Long-Term Investing In A Shaky Market
As the world’s financial markets continue to be mired in uncertainty, investors are looking for new ways to protect their portfolios from future market fluctuations.
While this is certainly a natural reaction, they may be overlooking some of the best ways to achieve their goal: straightforward strategies for managing money that will, over time, boost returns.
As investors grapple with the roller coaster ride markets are on right now, it appears that, for at least the next couple of years, they will be spending more time thinking about managing losses than generating really attractive returns. As we have watched the Dow Jones Industrial Average take a pounding in recent weeks, incurring the largest two-day point drop since November, 2008 and largest two-day percentage drop since December of that year, it is good to remind ourselves that the markets will go up again. There is so much macro instability, with investors adopting a coordinated, herd mentality, that it is not surprising to experience some wild swings in any investment.
Central strategies to wresting a profit from this uncertain time include minimizing costs and diversifying your portfolio as much as you are comfortable with. You also need an investment plan which will keep you focused, to resist the natural urge to panic when markets experience volatility, which they inevitably will.
Here are five suggested building blocks to help ensure your portfolio has a solid foundation:
1. Minimize taxes
Between 1981 and 2001, high-tax-bracket investors lost an average of 2.4% of the value of their domestic equity mutual funds each year. That was before President George W. Bush’s tax cuts slashed rates on qualified dividends and long-term capital gains, but also before the current bleak outlook for market returns made it even more essential to seek out strategies to legally minimize your tax obligations.
Two ways to meet this goal are utilizing tax-loss harvesting and tax-advantaged and taxable accounts to their best advantage.
Put taxable bonds, which yield ordinary income, in a tax-deferred account such as a 401(k) or an IRA. Put stocks in a taxable account, because long-term capital gains and dividends are currently taxed at a maximum of 15%.
One thing to consider: If you plan to hold the security for less than a year, you might want to consider your tax-deferred plan. If you do not, and a stock is a winner and you sell it in a taxable account, that short-term gain is taxed at ordinary income rates.
The ability to deduct losses means risky assets are more appropriate for taxable accounts. As a rule, you should consider investing in emerging-market stock, small-company stock, junk bonds and anything which is aggressive or volatile outside of your IRA, because you want to be able to realize a loss if things don't work out. If you have invested all of your money in a tax-qualified plan such as a 401(k), it may still make sense to invest in risky asset classes to diversify your portfolio. Just remember that if you do, you will not be able to take advantage of a tax break on your losses.
2. Control costs
The tried-and-true rule of minimizing expenses makes more sense than ever, especially given the prospect of lower average stock market returns in the years ahead. The average annual return on a portfolio comprised of 60% stocks and 40% bonds – after taxes, inflation and expenses – will be about 2.5% to 3% in the years ahead. If you can save 0.5% by managing expenses and taxes, that is going to have a huge positive impact.
You should consider consolidating accounts with one financial advisor as one way to potentially reduce transaction costs. You also may see a break on account maintenance fees with consolidation.
When it comes to mutual funds, you should watch for hidden trading costs which are not reflected in the expense ratio. Carefully read the prospectus and ask the fund company for its “statement of additional information,” which may contain details of commission information. In general, a fund with a very high turnover rate which traffics in smaller-cap names is going to be the most vulnerable to hidden trading costs.
Diversifying your portfolio among uniquely performing assets is becoming increasingly trickier, as financial markets continue to become more complex. Investors now must work all that much harder to find asset classes which diversify their portfolio without pushing them beyond their risk tolerance. This means considering real estate, commodities and currencies.
Above all else, you should focus on what you understand. Many alternatives are overpriced and will probably deliver returns that fall somewhere between stocks and bonds. Commodities should play a role in investor portfolios. While they can provide a hedge against inflation, there are also downsides. For example, most commodities-focused exchange-traded-funds focus on the futures market so they do not perfectly track commodity prices.
These days, since no one is immune to market volatility, you may need to rebalance more often if you want to stay consistent with your investment plan.
There are advantages and disadvantages to rebalancing. This strategy provides an opportunity to harvest losses for tax purposes as well as forcing you to buy low and sell high. Remember, though, that moving money comes with transaction costs. To reduce expense, you should strive to keep your portfolio simple. If your broker or custodian has competitive expenses and you have an efficient portfolio, with five or 10 holdings, it is not going to cost much to rebalance.
Some say you should consider rebalancing about once a year, doing so when an asset moves more than 10% beyond its target weight in a portfolio. This disciplined approach can help weather bad times and outperform in good times.
5. Be proactive, but patient
The best way to stick to your investing goals is developing a written financial plan, then revisiting it periodically. Instead of embracing a strategy of “buy and hold,” think of it as “buy and manage.”
During challenging economic times, that kind of thinking is essential. The biggest obstacle to long-term return for most people is their emotional state in a downturn. Investors should focus on goals, not returns.
Ask yourself an important question: “What do you want to do with your money?” If your goal is being able to pay for your kid’s college, decide how much money you need and how much risk you are willing to take to reach that goal. If you are okay with your child borrowing money if it comes to that point, it might be more acceptable to take risks with your investments. If that possibility is out of the question, then do not take those risks.
Realizing the stock market is like a rollercoaster is half the battle. It will move around quite a bit, but, in the end, it remains the best way to grow capital. Once you are content with that, there are two ways to approach your portfolio: one is to watch it like a hawk, following the market’s ups and downs on an almost minute-by-minute basis. The alternative is to craft a well thought-out plan with diversified investments, making sure you set identifiable goals and that it fits within your risk tolerance, then letting it go.
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