11 Apr 2014 8 Ways to Improve Your Wealth With No More Risk

Efficiency and control are two words not generally associated with the process of active investing, but they should be. The disciplines of saving taxes, keeping expenses low, and ensuring you don’t under-perform the markets in which you invest, offer real and measurable improvements in your returns – in fact, some like Betterment and Wealthfront claim up to 4% or more. Our clients have enjoyed the benefits of control and efficiency for eight years. Here are eight ways we do it.

1. Don’t let your emotions drive your investment decisions. Dalbar Inc. publishes an extensive 20-year study of investor behavior every year, with virtually the same unfortunate results every year. The latest reveals that “Individual investors in equity funds kept pace with the S&P 500 in 2012 but remained 3.96% behind for the 20 year period.” The majority of the shortfall is explained by emotion-driven mistakes – buying and selling out of excessive enthusiasm or fear. Our confidence-driven planning provides clients with objective reasons to stay the course. They know custom advice for adjustment will be provided when required.

2. Own Exchange Traded Funds rather than mutual funds. ETFs can save you as much as 1.5% in expenses. Index-based ETFs do not under-perform their market indices (greater than expenses). A study published by Rick Ferri, CFA and Alex Benke, published in the Journal of Indexes in January 2014 showed that over a 15-year period, an all index-fund portfolio outperformed a portfolio of active funds 83% of the time by a median of 1.25%. And finally, ETFs do not generate ‘phantom’ income taxes like mutual funds do, preserving your accumulating wealth from the steady erosion of taxes.

3. Diversify your portfolio. You might be surprised to learn that the practice of owning many mutual funds may not guarantee broad diversification. The reason is most funds largely own the same popular stocks. Fund holdings rarely exceed 1,000 – 1,500. Our portfolios represent ownership in some 5,800 companies in over 50 countries throughout the world. Broadly diversified portfolios are less volatile, improving the odds you will have money available when demands are made on your investments.

4. Optimal Allocation employs asset classes that oppose one another as markets rise and fall. Generally, bonds rise when stocks fall, and cash remains stable. These three major asset classes are allocated in measured proportions to provide optimal balances of risk and return along what is know in academic circles as the ‘efficient frontier.’

We use US Treasuries in our portfolios to hedge stock market volatility. There are other hedge techniques available with fancy names and equally fancy price tags, but none has proven better than US government bonds for offsetting extreme stock market volatility. An 8-year Morningstar side-by-side  study of the ETFs allocated as we do in our 60% stock 40% bond portfolio beat an industry standard allocation of 60% S&P 500 40% Barclays Aggregate US Bond Index by .50%. But remember, past gains are not indicative of future results.

5. Rebalancing is one of the most important aspects of maintaining the efficiency of your portfolio, and is one of the most overlooked disciplines by investors. Stocks and bonds that comprise your portfolio change in relative proportions to one another over time, throwing the optimal mix out of balance with model allocations. An unbalanced portfolio exposes you to more risk than you planned, potentially compromising your wealth and lifestyle. Rebalancing reduces the risk of extra volatility. An 8-year study of our 60/40 Balanced Model using Morningstar data revealed a .40% improvement over the same portfolio left unbalanced. Again, past gains are indicative of future results.

6. Tax-sensitive household rebalancing can save you hundreds and thousands of dollars in taxes over time. While common practice is to rebalance all accounts to the same model, the practice exposes your taxable brokerage accounts to needless gains taxes. Our household approach considers all appropriate accounts in your household as ONE portfolio. Rather than rebalance every account like the other, we concentrate the taxable gains in your qualified accounts (IRA, 401K, Roth, etc), thereby shielding them from current taxes. We can often balance many-account households with no more than two or three trades, saving commissions charges from the custodian broker.

7. Tax Location Management: The location of assets makes a huge difference in your tax bill, both now and more importantly, later in retirement. Now, the 2-3% interest paid on bonds can be tax-deferred in your qualified accounts, such as IRA’s and 401k’s. But there’s a substantially more important aspect of retirement planning that very few investors consider.

Retirement dollars drawn from IRAs and 401Ks are very expensive tax-wise. Distributions are taxed 100% at your ordinary income rate when withdrawn. There is a better way to invest your portfolio to address this fact. Let’s return to the household model – all your accounts are one portfolio. By concentrating the growth potential of stocks in your brokerage accounts and Roth accounts, you will significantly improve your tax-friendly spending (qualified dividends and capital gains and tax-free withdrawals from Roths) in your retirement years. Our modeling shows substantial lifestyle improvement with this elegant tweak to asset placement.

8. Tax loss harvesting: When markets decline some positions may represent temporary losses. If your circumstances required additional tax losses or gains, we routinely ‘harvest’ them for later use. Losses offset other capital gains (say from the sale of a beach house) as well as $3,000 of ordinary income.

We create the loss or gain, by selling the indicated positions, and immediately replace them with similar ETF’s to hold your position in that asset class. When tax rules are satisfied and market conditions warrant, we replace the substituted ETF with our preferred ETF.

Given that thousands, hundreds of thousands, even millions of dollars can be saved over investors’ lives with no additional risk, we marvel over the question – why don’t more people take advantage of these simple (some not-so-simple) disciplines of control and efficiency? Likely our emotions cause us to over-reach. Disciplined and efficient investing can substantially reduce the amount of risk required, or alternatively, increase your confidence of meeting or exceeding your goals.