What to Do With a Million Dollars - Investing

Ever ask yourself, “What would I do with a million dollars?” A good friend of mine recently sold some stock in a company for which she had worked a number of years. The sale generated around $1,000,000 after taxes. This person asked my advice on how to invest the money and, naturally, I was only too happy to oblige.

My friend is 55 years old and would like to take moderate risk in investing the money to help to pay for her children’s college tuition, assist her parents and save for her retirement (she does not have a private pension only social security. The proceeds of the sale are in a taxable account (not in a 401K or IRA accounts).

The first thing I suggested my friend do is read Random Walk Down Wall Street by Burton G. Malkiel. It is required reading and the best source of information I have found for the average investor who intends to invest for retirement, child education, etc. Malkiel does an excellent job of revising and updating the book every four or five years to keep the information current and relevant. It is the classic explanation of how financial markets work, and why investing in non-managed (index) funds is better than investing in managed funds. Random Walk Down Wall Street is on my top three list of all time investment books, the other two of which are targeted to more advanced investors: Common Stocks and Uncommon Profits (classic book on growth investing) by Philip A. Fisher and Security Analysis (classic book on value investing): the 1936 or 1940 edition by Benjamin Graham and David Dodd

If you have read any of my other articles you know that I like index Exchange Traded Funds (ETFs) over Mutual Funds (MFs) and have written a number of articles showing the advantages and disadvantages of ETFs versus MFs. There are three major reasons I like ETFs versus MFs for my friend’s stock allocation portion of her portfolio:

· MF performance versus index: Studies have suggested that actively managed funds (MFs) cannot out-perform index funds (ETFs). Whatever the category, active managed funds cannot beat their index benchmark.

· Tax advantages (for non tax exempt accounts): ETFs do not distribute capital gains every year like mutual funds (except on rare occasions) so you will only have to pay the capital tax when you sell the fund.

· Significant cost advantage: Expense ratios are generally lower for ETFs than for comparable MFs. Vanguard offers very similar ETFs and MFs that follow the same index but the ETFs have much lower expense ratios.

Malkiel’s recommended portfolio allocation for a person in their mid fifties would be the following:

· Stock 55%: One half in US and the other half in international stocks.

· Bonds 27.5%: This would include zero coupon treasuries, no load high grade bond funds, and Treasury Inflation Protection Securities (TIPS).

· Cash 5%: Money market funds and short term bond funds (less than 2 years)

· Real Estate 12.5%: This would include Real Estate Investment Trusts (REITs).

My recommendation is a little more aggressive than Malkiel’s. I would allocate more to stocks and less to bonds and REITs. The following are my recommendations:

· Stocks 70%: 75% US market index, 12.5% international non US index and 12.5% emerging market index. This differs from Malkiel’s allocation. A large number of US companies make over 40% of their revenue from international sales; I think you can have less allocation in foreign stocks because of US companies’ diversification.

· Bonds 18%: A large allocation of my bond fund investments will be in short to medium average duration bond funds because of the current economic environment (bond funds have interest risk)

· Cash 5%: Money market fund and short term ladder Certificates of Deposits (CDs).

· Real Estate 7%: All invested in one or two REIT index ETFs.

I recommended to my friend that she open a Vanguard brokerage account. Vanguard is the low cost leader for ETFs and MFs with 30 years of tracking stock indexes. They are well known for selecting the best target markets and tracking them very closely. You pay no stock commission fee when you buy Vanguard ETFs.

I recommend the following for the stock allocation – all are Vanguard index ETFs:

· US stock market index (75%): Vanguard Total Stock Market ETF (VTI). The current dividend yield (as of February 18, 2011) is 1.9%.

· International non US market index (12.5%): Vanguard FTSE All-World ex-U.S. ETF (VEU). The current dividend yield (as of February 18, 2011) is 1.92%.

· Emerging market index (12.5%): Vanguard MSCI Emerging Markets ETF (VWO). The current dividend yield (as of February 18, 2011) is 1.20%.

Because the money to be invested is coming from selling stock, my friend could invest all the money at one time or she could invest every month in, for example, 6 increments (dollar cost averaging strategy) if it’s looking like there could be a pull back in the market. Since the trades are commission free there will be no commission cost for doing this.

The following are my recommendation for the bond allocation:

· Short term bond fund (35%): Vanguard Short Term Bond Index Fund Investor Shares (VBISX). The average duration of the bond fund is 2.6 years. The current yield (as of February 18, 2011) is 1.14%.

· Short term bond ETF (35%): Vanguard Short Term Bond ETF Fund (BSV). The average duration of the bond fund is 2.6 years. The current yield (as of February 18, 2011) is 1.25%.

· Corporate and government bonds of all maturities fund (30%): Vanguard Total Bond Market Index Fund (VBMFX). The average duration of the bond fund is 5.1 years. The current yield (as of February 18, 2011) is 2.91%.

The following are my recommendation for the cash allocation:

· Money market fund (50%): Vanguard Prime Money Market Fund (VMMXX). The current yield (as of February 18, 2011) is .07%.

· Layered CDs (50%): Portfolio of layered 3 month (90 day) CDs. The current yield (as of February 18, 2011) is .2%.

For the real estate allocation I recommend the following:

· REITs (100%): Vanguard REIT Index Fund (VGSIX). This fund invests in REIT companies that buy and lease office buildings, apartments, hotels, medical buildings and other types of real estate. The current dividend yield (as of February 18, 2011) is 3.13%.

Once a year the portfolio allocation should be reviewed and rebalanced in keeping with changes in the economic picture and personal circumstances. For example, if interest rates are forecasted to decrease, my friend may want to reallocate some of the bond fund allocation to more long duration bonds. This portfolio should generate about $15,000 to $20,000 in cash every year (between dividends and interest payments). This cash can be used to rebalance the portfolio.

Please chime in with your comments on my investment recommendations for my friend. Is there too much risk in the portfolio, should there be different portfolio allocation recommendations, should I have suggested different ETF recommendations, etc.


© 2011

Paul Cusick