Key Takeaways
The stock market by nature is volatile. The sooner you accept that, the sooner you can move on and take prudent risk to grow your wealth.
Don’t let fear or emotion derail your plan during unsettling times. An investment policy can help.
How much of your wealth is being eroded by hidden fees, taxes and portfolio turnover?
“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” Mark Twain
With worries about inflation, interest rates, tech stocks, the debt ceiling, higher tax rates and COVID weighing on investors’ minds, the 4th quarter of this year is likely to be a bumpy ride.
With that backdrop, I thought now would be a good time to remind you that investing in equities comes with uncertainty. Now is not the time to be making drastic changes to your portfolio and retirement plan just because we’re having a little market turbulence. Uncertainty and risk are what an investor needs to expect and learn to embrace.
The confidence you need to weather any period of extended volatility comes from having a solid strategy and process in place. This is what will keep your emotions in check when the alarmist headlines could easily get the better of you.
Let’s think about how you make your investment decisions. Do you scan the paper, watch investment channels, or subscribe to an investing service to find new opportunities? Or do you first determine your goals, and then figure out the time frame, dollar amounts and asset allocation you need to reach those goals?
I hope you said the latter.
Remember, there are over 10,000 public companies in which you can invest your hard-earned funds. The pundits on TV need ratings. They know stories about “hot” companies, hot sectors and hot asset classes will attract eyeballs. But they don’t know your individual financial goals, risk tolerance or retirement timetable. So, something that’s a great investment for one viewer could be a terrible investment for another.
Strategy
The core of your investment strategy should entail understanding your resources, expenses, and future goals. You then apply those parameters to your investment options, and work within the time frame and dollar amounts needed to get you there. If your retirement goal is near, you should have more bonds than stocks in your portfolio. If the goal is years down the road, you should own more stocks than bonds. A healthy, well-diversified portfolio should resemble the food pyramid with balanced servings of stocks and bonds, U.S. holdings and international holdings, growth and value stocks, large cap and small cap, stocks spread out among various sectors, etc.
A hot tip can give you a temporary sugar rush, but it won’t sustain you for long. Any special whispered information that comes your way has almost always been digested by the market before you can act on it. As a result, the price has already adjusted by the time that “hot tip” reaches you and you end up being a day late and a dollar short. Countless empirical studies show that a well-diversified portfolio outperforms any over-concentration in individual stocks or sectors. So be kind to your health. Choose the diversified portfolio and make sure to get the recommended regular servings from each financial food group in the pyramid.
Process
Now that we’ve agreed a diversified portfolio is prudent for your needs, how do you go about constructing it?
Before answering that question, I want you to consider four key elements:
1. Expenses. 2. Allocation. 3. Taxes. 4. Rebalancing.
Each of these areas can detract from your investment returns if not properly implemented. Let’s take them one at a time.
1. Expenses It is painful to see investors pay 2% to 2.5% for simple investment advice. You can get all the strategy, planning, allocation and implementation advice you need for 1% or less from many fee-only planning firms. Because the commission component has been removed when working with a fee-only advisor, the conversations are about you and your family and your goals--not about what they can sell you.
2. Allocation
The next hidden expense has to do with assets that are chosen for you. You should always know what you are buying and how much you are paying for it. Don’t stand for anything less. When it comes to your portfolio, it is far better to be broad then to be highly concentrated and you should never pay for investments you don’t understand or don’t align with your values or risk tolerance.
3. Taxes No one wants to pay more taxes than they need to. But that’s what some financial institutions are asking you to do when they don’t consider the effect that portfolio turnover, dividends and income will have on your after-tax returns. Turnover is the amount of trading that takes place within the portfolio that an investment advisor is managing for you. The more buying and selling that takes place, the more you are racking up capital gains—gains you must eventually pay taxes on. That eats into your return. Which portfolio would you rather have? One that generates a 12% return, but forces you to pay 3% to 4% in taxes, or one that generates a 10% return with little to no tax bill? Hopefully you said the latter. The same thing happens with REITS (real estate investment trusts). Many of you may be drawn to REITs, but did you know REITs are required to pay out 90% of all the income they earn each year? So, if you have REITS in a taxable account and you are in a high tax bracket, say goodbye to a good chunk of your earnings.
4. Rebalancing
Most people do not have a strategy for knowing exactly when to buy or sell an investment. But if you have predefined rules that tell you to sell an investment after it grows to a certain size, or to buy more if it drops below a certain point, then your outcomes are substantially improved. I am not just talking about individual stocks or bonds; I am talking about a basket of investments in a mutual fund or ETF.
The reason this is so important has to do with compounding. The more money you can hold onto, the more you have available to compound year after year. Behavior
As emotional creatures, humans tend to make terrible investors. They are easily swayed by headlines, volatility or simply trying to keep up with what they think everyone else is doing. If left unchecked, emotion can cause even the most sophisticated investors to deviate from their plan and to make rash decisions they will regret down the road. As Nobel laureate Daniel Kahneman observed: “Individual investors tend to churn their accounts, they tend to trade too much, and that they trade too much seems to be due to over-confidence. They believe they know something that they do not know, and this is one essential characteristic of human beings, which makes them different from rational beings.”
The stock market by nature is volatile. The sooner you accept it, the sooner you can move on and take prudent risk to grow your wealth. A well-constructed financial plan (i.e., financial food pyramid) and an investment policy, combined with a healthy dose of education, will help you stay focused on what is important and true in the investment world.
If you or someone close to you has concerns about your portfolio’s ability to withstand a roller coaster market environment, please contact us any time. We’re happy to help.
ROBERT B. DUNN, CFP® is the President and
Managing Partner of Novi Wealth