Shift from Individual Stocks to Index Investing

[mehta]

Sorry for a very long first post. It is yet another individual situation. The questions are at the end.

Age: 52 with non-working spouse
Emergency funds: Covered
Debt: None
Responsibilities: Over
Tax Filing Status: Married filing Jointly
Tax Rate: Highest
State of Residence: NY
Portfolio size is sufficient for current & anticipated retirement needs. Have the ability to help children if and when the need arises. Likely to need estate planning.

Tax advantaged accounts (40%)
Traditional IRA's (including Rollovers).........Individual stocks........18%
401 (k).............................................VFINX.....................7%
Cash balance plan*................................VBMFX....................8%
Cash balance plan*................................VTSMX....................6%
HSA (Treat like Roth).............................VFINX.....................1%
*Cash balance plan hypothetical current value & approx investmentment style translated into VBMFX/VTSMX

Taxable Accounts (60%)
......................................................Cash for investing......18%
......................................................Individual stocks........32%
......................................................VGTSX.....................8%
......................................................VTSMX.....................2%
All Vanguard funds are actually in the corresponding admiral shares. All individual stocks are long term blue chip buys which are components of the DOW, S&P 100 or S&P Global 100.

Planned annual Contributions
Assume another 10 years of work, contributing maximum allowed to cash balance, 401 (k) & HSA
Add annual cash addition (savings) of 10-15% of present value to taxable accounts

Accounts
Personal accounts with Fidelity and Vanguard
401 (k) offers VTSMX, VBMFX, VGTSX, VGSIX and more

Financial Goals
1) Ease. Would like to shift to a lazy portfolio in case my spouse has to handle it alone. Indexing is the answer.
2) Ethics. However, would also like to stop investing in companies/businesses I consider unethical. Argues for individual stocks. At present I don't know which ethical index to trust. With individual stocks I can stay away from businesses that I learn to be particularly nasty (It does seem that they are all bad to some degree).
3) Hobby. I do have a mechanical strategy for individual stocks which has done better than the market for me since 1996. It does take about 2 hours a week updating numbers in a spreadsheet. And I have enjoyed doing it so far. I have been able to get through downturns because I can see the CAGR of pretend buys of index ETF's right next to my own CAGR. I can throw out anything I consider unethical from the basket I pick from (Dow, S&P 100, S&P Global 100)
3) Criterion 1 seems likely to trump criteria 2 and 3. So index investing it is until I get an easy idea for ethical investing.
4) Estate planning.

Questions
1) Please review my proposed allocation below. Am I wrong in thinking that to the extent one feels secure, either because of family or from savings, the risk taking ability should go up and consequently bond exposure could be less than usually recommended? Viewed as a family the common sense rules recommended for individual savings get blurry. If I was investing for not just one generation to retire on, what would be the right mix?
The delays in coming up with right answers here and in learning about and executing an estate plan are the chief reason for the delay in sorting out our portfolio. I have decided to proceed like an average person while working on the longer term answers.
2) Do I really need to sell our individual stock holdings in taxable accounts? They are 50% of my total, about 40 companies, all long term blue chip buys which are parts of DOW, S&P 100 or S&P Global 100. Most figure in the top holdings of the very indices I'll be buying. On the other hand there are some large losses from the past I can harvest. Taking a loss against $3000 ordinary income per year will take just too long.
3) What to use - ETF's, admiral funds, Fidelity equivalents? Combing the wiki and forums hasn't given me a clear basis for the choice. ETF's do seem to be the most convenient option.
4) The only reason to consider small caps is because I have such a huge chunk in large cap individual stocks. If I was to keep them, maybe I need to consider a small cap fund. I wouldn't bother if I was to repalce individual stocks with a VTSMX/VGTSX combo
3) What flaws can you spot in the folowing proposed execution plan? I would prefer to make it gradual somehow. Feel a little nervous about suddenly buying a big chunk of bonds or REIT's.

-Move IRA's to Vanguard, sell all equity and buy VBMFX
-Change 401 (k) selection to 100% (current holdings and future additions) VGSIX.
-Buy VGTSX and VTSMX from cash savings and cash inflow to keep the proposed percentages (individual stocks affect the mix for now)

Allocation..................Current.......Proposed......Resultant
Cash..........................18%..............1%.............1%
Domestic large cap stocks..51%.............35%............Close
Small cap stocks..............1%..............9%..............?
REIT's..........................0%..............10%............7%
International stocks..........18%.............20%...........Close
Bonds...........................11% ............25%............26%

[livesoft]

OK, I will read between the lines of your post. You have a multi-million dollar portfolio and very high income and too much in the way of large-cap individual stocks. You are going to try to keep working, so this portfolio should just get bigger and bigger. You want your money to help future generations.

1. Even though you write this is for long-term and not just you, I would probably have at least 35% fixed income (cash and bonds). You are proposing to reduce your fixed income. That may be OK, but be careful about that.

2. The individual stock thing is most worrisome to me since you write that some of them have big losses. I am going to chide you and say that you have a severe case of Loss Aversion which is a very bad behavioral finance trap. You need to re-read Gilovich and Belsky's "Why Smart People Make Big Money Mistakes" and Kahneman's "Thinking, Fast and Slow." If one is investing with individual stocks, one has to be ruthless with tax-loss harvesting each and every year. It is not just that one deducts $3,000 a year against ordinary income, it is also about offsetting capital gains from selling winners. I think every big portfolio should have about a few hundred thousand dollars in carryover losses just from 2008-2009. These carryover losses make the decision to sell winners and prune the portfolio easier as net cap gains could be zero for a while. So sell ALL the losers this coming week. You should be left with only winners in your individual stock portfolio. Use the money from selling losers to buy index funds right away, so that you are not sitting on even more cash.

Next, you can donate some of the most appreciated shares to your Donor-Advised Fund. Don't have a DAF? Get one. A lot of folks around here use the Fidelity one, including me.

You can also donate appreciated shares to relatives in a low tax bracket such as grandchildren. Do NOT tell them to keep the shares as they will eventually become an albatross around their necks. Tell them to sell the shares and put the money to good use.

It is probably OK to keep the rest of your large cap stocks. I have a couple myself, but I am slowing giving/donating them away. And yes, they would fit into your asset allocation as you have described. Of course, you are not automatically re-investing dividends in the taxable account, but using the money to rebalancing and buy index funds.

3. I use ETFs in my taxable account and Admiral (Vanguard) and Spartan (Fidelity) index funds in tax-advantaged. Since you own individual stocks, ETFs will be something you like. I like bond funds for fixed income and not bond ETFs (though I own both bond funds and bond ETFs). The re-investing of dividends with bond funds is straightforward and immediate. With an ETF, the dividend is paid 4-6 days after the bond fund fund dividend and the broker decides what the re-invest price is. There seems to always be a small haircut when the broker does the re-investing. However, sometimes the price is better than what a bond fund owner would get; sometimes it is worse. The reason is that in the intervening 4-6 days, the price of the ETF can change. So ... use both ETFs and funds. Try them out in tax-deferred to see if you have a preference. I am sure you have already read the pros/cons Wiki article link: ETFs vs Mutual Funds. Many mutual fund investors on the forum have expressed anxiety about entering ETF orders because they cannot decide on a limit price or they worry about the bid/ask price. That won't be a problem for you with your individual stock experience.

I like to spread my portfolio among a few vendors and not have it all at one place. WellsTrade/PMA, TDAmeritrade, Fidelity, and Vanguard have chunks of my portfolio. I don't pay any commissions at any of these places.

4. I didn't look carefully at your asset allocation, except to say think about fixed income in the 30% to 40% range. It seemed you are aware of tax-efficient location, etc.

[mehta]

@livesoft
Thank you so much for the detailed lucid answer covering all my concerns in the correct overall context. I have my homework set for some time ahead. I am going to assume that there is nothing wrong in re-balancing in a couple of swift steps as opposed to a slow transition.

At some point I'm going to go through some of your >25,000 posts to fast-track into utilizing this forum! Thanks again.