Q: I read your recent column on ''Small Percentages Make a Big Difference.'' I am retired. I rely on my investments for income. Can you tell me if I can draw an income of about 5% from a portfolio of low-expense mutual funds, exchange-traded funds and index funds?
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Right now I have investments with a dependable brokerage firm, some of them dividend-paying, solid stocks, some mutual funds (bonds as well as stocks), etc. But I have to pay trading costs, and the funds also charge fees.
I'm wondering if I can cut down on the high costs you cite in your article and have a better income from the investments (that is, low-expense mutual funds, exchange-traded funds and index funds). — C.R., by email
A: I think that's a good bet. For one thing, the cost savings will probably be about the same, or more, than the increase in your withdrawal rate. Suppose, for instance, the current cost of managing your money is 1.25% a year. If you add that to, say, a 4% withdrawal rate, the total burden carried by the portfolio is 5.25%.
Now suppose you move to a low-cost index fund portfolio with an average expense ratio of 0.25%. Then you increase your withdrawal rate to 5%. The total burden carried by the portfolio is, again, 5.25%. Since about 70% of all managed funds fail to beat their benchmark index, the change to passive management will actually increase the odds of portfolio survival, all other things being equal.
The key to higher withdrawal rates is the construction of well-diversified portfolios with lots of asset classes and low correlations between the asset classes. Craig Israelsen, a researcher at Brigham Young University, recently reported on the benefits of broad diversification in the Journal of Indexes. He found that as asset classes were added to a portfolio, its risk declined. The portfolio's maximum decline in a one-year period also declined, as did the frequency of losses greater than 10% in a one-, two- or three-year period.
This is important because large losses and slow recoveries are the major killers of portfolios that are expected to support regular spending rates.
You can experiment with the impact of different portfolios and management costs by visiting www.firecalc.com and testing how changes impact your portfolio based on historical performance.
Q: Why are Dodge and Cox International and Dodge and Cox Balanced rated four and five stars by Morningstar? — R.N., by email
A: Morningstar rates funds by considering the risk-adjusted return of the fund. This reduces the ratings of funds that take extreme risks in pursuit of returns and increases the ratings of funds that take modest risks in pursuit of returns. Basically, they rate funds by the amount of return they provide per unit of risk. In this respect, Dodge and Cox funds continue to compare well against their value-oriented peers.
Over the five years ending Dec. 7, for instance, Dodge and Cox Balanced fund (ticker: DODBX) earned 12.08% a year, putting it in the top 18% of its ''moderate allocation'' peers. Performance was off in 2007, but one year isn't a reliable measure of performance.
The level of risk in the Dodge and Cox Balanced fund, as measured by standard deviation, is usually slightly lower than average. Sadly, Dodge and Cox Balanced fund is closed to new investors.
Dodge and Cox International (ticker: DODFX), an international large-cap value fund, is a similar story. It returned 27.64% annually over the five years ending Dec. 7, putting it in the top 5 Dodge and Cox International (ticker: DODFX), an international large-cap value fund, is a similar story. It returned 27.64%% of its peer group. The average return in the category was 21.96%, according to Morningstar.
In this case, the Dodge and Cox fund has somewhat more risk than the group average, but it still provides more return per unit of risk. Dodge and Cox International is rated five stars, has a minimum investment of $2,500, and a net expense ratio of only 0.66%. That's less than half the 1.42% average of expense ratios in its category.
Questions about personal finance and investments may be sent by email to scott@scottburns.com or by fax to 505-424-0938. Please visit my website at www.scottburns.com to comment on any of my articles, find referenced web links or to discuss personal finance topics on my forums. Questions of general interest will be answered in future columns and on my website.
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