How you divide up your investments is called your asset allocation. You could invest in only one or a combination of cash, bonds, stocks and alternatives. The point is that you can control how you deploy your assets. Asset allocation is the most important part of an investment plan.
Know the purpose of the portfolio. Is the purpose for growth, principal preservation, or income? For what time frame? Two different goals and time frames (funding college in 5 years and retirement in 20) may warrant two different portfolios. The purpose of the portfolio drives its construction.
Determine an appropriate stock-to-bond ratio. The first step of construction is driven by the purpose of the portfolio (what level of returns or income is needed) and personal factors (comfort level, experience, etc.). If the purpose is growth, you’ll likely want to hold more stocks.
Know what adds value. A mix of an S&P 500 fund and a broad bond fund is a good start, but there are other investments that can add value to the portfolio. Research concludes that both small-cap stocks and value stocks outperform the S&P 500 over time. International stocks and REITs deliver equity returns, but also add some diversification. Bonds and alternatives (precious metals, etc.) are also great ways to add diversification.
Construct a broadly diversified allocation for the overall portfolio. You may have multiple accounts, but a single overall allocation should be used to tie them together. This holistic view can reduce confusion, costs, and taxes of managing a separate portfolio for each account.
Recognize constraints on the portfolio. Constraints such as limited 401(k)/403(b) investment options, taxable positions with low cost-basis, employer stock options, and investments with surrender charges need to be recognized and addressed in your overall allocation.
Select appropriate investment options. Avoid individual securities. Mutual funds and ETFs are much more diversified. Select investments that represent their respective asset classes well. Preferred investments are passive (index funds), very low cost, and have a large number of holdings.
Implement the portfolio in a cost- and tax-efficient manner. Keep transactions to a minimum (a good portfolio design should do that). Control the tax impact on sales of existing holdings that won’t be included in the portfolio.
Manage it. “Buy-and-hold” investing implies a “set it and forget it” mentality. Allocations can stray and opportunities can be missed with that approach. Instead, practice “buy, hold, and manage.” Management requires rebalancing at both the stock-bond level and at the individual asset class level based on certain tolerances. It also requires an eye on taxes, managing ongoing contributions, purchases and distributions, monitoring performance, and staying abreast of new research and investment options.
Cost containment is an essential element of successful investing. The lower your costs, the more return you get to keep.
Avoid commissions. Commissions are expensive and lead to conflicts of interest. In today’s market, there are plenty of no-load investment options.
Advisory fees must be competitive and add value. There is a cost to electing investment management services. Value must be derived in some manner (potential increased returns, potential tax savings, convenience, time savings, less worry, etc.) or it is not worth the cost.
Use funds with low expense ratios. Expense ratios cannot be avoided, so they should be minimized. There are plenty of great investment options with very low expense ratios.
Minimize transaction fees. Avoid frequent trading. Use funds and ETFs without transaction fees (available at some discount brokers). Go direct to a fund company.
Avoid higher bid-ask spreads. Use well-known ETFs that have a higher trading volume to minimize the difference between the buy price and the sales price.
Tax-efficient investing is about finding the right balance between minimizing current taxes and future tax liabilities.
Use proper asset location. It is usually best to place high growth assets in Roth IRAs, tax-efficient growth assets in taxable accounts, and tax-inefficient assets like bonds and real estate in tax-deferred accounts.
Don’t just max out your 401(k) or 403(b). Having only tax-deferred accounts in retirement could present a tax nightmare. Forgoing an immediate tax deduction (Roth IRAs, taxable accounts) provides for better tax flexibility in the future.
Use a buy, hold, and manage approach. Frequent trading in a taxable account could result in more taxes and a lower after-tax return.
Buy funds with low turnover. The less trading a fund does, the more likely you’ll have lower taxable distributions (if held in a taxable account).
Sell smart. Make sure sales in a taxable account are long-term gains. When rebalancing, try to make trades in tax-deferred or tax-free accounts to avoid taxable gains.
Review taxable accounts for losses throughout the year. Tax-loss harvesting is not just a December activity. Tax losses should be taken whenever they are available, even if no gains exist yet.
Consistent savings into your portfolio has many benefits. Regular inflows can help you reach your financial goals faster, and help your portfolio stay balanced, reduce its risk, and lower transaction costs.
Use the power of time and savings. With the “Rule of 72” you divide the expected rate of return into 72 to see how long it’ll take for an investment to double (72/8% = 9 years). The “Rule of 72 + You” adds your savings to the equation and demonstrates how you can accelerate these results.
Use ongoing contributions to maintain your portfolio’s balance. Just like an old-fashioned lawn sprinkler needs to be moved around to prevent over-watering, ongoing savings work the same way. Periodically review what investments are being bought and if any changes need to take place. This can help save time and costs of rebalancing through buys and sells.
Shift your asset allocation with ongoing contributions. Similar to above, but ongoing savings are used to slowly move a portfolio to a more conservative allocation (from 60% stocks to 55% for example). Don’t forget about dividend reinvestments. They are contributions too.
Avoid dollar-cost averaging into ETFs and mutual funds if you’re going to be hit with transaction charges. If you’re buying funds with transaction charges at a discount brokerage, decrease the charges by saving up 4-6 months’ worth of contributions before purchasing.
Larger windfalls should be handled according to your comfort level. Some people may prefer to just deposit the whole amount while others may want to utilize periodic purchases to ease into the market. Research indicates lump sums usually perform better, but dollar-cost averaging tends to avoid bad timing. Comfort is key.
Distributions also provide opportunities to rebalance and manage the portfolio. However, if you’re taking distributions, you are likely retired, and the bigger concern is how to create adequate and sustainable income for the rest of your life.
Retirement income planning is unique for each person. Rules of thumb may work in other areas of financial planning and investing, but not with retirement income. Financial goals, assets, income needs, ages, and life expectancies all play out differently for people.
Have a withdrawal plan. Withdrawals should not be random, they should be part of an overall plan. The plan should 1) provide for a smooth and predictable income stream, 2) insulate the withdrawals from market volatility, 3) shield the portfolio from untimely cash needs, 4) opportunistically replenish cash and rebalance the portfolio, and 5) provide for tax flexibility.
Withdrawal rates are not static. Withdrawal rates have to respond to market conditions and the health of the retirement plan. If the plan is going well, larger withdrawals may be OK. However, withdrawals may need to be lowered if it is not. Age also plays a factor in appropriate withdrawal rates.
Don’t overlook the option of annuitization. While there are usually better options than variable and fixed annuities, some people may want to consider an income annuity. Annuitization (turning a portion of your assets into a lifetime stream of income – like a pension) should at least be considered, especially for very risk-averse investors.
Distributions allow for portfolio rebalancing. As cash is withdrawn, sales are periodically needed to replenish the cash. Review the portfolio’s asset allocation and sell investments that have grown over-weighted. Not only do you free up cash, but you also rebalance the portfolio.
Consider taxes. Sales in taxable accounts may create taxable gains. Review accounts for offsetting losses. Distributions from tax-deferred accounts are taxed as ordinary income. Make sure to consider the tax ramifications of all your withdraws.
The last step of a successful investment plan is to control your nerves. You can’t control the direction of the market, but you can control how you react to it. Your behavior can dramatically affect your investment results.
Don’t be fearful. Fear decreases returns. Too many people move out of stocks after they’ve gone down. Sitting in cash or an ultra-conservative portfolio “until things look better” practically guarantees missing out on the returns of a market turnaround (i.e. 2009-2010). Investing is a long-term endeavor. Take tax losses in down years to set up “free” capital gains in good years.
Don’t be greedy. Greed increases losses. Too many people throw caution to the wind after the market has gone up. Abandoning your diversified asset allocation in favor of more stocks or a “hot” investment is a recipe for magnified losses. Enjoy your gains by taking some off the table (i.e. rebalancing).
Don’t be naive. There is no such thing as a no-risk, high-return investment. If it sounds too good to be true, it is. If you’re unsure about an investment, seek a 2nd or 3rd opinion.
Relax. Unless you have psychic powers, there’s not much more you can do. Give it time to work.
Recognize your biases. Investing is more of a mental game than anything else. In fact, a relatively new field has emerged that is devoted to the mental challenges of investing — “Behavioral Finance”.
Don’t waste time trying to predict the markets or find the next hot investment. Research shows that approach doesn’t work. Instead, control your ACTIONs. Spend your time on what matters and what you can influence. Having an ACTION plan for your investment portfolio can lead to better results.
Terry Green, CFP® is the owner of Blue Water Capital Manage-ment, LLC, a fee-only financial advisory firm in Apex, NC.