9/28/2011 11:39 AM ET|
5 investment tips for volatile times
Long-term investors may have to devote more attention to managing losses than going for outsize returns. Pay attention to taxes, costs and asset allocation.
With shock waves roiling financial markets worldwide, investors are seeking new ways to protect their portfolios from the next upheaval.
But they may be ignoring the best weapons in their arsenal: straightforward strategies for managing money that, over time, boost returns.
"We're on this incredible volatility roller-coaster ride," said Andrew Lo, professor of finance at Massachusetts Institute of Technology and the chief investment strategist at AlphaSimplex Group, a mutual fund firm.
"For the next couple of years," he added, "my guess is we're going to have to spend more time thinking about managing losses than generating really attractive returns."
Markets will go up again, Lo said, but there's "so much macro instability you're going to get investors rushing to the left side of the moat together and then to the right side of the moat together. When you've got this coordinated herd mentality, you can get some wild swings in any investment."
Key strategies to eke out a profit include minimizing costs and getting as much diversification as you're comfortable with, Lo said.
Plus, he noted, you need an investment plan that will keep you focused, so you don't panic "when markets start to dislocate, which they will."
Here are some building blocks for your portfolio's foundation:
1. Minimize taxes
High-tax-bracket investors lost an average of 2.4% of the value of their domestic equity mutual funds each year from 1981 through 2001, according to research from the Schwab Center for Financial Research.
That was before former President George W. Bush's tax cuts slashed rates on qualified dividends and long-term capital gains but also before the current dismal outlook for market returns made it even more important to seek tax efficiency.
Tax-loss harvesting and using tax-advantaged and taxable accounts to their best advantage are the two main ways to manage the tax hit.
Typically, put taxable bonds, which yield ordinary income, in a tax-deferred account such as a 401k or individual retirement account, while stocks go in a taxable account since long-term capital gains and dividends currently are taxed at a maximum of 15%.
One caveat: If you plan to hold the security for less than a year, consider your tax-deferred plan. Otherwise, if the stock's a winner and you sell it in a taxable account, that short-term gain is taxed at ordinary income rates, said Mackey McNeill, the president of Mackey Advisors, a financial-planning firm in Covington, Ky.
Meanwhile, the ability to deduct losses on your tax return means risky assets are more appropriate for taxable accounts, said David Bruckman, the managing director of Citrin Cooperman Wealth Management.
"Emerging-market stock, small-company stock, junk bonds, anything that's very volatile or aggressive, generally you don't want that in an IRA account, because you want to be able to realize a loss," Bruckman said.
(If all of your invested money is in a tax-qualified plan such as a 401k, it still may make sense to invest in risky asset classes to diversify your portfolio; you just don't get the tax break on losses.)
Consider putting real-estate investment trusts in a tax-deferred plan, because those assets pay nonqualified dividends, said Jonathan Bergman, the chief investment officer at Palisades Hudson Financial Group in Scarsdale, N.Y.
When tax-loss harvesting, don't make the mistake of exiting the asset, McNeill said. Say you own the iShares S&P 500 Index (IVV) exchange-traded fund, and it drops 20%, so you sell. "As soon as that trade clears, use it to buy, say, the Russell 1000 Index ($RUI) index," she said.
"You can improve your return by tax-loss harvesting and trading out for similar assets," she said. Just don't buy and sell the same asset; that's a wash sale, and the Internal Revenue Service won't allow the loss.
2. Control costs
Given the prospect of lower average stock-market returns in the years ahead, the tried-and-true rule of minimizing expenses makes more sense than ever.
Harold Evensky, the president of Evensky & Katz in Coral Gables, Fla., estimates the average annual return on a portfolio 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's going to have a huge positive impact," he said.
That means low-cost funds and a low-cost brokerage. Consider consolidating disparate accounts at one broker to reduce transaction costs -- you also may get a break on account maintenance fees by aggregating accounts with one provider.
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A gain is not a gain unless you sell. If you are deathly afraid of selling before a year and a day is up because you'll owe ordinary taxes, just weigh this - would you rather pay 25% on your gain now or would you rather 'harvest' losses? Sure, sell the loser at a loss and offset other ordinary income (limit of 3,000 loss allowed beyond gains and then you are in a carryover situation), but think before you let a gain get away in these tough times. There's no shame in taking a gain. You'll most assuredly lose out on the up side too at times, but you got your gain and no one can take that away.
Next, never (there are few nevers in life) - never, put your emergency fund in the market and always (same goes for always) - always have a separate LIQUID emergency fund established before you dabble in the market. Taking a loss smarts...and, despite your great intentions, it is going to happen...do not compound that agony by leaving yourself naked without an emergency fund.
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