Part 7: Things That May Improve Your Portfolio’s Performance

By Patrick Rau, CFA ∙ May 2016

 

 

Allow me to discuss a few concepts that may improve the investment performance of your portfolio over time. Once again, no guarantees, but I believe you will find these ideas to be based on sound investment theory and logic. Some of these are purely a function of math.

 

 

The Earlier You Start Investing, The Better Off You Should Be

 

This one seems is pretty obvious, but the more time your savings have to grow, the better. In the example below, assume you can earn 10% per year. If you invest $2,000 per year in a tax deferred account between the ages of 22-28, then stop investing entirely, you would still have roughly the same amount of money at age 60 as you would if you had invested $2,000 per year between ages 29-60. Behold, the magic of compounding.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

401k Matching Is Powerful

 

Many employers will match at least a portion of the contributions you make to your 401k or similar qualified retirement savings plan. For example, an employer may match the first 5% of your annual contributions. That is free money, and your immediate rate of return on that money is 100%. How many other investments double the second you make them?

 

Yet far too many fail to take advantage of this perk. Some simply aren’t aware of it. But I believe the two main reasons for not doing it are 1.) those living paycheck to paycheck feel they can’t take the hit that saving more money will have on their take home cash flow, and/or 2.) saving for more pressing needs, such as college.

 

The first reason may be more palatable, since we all gotta eat. But it also provides an excellent opportunity to really eliminate wasteful spending, in order to save more. Plus, remember your take home pay won’t fall by 100% of what you contribute to your 401k. Those contributions reduce your taxable income, so your after-tax take home pay won’t fall dollar for dollar.

 

The second reason really shouldn’t deter you from bypassing matching funds in order to save for something like college. Any growth you receive from those matching 401k funds will be tax deferred, and you can always withdraw part of those matched funds when those college bills come due. Yes, that money will be taxed at your ordinary income rate, and you will be assessed a 10% penalty by the IRS if you withdraw that money before the year in which you turn 59.5 years old. However, this strategy will likely still leave you with more money than you would have had otherwise.

 

For example, say you were putting $5,000 per year into your son’s 529 account, which is tax deferred. Instead, you take that money and put it into your 401k, which is also tax deferred, and your employer matches your $5,000 annual contribution dollar-for-dollar. You do this each year for the next five years, until your son is off to join a fraternity (and maybe even study once in a while….). Since you need the money in five years, assume you will invest in relatively safer securities that are expected to earn 3% per year.

 

At the end of those five years, and assuming 3% per year growth, those matched funds would be worth $27,342. Assuming an ordinary income tax rate of 28%, plus another 10% penalty for withdrawing those retirement account fund early, that would still leave you with an extra $16,952 to pay for college that you wouldn’t have had had you continued to forgo the 401k matching.

 

 

Reinvesting Dividends/Distributions Can Make a Big Difference

 

Way back in Part 1 of this series, I showed historical asset class returns, which include both capital appreciation and dividends. Those also assume that investors don’t just take dividends as cash, but instead reinvest those by buying more of the particular security. That enables the money earned through dividends to compound in value over time, which leads to a greater return than one would have earned by simply spending these dividends right away, or holding them as cash.

 

Just how impactful is dividend reinvestment on total returns? That depends on the type of security and your time horizon, but generally speaking, the longer the holding period, the greater the impact. Several studies I’ve seen suggest that dividend reinvestment explains more than 90% of total returns, although those may be a bit aggressive, as this Seeking Alpha article suggests. Still, no matter the actual quantitative impact, dividend reinvestment is an important contributor to long-term portfolio returns. If you need current income from your investments, then you should probably take the dividends as cash. That also means your expected returns for the various asset classes in Part 1 will be lower, since you won’t be getting the benefit of reinvestment. However, for those of you who are looking for growth, can forgo the current income, and/or have longer-term horizons, then reinvesting your dividends is most likely the better call. I would say this is a no-brainer, but an important thing to keep in mind is whether you will be charged a commission to reinvest those dividends. If so, then you might want to think twice about reinvesting dividends automatically. In this case, it might be better for you to accumulate those dividends in cash, and buy a larger block of securities from time-to-time.

 

 

Rebalancing 2x Per Year May Be Beneficial

 

Rebalancing is extremely important, for two main reasons. One, it ensures that you do not stray too far from your asset allocation targets. Remember, those targets aren’t random. They are there for a reason, and were designed with your specific goals and circumstances in mind. Two, it enables you to shift money from assets that may be a bit overvalued into those that may be somewhat undervalued, which should help boost your returns over time.

 

The key to rebalancing is not to do it so frequently that you start generating a lot of transaction fees, but to do it often enough to achieve the two benefits I just described. Many financial professionals and academics suggest rebalancing 1x-4x per year, but I normally do this every six months or so. Not only is that a compromise to this range, but also it may allow you to take advantage of the historical annual returns cycle for stocks. A 2012 Financial Analysts Journal article entitled “Sell in May and Go Away” Just Won’t Go Away shows that U.S. stock returns tend to be 10% higher between November and April than they are from May through October. Several authors have shown that August, September, and October ae typically the worst three months for U.S. stocks, and Jeremy Siegel observes that stocks tend to do three times as well during the first half of any particular month. Now, there is no guarantee that any of these historical trends will extend into the future, and for you finance heads, the efficient market hypothesis argues that trading periods should not exist at all, meaning they may not continue going forward. But if we are going to rebalance two times per year anyway, it makes sense to take heed of these historical relationships, rather than just to rebalance randomly. Given these data, I like to rebalance at or near November 1 and April 15 each year. That latter date is when U.S. individual income taxes are due, so that always serves as an annual reminder to rebalance as well. I also like to run Morningstar’s Instant X-Ray feature when I rebalance my portfolio, in order to ensure my investments haven’t become too top heavy or underweighted in any particular industry or geographical region.

 

 

Revisit Your Long-Term Portfolio Allocation Every 1-3 Years, Or Whenever Your Circumstances Change

 

As I wrote before, you don’t want to change your long-term asset allocations too often, otherwise you might get caught up in market sentiment and stray from your well-thought out long-term allocation rationale, and/or you run the risk of racking up fees.

 

 

Where to Place Certain Securities: Taxable or Tax Deferred Accounts?

 

The answer largely depends on what you intend to do with your investments, but these general concepts should help.

 

Concept #1: Assets geared to fund long-term goals may be more appropriate for tax deferred accounts, to the extent possible. This applies primarily to retirement and college savings plans. The main benefit of this is you can rebalance your portfolio or sell securities to adjust your asset allocation without incurring any capital gains tax. Tax deferred plans, such as 401ks, IRAs, and Keough accounts for retirement, and 529 Savings plans for college, have annual contribution limits, so that will limit the amount of new funds you can earmark to these accounts in any particular year.

 

Concept #2: Tax advantaged or lightly taxed securities generally do not belong in tax advantaged accounts. For example, the main advantage of municipal bonds is they are tax free at the Federal level as well as many state and local levels, but it makes little sense to put these in a tax deferred account, since you won’t be able to take advantage of these tax savings. Same goes for variable annuities, which I discuss a bit more in Part 8 of this series.

 

Concept #3: Securities that generate phantom income are better in tax deferred or tax exempt accounts. Treasury Inflation Protection Securities and zero coupon bonds are perfect examples of this. These generate taxable income every year, even if you never receive any actual interest from them.

 

Concept #4: Use Taxable Accounts If You Want to Trade. This enables you to take advantage of tax harvesting rules, where you can net losses against some of your gains in order to minimize your tax bill. For more on tax harvesting strategies, please click here. 

 

Concept #5: Traditional vs. ROTH IRA – There has been much written on this subject, so I do not wish to expand upon this here.  Fidelity.com has a very nice worksheet that can help you decide which is more appropriate for you. As a general rule of thumb, though, if your expected marginal tax rate in retirement is less than it is this year, then you should save in a traditional deferred tax account, such as a 401k or IRA. If your marginal tax rate is lower today than what you think it will be in retirement, then a ROTH IRA probably makes more sense. Also, if you elect to reclassify an existing traditional IRA to a ROTH IRA, it is advisable to pay the conversion taxes due from your cash holdings or a taxable account, rather than liquefying part of your retirement account to do so.

 

 

 

Next Time

 

Up until now, I have focused on the asset accumulation period of one’s personal investment cycle. In the final full length article of this series, I will address strategies for optimizing spending in retirement, guarding against longevity risk, and stretching the value of one’s portfolio using tax efficient planning methods.

 

 

Patrick Rau, CFA, is a former equity research analyst, both on the sell-side specializing in energy and the buy-side as a generalist for a financial advisory firm. He holds a B.A. in Economics from the College of William & Mary, and an MBA in Finance from Georgetown University. He is married to Brenda Rau, Licensed Real Estate Salesperson with Compasss Real Estate in New York City.

 

Disclaimer: All information and calculations are based on information deemed to be reliable. Patrick Rau, CFA is not an investment advisor, and this paper is for educational purposes only. Nothing herein should be considered financial or investment advice. Moreover, Patrick Rau, CFA shall not be held liable for any losses or damages that may result from any decisions you make based on any of this content.