In a couple of recent surveys of mutual fund investors, approximately 90% of investors said that their primary financial goal was to build their retirement nest egg. We would have guessed this number to be lower, but we agree that for most investors, wealth accumulation is indeed the main objective.

Living in this age of startling medical advances we are very fortunate indeed. We are likely to enjoy our retirement for a lot longer than our parents’ generation. Of course, the downside is that our retirement funds will have to “live a lot longer,” too.

If you couple longer life spans with rising health care costs (there is a price for all those medical advances, after all), the data suggests that most people are simply not saving enough, and when they do, many are not properly managing their portfolios either in the accumulation or the distribution stages. Which leads us to the three keys to successful retirement investing: save heavily; invest wisely; and spend reasonably.

While one could write a whole book on each one of these topics, let’s look at one aspect of each of them.

Save Heavily
At a recent conference held by Fidelity Investments, where the topic was focused on retirement, our Kobren Insight Management analyst in attendance took down some interesting notes on retirement savings:

• The typical American household is on track to replace 58% of pre-retirement income during retirment.
  
• But Fidelity estimates that people should expect to need to replace 85% of pre-retirement income (although they do concede this number varies).
  
• Only 15% of American households are on track to meet that 85% target.
  
• 36% of employees eligible for 401(k) plans don’t participate at all.
  
• 92% of those who do participate don’t invest the maximum allowable amount.

Look, we’re paid to be cynics. When a portfolio manager tells us something, we try to test it to see if they are telling us straight information. Trust, but verify. So we understand that when an investment firm tells clients to save more money, one might be skeptical and say it is in the firm’s self-interest. But like all professions with a good service, or merchants with a good product, who truly care about their customers, there are win-win situations for both parties. And, in this case, saving more money, and managing it appropriately, will indeed help clients to achieve their financial objectives.

Invest Wisely
Another key finding in the Fidelity study was that 86% of investors don’t rebalance their retirement portfolios. This can lead to unintended changes to your asset allocation. Take the case of small- to mid-cap stocks and value stocks. They have been performing much better than large-caps and growth stocks for seven years. So even if you didn’t move any money from large caps to small caps your allocation to small caps and value will have increased.

While small caps and value continue to outperform, in client accounts we have been recently shifting some assets out of small caps and into large-caps and out of value and into growth. This has prompted a few clients to politely question our sanity.

The outperformance of small-caps over the last seven years is impressive indeed. Since their respective peaks at the height of the last bull market in March of 2000, through today (April 4, 2007) the large-cap, Russell 1000 Index is still down 3%, while the small cap, Russell 2000 Index is now 34% higher!

Because the performance of market cap segments tends to be “mean reverting,” (i.e., they oscillate around their long-term averages, reverting to their averages, or means, when they get too far above or below those averages), this relative outperformance alone would give us reason to consider shifting some money from small caps to large caps.

But it’s what that outperformance has done to relative valuations that really makes the case for the reallocation. As the chart below shows, the average ratio of the Russell 2000 P/E to the Russell 1000 P/E since 1986 is 102 (red line). In other words, over that time, the average P/E for small caps has been about the same as that for large caps. Today, however, that ratio has ballooned to 140, indicating that small caps are now 40% more expensive than large caps.

Moreover, if we look back to March of 2000, when small caps began their run, we see that the ratio was less than 60, meaning small caps were 40% less expensive than large caps. In short, the position of these two sectors of the stock market has almost perfectly reversed.

A similar, but less extreme situation exists between the investing styles of growth and value. Typically, growth stocks trade at a premium to value stocks, and since 1986, the average ratio of growth stock P/Es (Russell 3000 Growth Index) to value stock P/Es (Russell 3000 Value Index) has been 155. Currently, it is 144, so growth stocks are indeed cheap relative to value stocks, but not as much as large caps are relative to small caps.

If you combine market cap and investment style, you can really see the extreme divergence. Since March 2000, small cap value stocks are up 177% while large cap growth stocks are down 36%! If you could only invest in one of these two today, which one would you pick?

Here’s another take on the data to help your decision. The “trailing” P/E for the S&P 500 (an even larger-cap index than the Russell 1000) using the last 12 months of actual earnings is 17.0. The “forward” P/E based on expected earnings over the next 12 months is 15.3. Dividing the trailing P/E by the forward P/E yields an implied earnings growth rate of 11% over the next year. This may seem a bit rich, given that the long-term average for earnings growth is 6%, but, it’s nothing compared to the implied earnings expectations for small caps.

The trailing P/E for the Russell 2000 is 38.7. The forward P/E using expected earnings is 23.7, resulting in an implied earnings growth rate of 63%! Given the maturity of the economic cycle, that does seem excessive.

In contrast, the implied earnings growth rate for the Nasdaq (an imperfect proxy for large cap growth) is -1%. If a leading reason why stocks move in the short-term is because they “beat expectations,” then the Nasdaq looks a bit more attractive than the other indexes.

Lastly and not surprisingly given the performance differences, investor sentiment, and money, has been flowing only one way. Since 2000, on a net basis, investors have pulled $51 billion out of large cap funds, while adding $619 billion into small, mid, and multi-cap funds.

Does all this mean that large caps will beat small caps in 2007? Not necessarily, even though such performance and valuation divergences are mean reverting, they often go to extremes first, and the exact turning point is difficult to judge. But, given their low relative valuations and lack of investor interest, large cap stocks and particularly large cap growth stocks, offer an attractive risk/reward profile going forward.

That to us is what investing wisely is all about, making moves that help to shift that balance of risk and reward in your favor. That in turn, often means investing in “cold” areas rather than throwing even more money at “hot” areas.

Spend Reasonably
As we noted in the beginning, living longer means our retirement funds need to last longer. For most of us, that means that we will need to be prudent in how much we take out of our nest egg each year of our retirement so that the remaining balance can continue to show some growth. And that amount is influenced by our expectations for the future returns on our investments.

We have often talked about our concerns regarding excessive expectations for the stock market, and an overall complacency about risk. Expecting high double-digit returns as we saw in the 80s and 90s is a dangerous gamble. However, we have recently seen expectations (at least from institutions) moderate to more reasonable levels.

At the aforementioned conference, Fidelity used an expected average annual return of 7-8% for equities and pension return assumptions for S&P companies are also coming down and currently average 8%. It should also be noted, that, in fact, the S&P 500 has produced an annualized return of 8% over the last 10 year as of the end of the first quarter.

With dividend yields at approximately 2% and with long-term earnings growth of 6%, and assuming no significant change in valuations, a long-term 8% expected return for stocks appears reasonable. Of course, annual returns can be expected to oscillate, sometimes wildly so, around this number.

However, it still appears that most people have unrealistic expectations regarding withdrawal rates (how much to take out of their retirement funds each year in retirement). With an expected return of 8% from equities, according to Fidelity, an appropriate withdrawal rate is typically around 4%, but they found that:

• 44% of investors expect a withdrawal rate of 5% or more and …
  
• 25% expect to take out 7% or more.

The problem is that those investors planning to withdraw at a higher rate, run an increased risk of having their money run out. Of course, if they were to reduce their annual withdrawals to 4%, they would need a bigger nest egg to generate the same income as they expected at the higher rates.

That, of course, leads us back to the first two keys to investing for retirement; save heavily and invest wisely.

Sincerely,

Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio ManagerCo-Portfolio Manager