The first significant question you have to answer is how much do you allocate to equities and cash/fixed income. There are many approaches to answer this question, but the vast majority of investors use one of these two approaches:

I. Fixed Income % = Age
This approach by far is the most popular among conservative investors. One of its most prominent proponents is Vanguard Group’s founder Jack Bogle. It is very simple to implement. Each year year you increase your allocation to cash/fixed income one percentage point to match your age and decrease your equity allocation one percentage point.

II. Equity % = 120 – Age

Many of the more “aggressive conservative” investors choose this approach.  The theory here is that equities have out-performed fixed income historically and this formula keeps you in a higher percentage of equities over your life cycle. Using this formula, you would have no fixed income allocation until you are 21 years old. It too is easy to implement; simply subtract your age from 120 and the resulting amount is the percentage that is allocated to equities with the remainder going to cash/fixed income.

For my allocation, I have chosen to implement option II.  However, when I retire and begin to receive large lump sum distributions from various plans that I participate in, I will strongly consider shifting to option I.

After determining your equity/fixed income split. The next step is to decide what type of investments belong in the equity portion of your allocation.  Traditional splits are based on capitalization (large/mid/small cap), origin (domestic vs. international) and sectors such as financials, healthcare, energy, etc. I chose a mixture of all the above. I look at 12 sectors as defined by Morningstar, plus real estate. In addition, I look at origin and capitalization. I review my allocation on a quarterly basis (Q1/2009 review).

From the above link, you will notice the targets are not clearly defined.  After much modeling, I have recently finalized my allocation. As I am apt to do, I put together an Excel model (D4L-Calc-Asset-Allocation.xls) for illustrative purposes of modeling my asset allocation over time. You may want to use it as a starting point for developing your asset allocation.  Here is a quick overview of how to use the model:

Input Section

• Year of birth: What you were you born?
• Fixed/Cash Status: Enter 1 (age) or 2 (120-age) here to select one of the two fixed income options described above.
• Age Override: Let you see what your allocation looks like at any age.
• Equities-Domestic: Percentage of the equity portion allocated to Domestic Equity
• Equities-International: Percentage of the equity portion allocated to International Equity
• Employer Equity: Percentage of the equity portion allocated to Employer Equity
• Small/Mid-Cap: Percentage of the equity holdings allocated to Small/Mid-Cap Equity

The sum of Equities-Domestic, Equities-International and Employer Equity should equal 100%. The sections in the model below the Input section calculate the allocation percentages. For example, given that I am 47 years old, the Asset Allocation – Origin section calculates as follows: My allocation to equities is 73% (120-47), leaving 27% (100-73) to cash/fixed income.  Equities-Domestic is 39% (73% x 53.3%), Equities-International is 24% (73% x 33.3%) and Employer Equity is 10% (73% x 13.3%).

Looking at the Asset Allocation – Capitalization section, Cash/Fixed Income at 27% and Employer Equity at 10% are as calculated above.  Small/Mid-Cap at 15% is input, leaving Large-Cap as a plug to make the section total to 100%. Periodically, you will need to reevaluate the appropriateness of the Small/Mid-Cap allocation since it does not automatically adjust annually.

Let’s consider some sample investments that would fall into each of these categories:

Cash/Fixed Income:

• Money Market Accounts such as ING for your emergency fund
• Vanguard Long-Term Bond ETF (BLV)
• Vanguard Intermediate-Term Bond ETF (BIV)
• iShares Investment Grade Corp Bond ETF (LQD)

Equities-Domestic (U.S. for me):

• S&P Index ETF (SPY)
• Johnson & Johnson (JNJ) – Analysis
• The Coca-Cola Company (KO) – Analysis
• 3M Co. (MMM) – Analysis

Equities-International:

• iShares MSCI EAFE Index (EFA)
• Vanguard Emerging Markets Stock ETF (VWO)
• Vanguard FTSE All-World ex-US ETF (VEU)
• Vanguard Total World Stock Index ETF (VT)

Large-Cap:

The securities listed above under Equities-Domestic are all Large-Cap.

Small/Mid-Cap:

• Vanguard Small Cap ETF (VB)
• Vanguard Mid Cap ETF (VO)
• Genuine Parts Co. (GPC) – Analysis
• Clorox Corporation (CLX) – Analysis

Employer Equity:

Obviously, this would include stock in the company you work for. It would also include stock options, SOSARs (Stock Only Stock Appreciation Rights) restricted stock and company match stock in your 401(k).

As Charlie Munger, Warren Buffett ’s long-time friend and partner said, “Allocate assets wisely. Proper allocation of capital is an investor’s No. 1 job.”

Full Disclosure: Long BLV, CLX, EFA, GPC, JNJ, KO, LQD, MMM, VWO . See a list of all my income holdings here.

I came across Kimberly Palmer’s article titled “The Future of Social Security: Not Good“. My first response was ‘No duh!’  After giving it more thought, I came to the conclusion that my reaction is probably in the minority.

I suspect most people believe that the U.S. government will not let Social Security fail. This is the same government that deemed certain large companies ‘too big to fail’ and dragged other unwilling participants into the fray.  BB&T’s (BBT) Chairman and CEO, Kelly King has been very outspoken on how the government has managed the TARP debacle. And now the government is ‘helping’ the auto industry. Watch out Detroit!

The U.S. government has become too big and too ‘helpful’ to the detriment of its citizens. The government should spend more time providing for the common defense and less time promoting the general Welfare (pun intended).

So, what are your retirement plans? Are you going to rely on the government to print your social security check and the money backing it up, or will you choose to take charge of your future and prepare for it? As it is with most things in life, those that prepare for retirement will find more success than those that don’t.  It is really not that hard when you start young.  Here are three simple steps:

1. Live on less than you earn. (another ‘No duh!’ statement)
2. Invest the rest using a sound asset allocation model.
3. Pick solid, conservative, low-cost investments.

Number 3. on first blush may seem complicated, but it doesn’t have to be. For those that don’t want to make investing their hobby, they can focus on a few good funds like Vanguard’s S&P Index Fund (VFINX) and Vanguard’s Long-Term Bond ETF (BLV).

For those a little more adventurous, a strategy based on an article by Richard Jenkins titled “A simple ETF strategy for beginning investors“ has been quite effective over time. Don’t let the “beginning investors” term scare you away. The goal of this portfolio is to provide diversification over a broad allocation of stocks and bonds by holding five ETFs:  iShares Lehman Aggregate Bond Fund (AGG), iShares MSCI EAFE FD (EFA), Vanguard Total Stock Market ETF (VTI),  iShares DJ Real Estate Index (IYR) and iShares DJ Basic Materials (IYM).

For those comfortable in selecting and holding individual stocks, there is nothing like Dividend Stocks to provide a growing income into the future. Dividend stocks found in many dividend investors’ portfolios include companies such as: McDonald’s  Corp. (MCD) [analysis], Johnson & Johnson (JNJ) [analysis] and The Coca-Cola Company (KO) [analysis].

Finally, you can choose not to prepare. In June 2008, I wrote about a retirement-age couple that would never retire because they chose to live life on the edge and always spent a little more than they made. Over the last year the noose has continued to tighten on Bill and Jackie (not their real names).  Due to the economy and health issues work has been hard to come by. Their house is one step away from foreclosure and on the market with no buyer in sight. Bill needs surgery and the family continues to grow weary of providing for them.

Life is a choice. You can choose how you live, but you cannot choose the consequences of how you live.

Full Disclosure: Long AGG, BLV, EFA, IYM, JNJ, KO, MCD, VFINX, VTI. See a list of all my income holdings here.

On including bonds in your asset allocation:

I have been saying for more years than I care to count not to forget bonds. And start to think about it as a rule of thumb, having your bond holdings equal your age.

Investors come to me and generally say one of two things, either ‘Thank God I followed your advice,’ or ‘I really feel stupid for not having followed your advice.’

On the economy:

We can’t fix our economy now, today. We can move in a direction of fixing it, but when you think about what is happening it’s very obvious: We have to save more.

The old 3% real growth which is the rate the economy has grown at, well I think that is too aggressive. We’re looking at much slower economic times.

On what a slower economy means for investors:

We have had a stock market crash of the largest proportions probably of the last century, with the possible exception of 1929 to 1933. We have had a big stock market crash. Do we have to have another one? I don’t think so.

I would guess the market probably has it about right. I would guess that we have seen the low for the year and maybe the low for this cycle.

On having an international allocation:

Decide where you want to put your money. I would say U.S. stocks, because international will do well and then it will do badly, and the same thing for emerging markets, which will do well for a while and then do badly and then do well again. I just think you don’t need to go beyond U.S. stocks.

On the reported death of asset allocation and buy-and-hold investing:

I am really concerned when I hear people say buy-and-hold is over. Investors, as a group, are buy-and-holders. We own the stock market, all of us together, we buy and hold it. As a group, we all have the same asset allocation. So when you hear someone say ‘It’s a stockpicker’s market,’ well if you picked well, then I picked ill, and as a group it’s the same.’

You can read the entire article here. I don’t agree with everything Mr. Bogle says, but I do think there is a lot we can learn from him. So what can we do to put some of the above in practice?

First, don’t forget about bonds. As recently noted, treasuries and bonds tend to be less risky than equity investments, but have historically under-performed equities. When the market is climbing by double digits, it is easy to question why you are including bonds in your asset allocation. However, when the market turns down, the importance of bonds becomes very evident. I currently hold some old savings bonds (U.S.) and several funds/ETFs in my 401(k) and taxable accounts. My two favorite ETFs are Vanguard Long-Term Bond ETF (BLV) currently yielding 5.6% and iShares Barclays Aggregate Bond (AGG) currently yielding 4.7%.

Unlike Mr. Bogle, I think international investments play an important role in your asset allocation. Due to the complexities in this arena, I prefer to use indexed ETFs to meet my allocation here. In addition to a fund in my 401(k), I currently hold iShares MSCI EAFE Index (EFA) and Vanguard Emerging Markets Stock ETF (VWO). In addition, I am currently evaluating Vanguard FTSE All-World ex-US ETF (VEU).

As  Mr. Bogle alluded to in the article, there are many excellent U.S. stocks to invest in. In this area I prefer to focus on great Dividend Stocks like Johnson & Johnson (JNJ) [analysis],  Procter & Gamble Co. (PG) [analysis], The Coca-Cola Company (KO) [analysis] and 3M Co. (MMM) [analysis].

It seems that ever so many years the market turns down and someone declares the death of buy and hold. Even some go as far to say the Warren Buffett has lost his touch. The buy and hold investors and Mr. Buffett always seen to make a spectacular rebound, and they will once again. In the mean time, we need to focus on acquiring value and maintaining our asset allocation.

Full Disclosure: Long BLV, AGG, EFA, VWO, JNJ, PG, KO, MMM. See a list of all my income holdings here.

Cash/Money Markets/CDs – “Cash Investments”
I have always considered “Cash Investments” an oxymoron. Cash is where some investors park their money when they believe the investment risk is greater than the potential return – their sole focus is capital preservation. Unfortunately, some people consider Cash/Money Markets/CDs et.al. as investments. This is a dangerous assumption. Their slow and predictable growth is generally always below inflation, but since it is growing the “investors” often lulled into a false sense of security and do not notice that they are actually losing ground each year until it is too late.

Land/Real Estate – “They aren’t making anymore land.”
Many investors have discovered the hard way that bubbles can also occur in the real estate sector. What was once seen as a safe place to put your money and forget it is now in the midst on an ugly down-turn. According to S&P, home prices tumbled by 19.1 percent in the first quarter, the most in its 21-year history. Home prices have fallen 32.2 percent since peaking in the second quarter of 2006 and are at levels not seen since the end of 2002. Still, there are no signs home prices have hit bottom. “We see no evidence that a recovery in home prices has begun,” said, David M. Blitzer, chairman of the S&P index committee.

Gold/Precious Metals
If you look at a historical chart of gold prices, you will see a pattern, gold spikes to a new level during a crisis, then comes down to a level above the previous steady state. It then trades sideways until the next crisis. It would be hard to time your retirement to coincide with a crisis/spike.

Professionally Managed Equity Mutual Funds
Every year several professionally managed mutual funds out-perform the market. Unfortunately, it is rarely the same funds each year. It has been well documented that over time, most professionally managed funds under-perform the market.

Treasuries/Bonds
Treasuries and bonds tend to be less risky than equity investments, but have historically under-performed equities. It is important to note that there is risk associated with them. For corporate bonds, the companies could default and not pay them. For all bonds, including those issued by government, there is an interest rate risk – rising interest rates drive the price of bonds down. I do consider bonds an important part of my asset allocation. You can purchase bonds directly in the open market or bundled in funds/ETFs. Below are some low-cost Vanguard bond ETFs:

• Vanguard Short-Term Bond ETF (BSV) – Yield: 3.38%
  The Fund seeks to track the performance of the Barclays Capital 1-5 Year Government Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds, with maturities between 1 and 5 years.
• Vanguard Intermediate-Term Bond ETF (BIV) – Yield: 4.67%
  The Fund seeks to track the performance of the Barclays Capital 5-10 year Government/Credit Index. This index includes U.S. Government, investment-grade corporate, and international dollar-denominated bonds with maturities between 5 and 10 years.
• Vanguard Long-Term Bond ETF (BLV) – Yield: 5.60%
  The Fund seeks to match the investment performance of the Barclays Capital Mutual Fund Long Government/Corporate Index.
• Vanguard Total Bond Market ETF (BND) – Yield: 4.55%
  The Fund seeks to generate returns that track the performance of the Barclays Capital Aggregate Bond Index, and will maintain a dollar-weighted average maturity consistent with that of the index. The Index measures investment-grade, taxable fixed income securities in the U.S.

Also, if you live in the U.S. you can purchase Savings Bonds via TreasuryDirect.gov. However, recent changes in this program have made it less appealing.

Index Funds/ETFs/CEFs
For most people, indexed investments including mutual funds, exchange traded funds (ETFs) and closed end funds (CEFs) should make up the core of their investment allocation.  In effect, you are aligning your investment risk with what the index fund tracks. If you believe that over time that certain index funds, such as the  S&P 500, will outperform the the various approaches listed above, you should have money invested in it.  Index funds allow you to easily track any sector, market cap or index. Here are some varied funds in this category:

• Vanguard 500 Index Fund Investor (VFINX) – Yield: 2.90%
  The Fund seeks to track the performance of a benchmark index that measures the investment return of large-capitalization stocks. The Fund employs a “passive management” approach designed to track the performance of the Standard & Poor’s 500 Index.
• IShares MSCI EAFE Index Fund (EFA) – Yield: 3.94%
  The Fund seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of the MSCI EAFE Index.
• IShares Trust DJ US Basic Mat Sector (IYM) – Yield: 2.58%
  The Fund seeks investment results corresponding to the price and yield performance, before fees and expenses, of the Dow Jones US Basic Materials Sector Index. Component firms are involved in the production of aluminum, chemicals, commodities, chemical specialty products, steel, and other goods and resources.
• IShares Trust DJ US Real Estate Index (IYR) – Yield: 8.69%
  The Fund seeks investment results that correspond generally to the price and yield performance, before fees and expenses, of the Dow Jones US Real Estate Index. Uses a representative sampling strategy. Component firms include hotel and resort firms and REIT’s.

Individual Stocks
Inherently, individual stocks will carry higher risk due to the lack of diversification when evaluated on a stand-alone basis. You can mitigate this risk to a degree by selecting solid dividend paying companies with a track record of increasing their dividends each year. Some of my personal favorites in this category are:

• Johnson & Johnson (JNJ) – Yield: 3.58% – Analysis
• Procter & Gamble Co. (PG) – Yield: 3.32% – Analysis
• Sysco Corp. (SYY) – Yield: 4.12% – Analysis
• PepsiCo, Inc. (PEP) – Yield: 3.49% – Analysis

When it comes to investing your money, there is no escaping risk. A good investor will determine the desired outcome and and invest in a way to acheive their goal with minimal risk.

Full Disclosure: Long BLV, VFINX, EFA, IYM, IYR. See a list of all my income holdings here.

I. International Fund in my 401(k)

This International Equity Index Fund seeks to match the performance of the MSCI EAFE Index which consists of approximately 1,200 stocks in 21 developed market countries outside of North and South America, and represents approximately 85% of the total market capitalization in those countries.  When compared to other options in my 401(k), I have been generally pleased with this funds performance over time. YTD Return:  (-7.2%)

II. International Exchange Traded Funds (ETF) Within My Asset Allocation Portfolio

The international component on my asset allocation portfolio is in iShares MSCI EAFE (EFA).  EFA seeks to provide investment results that correspond generally to the price and yield performance, before fees and expenses, of publicly traded securities in the European, Australasian and Far Eastern markets, as measured by the MSCI EAFE Index. This fund is tracking the same index as my 401(k) above, but with somewhat better results. YTD Return: (-5.1%)

III. Individual International Dividend Stocks

It was my desire to have international representation within my income investments, so I first looked to identify good non-U.S. dividend individual stocks that had an ADR trading on the New York Stock Exchange.  To identify these stocks I used the International Dividend Achievers™ list.  To become eligible for inclusion, a company must be incorporated outside of the United States. The companies must be have an American Depository Receipt or common stock trading on NYSE, NASDAQ or AMEX. Companies must have paid increasing regular annual dividends for five or more consecutive years. What I found is that most companies outside the U.S. follow a different dividend model.  Here are some of the differences:

• Many Foreign Companies Pay Dividends Based on a Percent of Earnings
  This produces a very erratic cash stream. Consider Unilever plc (UL). Its ADR paid $0.353 in Nov/07, $0.668 in May/08 and $0.33 in Nov/08.
• Many Foreign Companies Only Pay Dividends Annually
  I need more feedback than this. I would hate to wait a full year before learning a company plans to slash its dividend. Examples of annual dividends include Shenandoah Telecommunications Co. (SHEN), Siemens AG (SI) and Stryker Corp. (SYK).
• Most Foreign Companies Pay Dividends in Their Local Currency
  Most Canadian companies pay quarterly consistent dividends, similar to companies in the U.S. However, they pay the dividends in Canadian dollars, so the currency risk is with the U.S. investor.  There is probably much less fluctuation between the U.S. and Canadian dollars than most other currencies. However, it exists. Consider the last five dividends on Canadian National Railway Company (CNI): Mar/08 $0.223, June/08 $0.225, Sep/08 $0.217, Dec/08 $0.189 and Mar/09 $0.200. The quarterly dividend dropped 10% from Mar/08 to Mar/09 in U.S. Dollars while it increased its dividend 10% over the same period in Canadian dollars.

I am sure there are more, but one exception to all the above is BP plc (BP). BP’s ADR has paid a consistent quarterly dividend denominated in U.S. dollars.

IV. International Income ETFs and Income Closed-End Funds (CEFs)

One thought was that a market basket of international stocks in either an ETF or CEF would help mitigate some of the issues above. Many of these created problems of their own. Some such as Alpine Total Dynamic Dividend Fund (AOD) has the option to invest in the U.S. also and when things turned ugly, they brought the cash home.  Other funds such as Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO) and PowerShares International Dividend Achievers Portfolio (PID) have not performed well as dividend investments. Each has cut its dividend, with PID cutting multiple times.  I now question the wisdom of ETFs and CEFs inclusion in an income portfolio, but that is a different discussion.

Conclusion

After much consideration, I have concluded that income investing and international securities don’t mix very well for all the reasons listed above.  Going forward, my primary focus will be on U.S. equities for my dividend income portfolio.  I will use my 401(k) and my Asset Allocation Portfolio to ensure an adequate international allocation. As for the securities that I currently hold, I will individually evaluate the appropriateness of them remaining in my portfolio. Consistent with this methodology, I will remove most International Achievers from the Stock Ideas page, leaving only those that I own or have identified as being an excellent income investment.

Full Disclosure: Long EFA, CNI, BP, AOD, ETO, PID