by Carrie Schwab-Pomerantz, CFP®, President, Charles Schwab Foundation; Senior Vice President, Schwab Community Services, Charles Schwab & Co., Inc.
August 19, 2009

Dear Carrie:

I want to switch my stocks for mutual funds and manage my money myself. I have about $1 million in bonds and $350,000 in equities. I need to produce approximately $50,000 a year to live on. Any suggestions on how I go about this?

—A Reader

Dear Reader:

My whole career has focused on the idea that when it comes to personal finance, most people can do most things by themselves, from determining their objectives to building a portfolio that helps them reach their goals. And I applaud people who, like you, want to take control.

At the same time, I think people should be prudent when it comes to managing money—and $1.35 million is a lot of money to manage. You’ve got some big decisions to make: How much capital will it take to generate $50,000/year? How will you construct your portfolio? On the fixed-income side should you invest in bond funds or individual bonds? And what’s the best way to manage your equities?

You might approach this significant challenge by thinking of yourself as the general manager of your portfolio. You determine the objectives, and you decide the best way to reach them. If you can do it yourself, great! But keep an open mind about tapping outside advice where and when it makes sense. Here are a few aspects of your plan that strike me as particularly challenging:

Tax implications: Depending on what you own and for how long, you could be facing some pretty substantial tax liabilities from liquidating your portfolio. Before you sell off everything, make sure you understand the tax implications, which may necessitate a meeting with your tax advisor. A gradual approach in which you divest holdings and purchase new assets over time might be best.

Asset allocation: You stated one goal (generating income), but do you have other financial objectives? It’s the whole package of goals, along with their associated time horizons, that will help you determine an appropriate asset allocation. You can probably do this part yourself, but you may also want to validate your decisions with an objective financial planner.

Portfolio construction: It’s one thing to say that you want, for example, 70 or 75% exposure to fixed income. It’s quite another to build a fixed-income portfolio that gives you that exposure and has the risk/return characteristics you need. In your case, you essentially have three choices: fixed-income funds, individual bonds, or hire a dedicated fixed-income investment manager. Funds are easy and offer the advantages of professional management, diversification, and solid credit oversight, but they also generally entail fluctuations in income and investment value. Individual bonds can give you more precision and control, but you’ll bear the brunt of the responsibility for credit analysis and portfolio management. If you have the technical skills to do this, great. But professional management might be particularly valuable to you here, at least in the initial construction of your portfolio. Substantial bond portfolios require specialized expertise; in my opinion, even the savviest fund managers or financial advisors often turn to a bond expert for help.

One strategy worth looking at is a “laddered portfolio”: using individual bonds to spread out maturities over a period of several years. For example, you might buy bonds with maturities ranging from one to ten years, so that 10% of your portfolio matures each year. When it does, use the proceeds to buy bonds with maturities for the furthest year out, in a rolling ten-year cycle. When rates are rising, you’ll be buying new bonds at the higher rates; when rates are falling, you’ll already have higher yielding bonds in your portfolio. But unless you stick with Treasuries, also be sure to consider credit quality as you construct your portfolio. Higher yielding bonds carry higher risk, so you have to find the balance that best suits your needs for safety and return.

As for the rest of your portfolio, bonds aren’t a good cushion against inflation and the rising cost of living – which is why you will likely want to keep a portion of your money in stocks. You’ll have little trouble finding funds that cover the spectrum of the equity asset class (U.S. small cap, U.S. large cap, and international) and provide adequate diversification. You can invest in actively managed funds or index funds (or a combination of the two) and build an equity portfolio that fits your objectives.

To summarize, think about taxes as you set out to liquidate your portfolio. Have a clear understanding of your goals before you start to build your new one. And finally, don’t be afraid to seek the help you need for those parts of the process that are challenging. Good advice—sound, objective guidance that reflects your needs—is out there, and if it helps you make the most of your resources and avoid a devastating mistake, it’s well worth the expense. Good luck!

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Investment value and return will fluctuate with shares and, when redeemed, may be worth more or less than the original cost.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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