MAKING A BOND PORTFOLIO

In retirement I am a consumer of investment returns and/or capital. So I need to have thought and *keep* thinking about my investments the way a pension fund does. They have a pretty good idea what they are going to have pay out each month over the next 20-30 years. We have to do the same.

With a large IRA or 401K account the IRS does it for us. They tell us each year how much we must take out and pay taxes on. It's based on a life expectancy table, and it goes up each year. Hugh Chou has a calculator http://www.hughchou.org/calc/irawith.cgi I can fill in with IRA totals. I put 0 (zero) for monthly contribution, estimated inflation, dollar estimated contribution increase, and minimum withdrawal to get the actual IRS required minimum withdrawal (RMD). This is an eye opener. You can experiment with earnings estimates, but personally I want to be very conservative and assume not more than 5% annual returns for now. One can vary return assumptions and one can force a distribution greater than the minimum. Try multiplying what you'd like to get each month by 12 and putting that in the last row to see what that does to length of years of payout.

While Chou's calculator is designed for IRAs and 401Ks, you can use it for all your investment funds to see what's realistic to expect from the investment totals you actually have.

OK, so you know what 5% per year will do at each year of age for safe but progressively larger annual withdrawals. How do you get 5% per year on average at this time? Not easily. Go to http://www.gmo.com and click on individual or private investor and sign up for access to their free comment and position papers. Do NOT worry they will try to sell you something, even if you have over $10,000,000 to invest. They don't want you as a client! They are being kind and generous to let us look at some of their work. Once you get your approval email back--it took me three minutes--go to the research area and click on the picture of James Montier. Some of you may remember several posts here on Montier three or four years back when he was with Dresdner Kleinwort and later with Societe Generale. Being a conservative value investor, he's a natural at GMO. Near the top of his most recent report at GMO look for Exhibit 2: GMO 7-Year Asset Class Return Forecasts as of January 31, 2011. Study that exhibit and see why 5% per year adjusted for 2.5% inflation may be hard to get according to GMO, one of the best. Then go back and plug 2.5% inflation into Hugh Chou's calculator and experiment with increasing the annual return % up or down 1-3%.

GMO's 7 year forecasts are similar to those of John Hussman in his weekly blog posts at http://www.hussmanfunds.com . Hussman is value-orientated like GMO and presents a lot of his calculations and assumptions.

Another research report at GMO I find very useful for understanding how to structure my own "pension fund" bond portfolio is Bill Nemerever's August 2010 report New World Bond Management: A Practical Framework for Decision Making. This is how pros do it, and I learned a lot about what bonds can and can't do, how, and why. Especially look at the Exhibits 4 and 5 in Nemerever's report showing how 75% bonds reduced the losses of 25% stocks in the worst quarter years for stocks since 1980. Keep in mind, however, that bonds have been in a bull market since 1981. But reducing capital losses is so important for a personal "pension fund" that it's essential to understand what bonds *can* do and did under difficult conditions for stocks. Re-read my own post of yesterday on what I am taking away from all of this.

Very much as an aside to the GMO reports is the fact that they do not directly address how to protect the portfolio from inflation except to say there are derrivatives to do this. Personally I think gold is such a "derivative, as you know. Currently I have 29% in precious metals holdings about equally divided between metals and metals stocks, the latter half of which are traded into and out of from time to time. That's a higher percentage than most advise, and it is just my own idea and NOT a recommendation. Husman's HSTRX does the same trading in gold stocks but within a range of about 2-15%.

I've covered a lot here. If you have time you might want to check Hugh Chou's calculator, play with it, and see the future realities for the investment totals you now have. If you aren't retired you can also see what you would need to put in every year to get back what you want. Let me know your own thoughts on this or your own ideas.