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.
With mutual funds, watch for hidden trading costs that aren't reflected in the expense ratio. Pore over the prospectus and ask the fund company for its "statement of additional information," where commission information may be detailed, said Christine Benz, the director of personal finance at investment research firm Morningstar.
"In general, a fund with a very high turnover rate that's trafficking in smaller-cap names is going to be the most vulnerable to hidden trading costs," she said.
Diversifying a portfolio among uniquely performing assets is trickier as financial markets have become more complex.
"Investors now have access to many more strategies and investment styles than they did before," said Lo, the MIT professor. As a result, "many of these investments have become crowded trades."
Those crowds can foil diversification -- if investors pull out, it's a broad-based sell-off.
Investors now must work harder to find asset classes that diversify their portfolios while remaining within their risk tolerance. That includes looking at real estate, commodities and currencies. Still, Lo and others caution: Focus on what you understand.
Morningstar's Benz said she's not that enthusiastic about some alternative investments, such as funds that employ short-selling strategies. "A lot of alternatives are overpriced and will probably deliver returns that fall somewhere between stocks and bonds," Benz said.
Still, she said, commodities have a role in investors' portfolios. They can provide a hedge against inflation, but there are dangers, too.
Most commodities-focused exchange-traded funds, for instance, focus on the futures market so don't perfectly track commodity prices. "Some professional money managers seem to be veering away from commodities as an asset class and instead are talking about buying just natural-resources stocks or funds, such as T. Rowe Price New Era (PRNEX), for example," Benz said.
While alternative investments and tactical asset allocation are two strategies popular now to help investors weather storms, "I'm in favor of a more-traditional approach," Benz said. "If investors come up with a sane asset-allocation mix and adjust it gradually over time to make it more conservative, that is more than 90% of the battle."
Others agreed. "You can be extremely well diversified with five or 10 holdings," said Rick Miller, the founder of Sensible Financial Planning in Waltham, Mass. He suggested a portfolio with a total U.S. stock-market fund, international fund, emerging-markets fund, Treasury inflation-protected securities fund, total bond-market fund and REIT. "For people doing this themselves, that's great. It's cheap, and it's inexpensive to rebalance."
But, he said, diversification is about averaging out security-specific risk. "Market risk is undiversifiable. You cannot get rid of it unless you don't hold it."
Bergman made a similar point: "Diversification still works. It's just that when all hell breaks loose, correlations rise."
For the equity portion of his clients' portfolios, Bergman said he focuses on small- and large-cap stocks, international equities, natural resources and real-estate securities. In extreme periods, the price movement among those asset classes is high. "That's OK," he said. "We don't put any money that we need in the next five years into the stock market."
Evensky said his firm employs a "core and satellite" approach, with 80% of the portfolio invested to capture market-based returns cost-efficiently and the other 20% for risk taking -- assets that may be costlier and tax-inefficient but have potential returns to overcome those costs.
With market volatility as common these days as political gridlock, you may need to rebalance more often to stay true to your investment plan. That's good and bad.
Rebalancing provides an opportunity to harvest losses for tax purposes, plus it forces you to buy low and sell high. But moving money comes with transaction costs.
To reduce expenses, keep your portfolio simple. "If you have a broker or a custodian that has competitive expenses and you have an efficient portfolio (with just five or 10 holdings) then it's not going to cost you that much to rebalance," Miller said.
Some suggest rebalancing about once a year. Bergman of Palisades Hudson said he rebalances when an asset moves more than 10% beyond its target weight in a portfolio. That disciplined approach helps his clients weather bad times, and outperform in good times. In fall of 2007, before the downturn, "we were selling stocks," he said.
5. Be proactive, but patient
Sticking to your investing goals means having a strategic plan in place that you revisit periodically. "It's buy and manage," Evensky said, as opposed to buy and hold.
In times like these, that plan is essential. "The biggest obstacle to long-term return for most people is their emotional state in a downturn," McNeill said.
To create a plan, focus on goals -- not return. That is, what do you want to do with your money? If the goal is to pay your kid's college costs, decide how much money you need and how much risk you're willing to take to get there. If you don't mind your student borrowing money in a worst-case scenario, then maybe it's OK to take on risk with your invested dollars. If student debt is out of the question, don't take that risk.
If you don't have a financial planner, consider getting help online to develop your plan. Vanguard, Charles Schwab, Fidelity Investments and others offer research and tools on their sites. MarketRiders is an online portfolio manager. ESPlanner is a do-it-yourself planning tool that takes a holistic look at your financial picture.
The stock market is "like a roller coaster," Bergman said. "It's going to move around quite a bit, but in the end it's the best way to grow capital. There are two ways to approach that. One is to watch it minute by minute, day by day and make yourself nauseous."
The other is "to create a plan with diversified investments, making sure you have your goals identified, making sure it fits within your risk tolerance, making sure your cash-flow needs are met," Bergman said. "Then let it go."
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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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