While there are a variety of investment options available to everyone, an astute investor must practice good fundamentals to control risks and optimize potential returns, including taking the time to be informed. As stated by Peter Lynch, renowned manager of the Fidelity Magellan Fund from 1977 to 1990 who beat the S&P 500 index 11 of 13 years, “Investing without research is like playing stud poker without looking at the cards.”
As you build your portfolio for retirement, it is crucial to keep several principles in mind.
Investing Principles for Retirement
1. Manage Your Risks
Warren Buffett, the “Sage of Omaha” often credited as the “Greatest Investor of All Time,” supposedly had two rules: “Rule number one: Never lose money. Rule number two: Never forget rule number one.”
It has been generally accepted that investments with higher returns involve the assumption of greater risk. Logically, you want to balance risk and reward. Unless you are a diehard gambler, you probably do not want a portfolio that is all or nothing (all assets in the high-risk, high-reward category) or, even worse, assets that have high risk, but low potential reward.
Fortunately, stock market analysts and theorists have conducted numerous studies to better understand the correlation between risk and reward in attempts to minimize risks and maximize returns within portfolios. As you select your investments, be aware of the beta and R-squared values, two measures that compare the investment to a commonly accepted market index (T-bills for bonds; S&P 500 for equities) and can help you better balance risk.
- Beta is a measure of volatility – how the asset will move in comparison to the market; a 1.2 beta means that the asset will move 20% more than the market up or down, a 0.75 beta means it will move only three-quarters as much as the market. As you grow older, you should seek to have an average beta of 1.0 or less, thereby reducing the volatility of your portfolio and the likelihood of an extraordinary loss.
- R-squared is the measure of correlation between a portfolio and an index. A high rating (80%-plus) indicates that the fund will benefit or lose significantly as the index moves; a low R-squared rating is an indication that there is less correlation. In practical terms, if you are paying fees and commissions to a mutual fund manager for a fund with a R-squared rating near 1.0, you should consider liquidating the fund and investing the proceeds in the index, capturing the same return as before plus the fees and commissions which you previously paid.
2. Let Time Work for You
When instructing his protegé Warren Buffett, author Benjamin Graham said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” The numbers reflect his view – in the period between 1950 and 2010, the average return of the S&P 500 during a single year was 8.4%, which included a year with a great return of 53.4% and a stomach-wrenching loss of 44.8%.
In the short-term, equities are exceptionally volatile, reflecting the emotions of buyers and sellers. Over time, logic and actual financial result replaces emotions and returns even out (become less volatile). For example, since 1900, there have only been five 10-year periods that the market has produced a negative return. According to a study by Crestmont Research, the average return for the whole period (including the negative decades) for a 10-year period has been 10%.
The lessons to be learned from this history are as follows:
- Stay Invested. Pursue your investment strategy in up and down markets. There has been more money lost trying to call market direction than saved due to the emotions involved. If your goal is long-term capital appreciation, recognize that there will be times when market values are down.
- Dollar-Cost Average Your Purchases. Do not try to call the market’s direction – investing a periodic fixed sum will buy more shares when they are cheap and less shares when they are expensive.
- Diversify Your Investments. Individual companies are affected by the economy in different ways. Spreading your risk avoids a catastrophic loss in a single investment.
3. Focus on Asset Allocation
While the claim that asset allocation is the primary determinant in portfolio performance has been challenged by recent studies, it remains important, accounting for as much as 33% to 75% of the variance in returns. It is the single greatest factor for a long-term portfolio without active management (a typical self-managed retirement fund) – not individual investments, nor market timing. Many financial advisors recommend that the age of the account owner/beneficiary be considered when allocating assets; the younger one’s age, the greater proportion of assets should be invested in equity investments. For example, a 50-year-old might have a portfolio of 70% equity and 30% fixed income, while a 70-year-old would be better served with a portfolio equally split between equity and fixed income.
Re-balancing your portfolio annually is important, as values will constantly change. However, don’t become too aggressive trying to accommodate small changes. A study by T.Rowe Price showed a benefit of almost $20,000 over a 20-year period for those investors who balanced annually versus those who tried to adjust their holdings monthly.
And don’t forget the impact of management fees, commissions, and advisory fees on your total return when selecting your investments. While many fund managers promote the goal of “beating the market,” research shows that many fail to achieve that goal. Constant activity – buying and selling on a short-term basis – increases administrative costs. Consider the use of ETFs in your portfolio to minimize these costs with degrading profit potential. These costs can be greater than the effect of inflation on your ending values.
4. Minimize Your Tax Liabilities
Income taxes can substantially impede the growth of an investment portfolio and significantly reduce the level of available income that can be distributed to account holders. Whether building your account initially, maintaining it during retirement, or repositioning the individual components within your portfolio to generate higher income, you must be aware of the tax consequences. Fortunately, the tax code provides ample opportunities for you to minimize the tax bite, whether you are building your account balance or liquidating assets for distribution.
The opportunities include:
- Capital Gains and Losses Treatment. Profits on assets that are owned for one year or longer are subject to a lower tax than profits on those assets owned for less than a year. The capital gains tax rate applies to all assets held longer than one year; assets held less than one year (short-term) are taxed at regular income rates. For example, if your marginal income tax rate is 28%, the tax rate for profits on assets held one year or longer would be 15%. Married tax payers with a taxable income greater than $450,000 are subject to a maximum tax of 20%. In addition, losses on sales of assets can be used to either reduce capital gains, or reduce ordinary income up to a maximum of $3,000 per year. Losses in excess of the $3,000 limit can be carried forward and used in later years.
- Investment Expense Deduction. Investment expenses such as fees for investment counsel, financial publications subscriptions, attorney and other legal costs, and safety deposit boxes can be deducted from your ordinary income if they exceed 2% of your adjusted gross income. Interest paid on loans you make to purchase investments can be used to offset investment income such as dividends and interest, although “qualified dividends” – dividends that receive a preferential tax treatment – are not included. Excess investment interest costs can also be carried to future years.
- Tax-Deductible Accounts. The tax code encourages savings through a variety of tax-favored accounts, allowing contributions to the account to be deducted from ordinary income (thus investing pretax dollars) and the balance of the account to accumulate on a tax-deferred basis. Taxes on these accounts are paid when the funds are withdrawn in later years. In other words, you get a deduction immediately, but will pay taxes as you withdraw and use the funds.While there are limits to the annual contributions to the accounts, there are special provisions to allow older account holders to invest greater amounts than the limits. For 2014, the maximum you can contribute to a traditional or Roth IRA is the smaller of $5,500 ($6,500 if you are over age 50) or your taxable income for the year. Examples of these tax-favored accounts include the traditional IRA, 401k plan, 403b plan, and 457 plan – all popular ways to save for retirement. Traditional tax-deductible accounts make sense if your tax bracket will be lower when you withdraw funds than your bracket when you make the contribution to the account. Both IRAs and 401ks have Roth versions, which differ from the traditional plans. Established by Senator William Roth in 1997, a Roth version of an IRA or 401k doesn’t give you a tax deduction when contributing, but allows the balance to grow tax-free meaning that there are no taxes to pay when you withdraw the funds.
Tax laws are constantly being changed and reinterpreted. The advice of a professional tax expert can be invaluable and save thousands of dollars in unnecessary taxes. Since such advice is deductible from ordinary income, wise investors should seek tax counsel regularly to ensure their activities comply with the law and minimize tax.
Saving for retirement is a life-long process. There are no perfect investments, nor methods that guarantee success. If you determine to follow one piece of advice, consider the words of Dave Ramsey, noted financial author and television personality: “Financial peace isn’t he acquisition of stuff. It’s learning to live on less than you make, so you can give money back and have money to invest. You can’t win until you do this.”
Do you have principles of investments you follow?