing strategies –100% stocks, 90% stock/10% bonds, 80%/20%, etc. — and see how the probability of achieving a secure retirement changes as you reduce the percentage of your savings you devote to stocks.

Related: 4 ways the market could really surprise you

If you’re really the diligent saver you say you are, you may find that you don’t have to resort to a high-octane stock mix to have a good shot at a comfortable retirement. You may be able to get by with a more conservative stocks-bonds blend. You might also find that after a certain threshold — say, 70% or 80% stocks — adding more equities doesn’t improve the odds very much at all.

Of course, it’s also true that the more you invest in stocks, the better you’ll do if the markets do well. But that upside isn’t a given, and even if it materializes it can come with some frightening spills and chills along the way. So it can pay to sacrifice some upside in return for a less jarring ride.

As you near and enter retirement, you’ll probably want to gradually scale back the amount you devote to stocks. Research shows that risk tolerance tends to decrease with age. Besides, the consequences of aggressive investing can be more dire later in life. Once you’re retired, you no longer have a chance to make up for investment losses by saving more.

That means a big hit to your nest egg could result in you running out of money before you run out of time. For guidance on how you might shift from stocks to bonds as you age, check out this illustration of a target-date retirement fund “glide path.”

But whatever you do, don’t go all stocks on the mistaken notion that equities are a definite win as long as you remain invested in them at least 10 years. If you do, you may later find, as Lord Grantham did, that no forecast, regardless of how certain it may seem, can ever guarantee that you can’t lose.

MONEY Ask the Expert

Investing in TIPS: Can Retirees Beat Inflation?

Q. Are TIPS a good investment for a retiree? — Rich Sherman

A. If your goal is to protect the value of your assets and your income from inflation over the course of a long retirement, then you should certainly consider TIPS, or Treasury Inflation Protected Securities.

But before you go stuffing your retirement portfolio with them — or more likely, TIPS funds — you first need to understand the type of the inflation risks you face in retirement. You’ll also want to keep in mind that you already have a very powerful inflation buffer in Social Security, as its payments are pegged to the inflation rate.

So as important as hedging your retirement portfolio against inflation is, you don’t want to overdo it.

Essentially, you need to guard against two forms of inflation during retirement. The first is what economists call expected inflation, or the steady rise in the price level that takes place over many years.

Hedging against this version of inflation is relatively straightforward: Keep a portion of your savings in investments that have the potential to generate returns several percentage points or more above the inflation rate over the long term.

Stocks are clearly one such investment, although mutual funds that invest in REITS and other real estate-related investments can also provide long-term inflation-beating returns. (Don’t forget that if you own a truly diversified portfolio of stocks, such as a total stock market index fund, you already have REITs in the mix.)

Related: Long-term investing — keep it simple

The second type of inflation you need to protect against is unexpected inflation. This is the kind that can flare up suddenly, like the oil-price shocks of the mid-1970s and early 1980s.

These spikes are usually relatively short-lived, so they’re not a major issue for people still investing for a retirement that’s decades down the road. But if you’re a retiree relying on your investments for current spending cash, even short spurts of inflation can make it more difficult to maintain your standard of living.

The issue is how to deal with this second inflation threat. Many advisers recommend investments like commodities or gold, which have the potential to generate lofty returns when unanticipated inflation takes off.

But Vanguard Investment Counseling and Research principal John Ameriks points out that these outsized returns aren’t a given. “There are many historical instances where you see high inflation and low commodity returns,” says Ameriks. Indeed, research shows that there’s roughly a 30% chance that commodities could post negative returns if inflation goes up.

TIPS, on the other hand, are uniquely suited for handling unexpected inflation. Unlike commodities or gold, which may be statistically likely to climb in value if inflation spikes, TIPS have been specifically designed to rise along with increases in the consumer price index.

Related: Are emerging market bond funds a safe haven?

That said, TIPS also have some drawbacks. They are bonds, so their value can fall if real interest rates rise. What’s more, demand for TIPS from investors seeking shelter from inflation has pushed their real yield, or their payout after inflation, close to or even below zero. Recently, for example, the real yield on 10-year TIPS was -0.53%.

Many advisers have pointed to TIPS’ negative real yields as a reason not to own them. But while investing in TIPS when their real yield is negative does mean you’ll earn less than the inflation rate, the principal value of the TIPS and the income they throw off will still rise if inflation picks up. Thus, by owning them you are still protecting yourself should inflation climb in the future or spike unexpectedly in the short-run.

Besides, it’s not as if regular Treasuries or other bonds will thrive if inflation heats up. Quite the opposite. Conventional 10-year Treasuries recently yielded about 2.03%. So if inflation exceeds that level over the next 10 years, regular 10-year Treasuries would generate a loss. And if inflation exceeds 2.56% — the recent difference between the -0.53% yield for 10-year TIPS and the 2.03% yield for 10-year nominal Treasuries — then TIPS will outperform regular, or nominal, Treasuries.

That’s why you really want to own both TIPS and regular Treasuries and other bonds. If inflation rises over time or just spikes for a shorter period at some point in the future, then TIPS could be the better performer. If inflation stays tame or becomes even more docile, then conventional bonds will generate better returns. By owning both, you’re hedging your bets.

You can argue about how much of a retiree’s bond stake should go to TIPS vs. nominal bonds. But if your retirement portfolio already includes some stocks to protect against expected inflation over the longer term, then devoting, say, 25% to 30% of your bond holdings to TIPS seems a reasonable way to guard against both expected and unexpected inflation.

Bottom line: Investing in TIPS is a reasonable way for you to protect your purchasing power in retirement. But do it in moderation. Because the more you focus your investing strategy toward dealing with one risk, the more vulnerable you are to others.

MONEY Ask the Expert

Long-Term Investing: Keep It Simple

Q. I have $12,000 that I’m ready to invest for a long term. But I’m not sure whether to buy regular mutual funds, index funds or a mix of both. What do you suggest? — Daniel, Sugarland, Texas

A. I believe that investors are generally better off when they keep things simple. So for that reason alone, I’d go with index funds.

You can make a very nice diversified portfolio for yourself by combining just two funds: a total stock market index fund VANGUARD INDEX FDS TOTAL STK MARKET PORTFOLIO VTSMX -0.2414% and a total bond market index fund VANGUARD BD IDX FD COM NPV VBMFX -0.0923% . That would give you a portfolio that covers all sectors of the U.S. stock market — large and small caps, value and growth shares, virtually every industry — as well as the entire investment-grade taxable bond market, including government and corporate bonds.

You would do just fine if you stopped there.

But if you want to add some exposure to foreign markets — which over the long run can reduce the volatility of your portfolio overall — you could also throw in a total international stock index fund VANGUARD STAR FUND TOTAL INTL STOCK INDEX FD VGTSX -0.3448% . For guidance on how to divvy up your holdings between stocks and bonds, you can check out our Fix Your Mix asset allocation tool.

Simplicity aside, this approach offers another huge benefit: low annual expenses.

By sticking to diversified stock and bond index funds, you’ll likely pay yearly fees of less than 0.25% of the amount invested, in some cases less than half that figure. Regular, or actively managed, mutual funds on the other hand, often charge 1% of assets or more. And while there’s no guarantee that lower expenses leads to better performance, there’s plenty of evidence that’s the case, including this 2010 Morningstar study.

Oh, and there’s one more reason I prefer index funds: You know exactly what you’re getting. As their name implies, index funds track a particular index or stock market benchmark. The fund holds all, or in some cases a representative sample, of the stocks in the index and nothing more (except, perhaps, a smidgen of cash to accommodate redeeming shareholders).

Managers of actively managed funds, by contrast, have lots of wiggle room when it comes to investing.

So even though a fund may purport to specialize in, say, domestic large-cap value stocks, it’s not unusual to find a manager making forays into small-caps, growth stocks or even foreign shares in an attempt to juice returns. This sort of “adventurism” makes it harder to use actively managed funds as building blocks for a diversified portfolio in which you’re counting on each fund to play a specific role.

But as much as I believe index funds are the better choice, I don’t think you’d be jeopardizing your financial future by devoting a portion of your investing stash to actively managed funds. And if that’s the way you want to roll, you should have no trouble finding funds run by smart managers with solid long-term records who can do a credible job of investing your money.

In that case, you might employ a version of what’s known as a “core and explore” strategy: put most of your money into index funds and then round out your portfolio with some well-chosen actively managed funds.

Related: Mutual funds – a simple way to diversify your portfolio

How much of your dough goes into the core vs. explore is up to you. But to prevent any bad picks from undermining your portfolio’s overall performance, I’d recommend keeping the active portion of your holdings pretty small, say, 10% to 15%.

There’s one other thing you’ll want to be careful about if you decide to take this hybrid approach. Some advisers suggest using index funds in “efficient” markets like those for U.S. and developed country large-cap stocks and recommend actively managed funds for “inefficient” markets like those for small-caps and emerging market stocks. But identifying efficient vs. inefficient markets isn’t quite so simple, and finding active managers who consistently outperform is difficult in almost any market.

So I’d recommend that you get exposure to all markets with index funds and then add the actively managed funds you like even if it means you’ll have a bit of overlap in some areas.

I also suggest that as much as possible you go with actively managed funds that have reasonable expenses, as that should give those funds a better shot at competitive performance. You can find such funds, as well as all the index funds you’ll need, on our MONEY 50 list of recommended funds.

To sum up, I think most investors would be best served if they just stick with a straightforward portfolio of broad index funds.

Human nature being what it is, however, many people will give in to the urge to venture beyond the indexes for the thrill (even if only fleeting) of finding a fund that beats the market. If you’re one of those people, fine. Just don’t let yielding to that urge undermine your investing results.

MONEY

The other way to invest in a Roth IRA

My income is too high to contribute to either a deductible IRA or a Roth IRA. So am I better off investing in a nondeductible IRA or should I just invest my money in a regular taxable account? — Dennis, Cranston, R.I.

You’re giving up on the Roth IRA too easily.

Even if your income exceeds the Roth IRA income eligibility requirements — and I suggest you check out this calculator to verify whether that’s really the case — you can easily get around that hurdle: Simply open up a nondeductible IRA — which anyone under age 70½ with earned income can do — and then immediately convert the nondeductible IRA to a Roth IRA.

If you avail yourself of this option — colloquially known as a backdoor Roth IRA — before April 15th, you can make the contribution for the 2012 tax year. By doing that, you’ll still preserve the option of making a contribution for 2013 as well.

The maximum contribution for 2012 is $5,000 ($6,000 if you’re 50 or older), while the limit for 2013 is $5,500 ($6,500 if you’re 50 or older). So if you contribute for both years, you can get quite a nice sum into that Roth this year: as much $10,500 if you’re under 50, $12,500 otherwise.

Keep in mind that whenever you convert funds to a Roth, you must pay income tax on any portion of the converted amount that has yet to be taxed. This isn’t likely to be much of an issue if the only IRA you own is the nondeductible IRA you open and then convert.

Related: Your future self thinks you should save more

After all, you made your contribution in after-tax dollars, so those funds won’t be taxed again. The only tax bill you would incur is on investment gains, if any, that accumulate in your nondeductible IRA between the time you opened it and the conversion.

But if you also have money in other non-Roth IRAs — say, traditional deductible or nondeductible IRAs you opened years ago or a rollover IRA that holds money from a 401(k) with a previous employer — then you’ve got to consider the balances in those accounts when figuring the tax on the conversion.

For example, if you have $45,000 in an IRA rollover that consists totally of pre-tax dollars and you contribute $5,000 to a nondeductible IRA that you plan to convert, 90% ($45,000 in pretax dollars divided by your total IRA balance of $50,000), or $4,500, of your $5,000 conversion would be taxable. If your nondeductible IRA had investment earnings, those untaxed gains would have to be included in the calculation as well.

So if you were in, say, the 33% tax bracket, you would owe $1,485 in taxes on the conversion, which means you would effectively have to come up with $6,485 to get $5,000 into a Roth IRA.

But if you’re in this position — that is, you already have money in non-Roth IRAs andwant to get money into a Roth IRA but earn too much — there are two other maneuvers you may want to consider.

If you have a 401(k) plan through work and it accepts IRA rollover money (as most do) you could roll your IRA funds into the 401(k) and then convert your nondeductible IRA. Since you would have no other IRA money, you could convert your nondeductible IRA and avoid taxes (assuming your nondeductible IRA had no investment gains).

The other move you might consider is taking the money that you would have contributed to the nondeductible IRA and paid in taxes to convert that account ($6,485 in the example above) and use those funds to pay the tax to convert as much of the money in any existing IRAs as possible.

This would allow you to get more dough into a Roth than you could via the backdoor method, or nearly $20,000 assuming a 33% tax rate.

If you choose this last route, don’t forget that any pretax dollars you convert are considered taxable income. So moving more money into a Roth could push you into a higher tax bracket and boost your conversion tax bill.

Remember too that converting IRA funds to a Roth IRA — or contributing to a Roth IRA, for that matter — usually makes the most sense if you think you’ll face the same or higher tax rate when you withdraw the money as you did when converting.

That said, unless you’re absolutely sure you’ll face a lower tax rate in retirement, I think it’s a good idea to have at least some money in a Roth account if only to diversify your tax exposure.

Bottom line: if you would really rather invest money in a Roth IRA than a nondeductible IRA or a taxable account, you can easily do so. Okay, maybe “easily” is going too far. But you should definitely be able to pull it off.

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