By: Investor Solutions, Inc.
How do you define a successful investment portfolio? For some people it’s a steady 10% return, for a few it may be 8%, while others may say “I’m happy if I didn’t lose anything this year”. With the volatile markets of today, many retirees are scared to death that they may outlive their retirement savings. Whatever fuels your investment philosophy, hopefully; it all focuses on making wise investment decisions. Selecting investments is only part of the investment puzzle; other factors that need to be considered include diversification, risk, time horizon, fees, tax effects, and marketability & liquidity.
Diversification among different Asset Classes
My portfolio is fine, I’m well diversified. If I only had five dollars for every prospect that came to our firm feeling this way, I’d probably be able to retire now. I can’t even count the times that someone has presented their portfolio to us with 20 to 30 different stock holdings that their broker has advised them makes up a well-diversified portfolio. When you dig a little deeper into these holdings of Disney, Wal-Mart, Intel, Best Buy, etc…you’ll find that they have one thing in common- they all make up stocks in the US Large Capitalization sector. So what’s the worst that can happen to a portfolio that is made up entirely of one sector of the market? Well in 2000 this sector lost over 9%, in 2001 lost over 11%, and in 2002 losses exceeded 22%…that’s 42% in three years! Ouch. True diversification is tied to asset allocation, where you define different asset classes to invest your portfolio, such as Emerging Markets, International Small Value, US Small Growth, just to name a few. A good diversified portfolio should have at least 8 to 10 different asset classes with no more than 15% in any one class.
Measuring your Risk Tolerance & Time Horizon
I’d like to average 20% on my investment return each year. Well, as the old saying goes “the higher your expected return the higher your risk”. Far too many investors are concerned with chasing investment returns instead of developing a portfolio that matches their risk tolerance and time horizon. If you’re planning to retire in the next two years, your time horizon for needing funds from your portfolio is quickly approaching. How would you feel if you lost over 33% of your portfolio value within those last two years of full-time employment? Well, it happened to many pre-retirees during the 2001-2002 years, and now many of them have delayed their retirement for another five or more years in hopes of getting their finances back on track. Your time horizon is the key variable in determining the proper allocation of equities and income producing investments in your portfolio. Measuring risk is not a complete science either, some advisors use questionnaires, while others will access risk based on prior conversations with the client. Your goal should be to find a risk comfort level and then select your investment vehicles based on your risk tolerance and efficient markets. The efficient frontier consists of portfolios with the highest expected return for a given level of risk. You’ll want to try to construct an efficient portfolio( Risk vs. Return) that puts your portfolio somewhere on the efficient frontier line.
When you go to buy a new car, hopefully; you ask your salesman for a detailed list of all the hidden charges associated with purchasing that particular car. Well, managing your investments should not be any different. This is perhaps one of the most overlooked areas in portfolio design. At all times, you must be aware of the commissions or investment management fees that your broker or investment advisor charges. You must also dig a little deeper into your mutual funds (read your prospectus or visit http://www.morningstar.com/) to determine if the fees inside the funds you are about to purchase are reasonable. First of all, if you’re still paying a load- whether it’s front-end, back-end, or whatever…dump that dog, loads are for losers. Next, look to see if you’re paying a 12b-1 fee, this is the fee charged by mutual fund companies to recoup their cost of advertising. Your fund might have the best halftime commercials, but keep in mind, your paying for it. And lastly, check the expense ratio. In most cases, you’ll want to try to keep each fund under 1%, but most importantly is the overall expense ratio of your portfolio which should be below 0.80%. Remember, the less you pay in expenses the greater your overall return.
Tax Effects Planning
Almost all investments will have some type of dividend, income payout, or capital gain/loss consequence. It’s how you manage these potential tax consequences that can make or break your portfolio. If you’re planning on buying a REIT mutual fund (which we all know tends to have high income payouts), your best bet is to slide that guy into your tax-deferred account such as an IRA or company retirement plan. This allows all dividends, capital gains, and income payouts to continue to grow for you tax-deferred until you start to withdrawal assets from that plan. Depending on your tax bracket and the current tax laws, it might even make sense to keep a majority of your bond holdings in the tax-deferred accounts too, since they tend to have consistent income payouts. Mutual fund companies are finally starting to see the increased demand for more tax efficient funds. If taxes are starting to kill you in your taxable accounts, it might be a wise decision to start to look at companies that offer tax-managed funds to investors such as Dimensional Fund Advisors or the Vanguard Group to help you cut your year-end tax bill.
Marketability & Liquidity of Investments
Liquidity is known as the ability to quickly convert your investment to cash without a large decrease in principal. Marketability refers to the ability to readily buy, sell, or exchange an asset. It is imperative that you have a grasp on your time horizon and liquidity needs when buying particular assets. Assets such as homes, limited partnerships, and 20-year bond funds are not particularly the best liquid investments for a 62-year old that is getting ready to start retirement. Older clients tend to have higher liquidity needs due to the unexpected costs of medical and long-term care expenses.
Developing a structurally sound portfolio requires many steps above and beyond selecting individual securities. You should review your risk tolerance and time horizon each year and adjust your asset allocation accordingly to fit your particular changing circumstances. Remember, not all investments are created equal, so it’s up to you to sort out the good, the bad, and the ugly. Volatility in the market will continue to be a challenge for all equity investors, are you ready?