Get more from your nest egg; 7 steps

By Tim Middleton

A friend of mine recently asked my opinion of his nest egg, an account that is 30% foreign-stock mutual fund and 70% cash. He arrived at this odd mix because he's terrified of risk but knew cash alone wouldn't give him enough growth to carry him through 20 or more years of retirement, which today's generation can expect.

You can do better, pal. So can anyone. I've devised seven simple steps that can boost an income-oriented investor's returns by more than 60% over plain-vanilla bonds, and 125% over my friend's mix, which has returned an annual average of 3.63% over the past five years.

I'm talking returns of more than 8% a year -- as much as stocks have delivered in the past decade -– with less risk than bonds themselves.

What I'm recommending is a total-portfolio approach. That way you can balance one kind of risk against another. You could, however, just cherry-pick the ideas you like the most from among these seven. Either way you're likely to do better than you're doing now.

Here are my seven steps:

1. Active beats passive

The reigning orthodoxy of investing, Modern Portfolio Theory, holds that efficient markets cannot be beaten. Ergo, indexing wins in the end, in part because passive management generates the lowest costs.

This is baloney. Bill Gross, chief investment officer of Pacific Investment Management (PIMCO), has been beating the bond market since 1971. The most economical way for most investors to access his talent is a no-load fund, Harbor Bond Institutional (HABDX). In retirement accounts, you can often hire him through PIMCO Total Return Institutional (PTTRX), whose expenses of 0.50% are even cheaper than Harbor's 0.60%.

Over the past 15 years, Harbor has beaten the Lehman Brothers U.S. Aggregate Bond Index by 0.88 percentage points annually, on average. So this is our fundamental portfolio building block.

Harbor has a standard deviation, a risk measure that predicts how much its price can move in normal circumstances, of 4.13. By contrast, the standard deviation of the Lehman Agg is 4.01, and of the stock market 13.66. Lower is better. We will keep our eye on risk as we fill out the portfolio.

2. Cash is a counter play

The problem with bonds is that their price goes down when interest rates go up, as we've learned to our pain in the past two years. Happily, the opposite is true of money market funds; they follow rates higher as well as lower. Thus they always move opposite to bonds, and therefore are bonds' perfect complement.

A portfolio that consists of the Harbor fund with 80% of assets and a money market fund with 20% has returned 5.11% annually over the past five years. That is 0.1 percentage point more than the Lehman index. Plus the standard deviation of this mix is 3.34. That means we are still beating the market but with 17% less risk. Now our goal is to pump up returns.

3. Princes of property

Because of their stock-like attributes, real estate investment trusts, or REITs, are overlooked by most income investors. That's a mistake. Though they are extremely volatile compared with high-quality bonds, a hint of REITs can boost returns and actually reduce portfolio risk.

My favorite REIT fund is iShares Cohen & Steers Realty Majors (ICF, news, msgs). This is an index of top REITs created by the foremost investors in this business. It has averaged gains in the past five years of 20.63% annually, four times as much as the Lehman Agg.

REITs deliver an income stream -- currently 3.57% for the Cohen & Steers fund -- but they deliver capital gains as well. Income investors must learn to look beyond yield. Bill Gross named his flagship bond fund PIMCO Total Return to stress this point, since the value he adds comes from gains as well as yield.

We'll add this fund to the portfolio in the amount of 10%, taking that portion away from Harbor Bond. Our new 70/20/10 mix has delivered annualized returns of 6.61%, a premium of 1.5 percentage points over the Lehman Agg.

Our blended standard deviation is 3.27. Voila! Real estate moves to a different beat than bonds. In 2002, when bonds rallied in double digits, C&S Realty eked out a 2.96% gain. In the succeeding three years, bonds struggled, but the REIT fund surged in double digits each year.

4. Dividends are divine

In grandfather's time, he retired at 65 and died at 72, and so only had to worry about investing for seven years. Today's retiree can expect to live to 85; she needs growth in capital as well as yield.

That means stocks. Many of them pay fat dividends, and that income stream helps defend their price, so they're less volatile than stocks in general. iShares Dow Jones Select Dividend Fund (DVY, news, msgs) consists of more than 100 stocks, most of them blue-chips, that together are yielding 3.10%.

The fund doesn't have a five-year performance record, but projecting back from what we do know (using Microsoft's Principia portfolio software) indicates five-year returns for our new 60/20/10/10 mix of 7.02% and standard deviation of only 3.28. Once again, the risks of these stocks run counter to those we already have. In the past five years, stocks and bonds have moved almost exactly opposite each other. In our portfolio, this fund adds virtually no risk.

5. Overseas opportunities

Uncle Sam isn't the only issuer of gilt-edged bonds in the world; the very expression was coined to describe those of Great Britain. Germany, France and especially Japan also issue sovereign debt of unquestioned integrity. And bonds are far less risky than my friend's foreign stocks.

We'll take 10% away from Harbor Bond and use it to take a corresponding position in T. Rowe Price International Bond (RPIBX). This fund does not hedge currency exposure. That makes it a bit riskier than hedged foreign-bond funds, but it also offers fatter yields when the dollar is weak, which it is bound to be when the trade deficit is at record highs, as it is now.

This fund has delivered 9.65% annual returns in the past five years. Now we're looking at a mix that is 50/20/10/10/10 with an indicated annual return of 7.44% and a standard deviation of 3.52. This is not quite money-under-the-mattress safe, but it's as close as you can get without FDIC insurance.

6. Emerging excitement

The granddaddy of funds investing in the emerging markets (Southeast Asia, Eastern Europe, South America, etc.) is PIMCO Emerging Markets Bond Institutional (PEBIX), which has delivered annualized returns of 17.20% over the past five years. It manages this feat by accepting much more risk than most bond investors are comfortable with: a standard deviation of 8.27.

But when it is added to our mix, as 5% of assets (taken from Harbor), our 45/20/10/10/10/5 blend has generated average returns of 8.05% over the past five years, and our blended standard deviation is 3.68, barely moving the risk-meter needle.

One issue remains: Are we sufficiently protected against inflation, since rising prices are the archenemy of a fixed income? Two of our six portfolio holdings, REITs and dividend-paying stocks, offer some protection, but not as much as I would like. In the late 1970s, when inflation was raging, the stock market was tanking. (REITs weren't around, so we don't know how they should behave.) I need something else. So …

7. Feeling TIPSy

Treasury Inflation-Protected Securities (TIPS) adjust their value upward if the consumer price index rises, delivering the exact kind of protection I'm looking for. The lowest-cost offering in this arena is Vanguard Inflation-Protected Securities Fund (VIPSX).

TIPS tend to have slightly longer maturities than the average bond and are considered riskier, but they also tend to yield a bit more. We have plenty of leeway to accept the risk. We are taking a final 10% allocation from Harbor Bond and using it on the Vanguard fund.

Our final 35/20/10/10/10/5/10 mix has returned 8.15% annually over the past five years, with a standard deviation of 3.84. This is alchemy: We have combined base elements and created gold, a portfolio that yields 3.04 percentage points a year more than the bond market with less risk.

In this portfolio, dividends are not reinvested, and yield is supplemented by trimming back the most successful securities in order to take out 5% of the portfolio's total value as income. The excess outperformance remains within the portfolio, allowing it to grow. That way our annual payout rises steadily, protecting us from higher consumer prices.

One reason our returns are so high is that our annual expenses are so low: A blended rate of 0.44%, less even than our inexpensive bond fund. Equity investors can debate whether high expenses matter if you get high returns; in the low-return world of fixed income, they matter enormously.

Year to year, any portfolio's value will rise and fall in unpredictable ways. But historical data predict this portfolio has a 68% probability of delivering positive annual returns of between 4.31% and 11.99%. You can have confidence that in 95 years out of 100, the range of returns will be between 0.47% and 15.83%.

In short, you're not ever likely to lose your original investment. If you hold emergency savings equal to at least six months' spending outside your investment portfolio -- and everyone should -- you can draw against that in the lean years and restore it in the fat ones.

These two things working together can assure you an income throughout your retirement, and the cushion of your principal value for whatever the future holds.

Meet Timothy Middleton at the Money Show

MSN Money mutual funds columnist Timothy Middleton will appear along with many other top investment professionals at the Money Show in Washington, D.C., July 20-22. Tim will hold a seminar on "Seven ways to boost investment income," and speak at an in-depth intensive seminar titled "Exchange-traded funds -- the future of diversification." Admission to the show is FREE for MSN Money users; there's a separate fee for the ETF seminar. For complete details or to register for free admission, call 800/970-4355 (be sure to mention priority code #006137), or click here to register online.

Can't make it? On Thursday, you can watch the "Seven Ways" seminar live online as well from 6:15 p.m. to 7:00 p.m. ET; you just need to register in advance. Click here for more details and to register for that Web broadcast.

At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Harbor Bond Fund. He is the author of "The Bond King: Investment Secrets from PIMCO's Bill Gross." He was formerly mutual fund columnist of The New York Times and works from home in Short Hills, N.J.