This article is original content written by Manchester, CT Financial Advisor Thomas Scanlon, CFP®, CPA
Investors can easily get distracted these days. Hop in the car on the way to work, turn on the radio and get updates on the stock market futures. Check your online portfolio at work during your lunch break. Perhaps you even check it several times a day when you should be working. Stop off after work with some friends at the local watering hole for a beer and they have CNBC on the TV. Can you ever get away from this stuff? (Yes, you can. And you should. We’ll discuss more on this later.) Investors are bombarded with the news coming at them 24/7. Is this productive and helpful? Not so much. Why is this? Most of the daily gyrations of the market are outside of an investor’s area of control. What should investors focus on? Here is Four Things Every Investor Can Control:
The Amount of Money Saved
Sorry for stating the obvious. The amount of money an investor saves (or not) is within their control. Granted someone making $100,000 a year can’t save $120,000 a year. (Although it appears that folks that like to spend that are making a $100,000 a year can spend $120,000 a year. But that’s another story.) Investors need to calculate how much they can save and invest every month. This exercise should not be taken lightly. While there are many monthly bills that need to be paid, saving also needs to be a priority. This is especially true with younger investors. Why is this? Saving is a habit. If you get into this habit when you are younger you will be more likely to reach your financial goals.
Everyone has heard the expression, “Pay yourself first.” Many times, I suspect. It’s become and old saw. How come? It’s true, that’s why. Perhaps your parents or grandparents didn’t need to pay themselves first. They may have worked at one company their entire career. This made them eligible for the company pension retirement plan. Additionally they would collect their social security when they retired. For many folks this provided a reasonably comfortable retirement. Now most companies have terminated their pension retirement plans. Federal, State, County and Municipal workers are about the only employees that will be eligible for a pension now. What does this mean to you?
YOU ARE ON YOUR OWN.
Therefore you will need to pay yourself first. For most employees this should be initially done through your employer 401(k) plan. For 2023 you are allowed to contribute up to 22,500 annually into your 401(k) plan. Taxpayers over age 50 can contribute and additional $7,500 as a so called ‘catch-up contribution’ for a total of $30,000 annually. Many employers will make an employer match contribution to the 401(k) plan. Employees should attempt to participate and contribute to the 401(K) plan up to at least the amount to get the match. This is a fringe benefit that employees need to capitalize on. Other vehicles to use to help you to save for retirement are IRA’s and Roth IRA’s. If you have children and are saving for college the College Saving 529 Plan can be an excellent tool for this.
If you haven’t hit your savings goals in the past don’t beat yourself up. It is what it is. You can’t turn the clock back. Begin where you are now. If you’re saving 6% of your income into your 401(k) plan just move it to 7%. You might not even notice the difference. The next year move it to 8%. Gradual changes that stick tend to be the most effective ones.
Keep in mind that typically, the more money you save, the lower rate of return on your investments you can accept. This is an important concept. If you are saving for retirement you will need an investment portfolio to draw down from in retirement. This is known as the distribution period. The portfolio is making distributions to the investor during their retirement. To get to this place you will be in the accumulation period, also known as your working years. The portfolio will be a result of contributions, asset allocation, investment returns and the time invested. The more that is saved, the lower the rate of return that can be accepted.
Asset Allocation
Asset allocation is a process to determine what asset classes an investor would consider investing in and how they would allocate the portfolio among the classes selected. This is one of the more important decisions an investor needs to make. What percent of your investments will be allocated to cash, fixed income and equities? The Brinson, Hood and Beebower study found that 94% of the returns achieved are related to the asset allocation model selected.
Investors will need to spend some time on their asset allocation. For example, one time I was meeting with a potential client using the Ibbotson chart explaining the various long-term rates of returns. This chart shows the rates of return for cash, short and long-term bonds and large and small cap stocks. It goes back over seventy five years and shows the various assets classes in different colors. On this particular chart the highest return is for small cap stocks and the color is green. During the meeting I was explaining the various assets classes, rates of return and risks to her. About halfway through my presentation she interrupts me and says, “Tom that sounds great. But I’ll just take the green one.” Unfortunately, designing your asset allocation is going to require more than just picking out the “green one.”
When designing their asset allocation investors should treat all of their investment assets as one portfolio. Yeah, I know, most investors probably still have too many investment accounts. Hopefully they will consider consolidating their accounts which can help simplify their financial life. Most of these accounts are earmarked for different goals. The 401(k) plan and IRAs are for retirement and the 529 Plan is for education. The money that’s going into the money market account every month is for that new boat you’re planning on buying next spring. So there still may be a lot of accounts, several different goals but just one portfolio. Make sure your asset allocation includes your entire portfolio.
There’s an old rule of thumb that says an investors equity allocation should be 100 minus your age. For example, A forty year old should have 60% of their portfolio in equities (100 – 40 = 60). Don’t follow this rule of thumb, it just doesn’t work. The reason this rule of thumb doesn’t work is simple, it doesn’t address the specific needs of each individual investor. Not every forty year old is in the same financial situation. Investors that were “Early” in the savings and investing game may not need to have as high of a risk level as “Tardy.” If someone’s nickname is “Tightwad” as opposed to “Mr. Jones”, they probably won’t need as large of an investment portfolio as their standard living expenses will probably be a lot lower. An investor’s asset allocation is based on various factors including their goals, risk tolerance and when they need the money, not on the number of birthdays they have had.
Then there’s the popular 50% – 50% portfolio commonly promoted in the media. This portfolio has half of the portfolio invested in equities and half invested in fixed income. I’ll give this portfolio its due, it’s simple and there’s something to be said for that. For some investors this approach may be appropriate. Most investors however will need a more comprehensive strategy.
Another consideration is rebalancing which means selling some of the positions that have gone up in value and taking this cash and buying more of the ones that have gone down in value. Investors that rebalance aren’t following the crowd. They are following a process. Investors that didn’t rebalance their portfolio during the Bull Market that ended in early 2000 know what happens. An investor can get mauled, which isn’t pretty. How frequently should investors rebalance their portfolio? Rebalancing a portfolio annually should be sufficient. Rebalancing more frequently than this will increase transaction costs and income taxes. Rebalancing in a taxable account may result in capital gains. These are two costs that need to be managed.
Before moving on lets take a look at the Math of Investing.
The Math of Investing
The math of investing was really brought home during the Bear Market from 2000 through 2002. The stock market had essentially been in a Bull Market from 1982 until 2000. Sure, there was a huge and sudden meltdown in 1987. Some people thought the world was coming to an end. There were other significant bumps along the way but it didn’t take the market long to recover. In early 2000 the NASDAQ peaked at 5,048. Three years later it bottomed out at around 1,000. In other words, it lost nearly 70%, which qualifies as a Bear Market in most everyone’s book. And here’s where the math comes in. For example, an investor buys 100 shares of a stock for $10 per share. The next day the stock goes to $5 share. Not a very good investment. Put aside the poor stock selection and look at the math. How much was lost? The loss was $500, or 50%. Now, what rate of return is needed to for this investor to get back their original investment of $1,000? A 100% rate of return is needed to get even. That’s a 100% rate of return. I realize I’m repeating myself, you tend to do this a lot when you have a teenage son living with you. Think about it, your investment was cut in half, now you need a double just to break even. So, the question becomes, how long will it take to get your proverbial double? For the answer, let’s take a look at the Rule of 72.
The Rule of 72 calculates how long it takes an investor to double their money. This is a great rule that was abused during the Bull Market that ended in early 2000. Online calculators soon became mental calculators. To apply this rule, just take the assumed rate of return and divide into 72. Gee, at 9% my money doubles every seven years. So, with the poor investment mentioned above, if the return was 9% you would be made whole in seven years. This rule works if you get the assumed rate of return each and every year. What’s the probability of this happening? I would suggest very low. It’s as close to zero as possible. Actually, it’s probably zero. Stock market returns are random, which means investors can’t predict what will happen in the future. Sure there will be times when a Bull Market is on and the returns are great. Other times a Bear Market rears its ugly head and wipes out a lot of investment capital. The math of investing forces investors to take a hard look at their risk tolerance. Can you stand this kind of loss? Even if it’s just on paper? Will you bail out and sell because ‘you can’t take it anymore?’
Bear Markets are, unfortunately, going to happen in the market. The traditional definition of a Bear Market is when stocks decline by at least 20% off their highs. There have been some Bear Markets where you wish the market only went down by 20%. According to Stockcharts.com the stock market has had five major Bear Markets since 1900. These Bear Markets were as follows 1906-1921, 1929-1932, 1937-1938, 1973-1974, and 2007-2009. All of these markets were vicious and wiped out a lot of investors capital. This purging, unfortunately, is necessary to wring out the excess valuations. The problem for investors is when a Bear Market occurs. For people in the accumulation phase a Bear Market becomes a buying opportunity. Stocks are on sale. Now is the time to buy for these investors. On the other hand if an investor was in the distribution phase and their investment portfolio quickly declined by a third, they would be forced to go back to the drawing board. Not a pleasant thought, is it?
Timeline
The timeline is when you will need to start accessing the portfolio. Each financial goal may have a different timeline. The retirement goal might be between ages 65-70. The education funding goal would be when your child turns age 18. Buying that second home down at the shore might be three years from now.
If you have a long investment timeline you definitely want to go on a financial media diet. Turn off the radio, TV and computer. Cancel your subsription to Money Magazine. Walk away from the chatter about the next hot tech stock at your neighbors cocktail party.
Managing Taxes and Investment Expenses
The last Bull Market before the one we are currently in essentially ran from 1980 into early 2000. Heck of a run, wasn’t it? What else happened other than the good times rolling? Well, some investing basics were forgotten. What was forgotten? Managing taxes and investment expenses certainly was. During the rock and roll times of the 80’s and 90’s who cared about these details? When returns are 15% a year who cares about taxes and inflation? Not me, just make more money, taxes and inflation are just the cost of doing business. Well, this has changed, just a wee bit. So, returns might not be 15% a year, year after year, as far as the eye can see. Sorry, I meant to say 15% positive rate of return. So investors will just settle for the long-term average of, oh, say 11% and extrapolate this for the next sixty years or so. Well, maybe this isn’t the best assumption to make. Hey, don’t get me wrong, I’m an optimist. Capitalism, which our country was founded on, not only works but is cool. It’s that Darwin survival of the fittest thing. What should investors be looking at? With those outsized returns from the last Bull Market of almost twenty years, what’s going to happen in the future? Another twenty years of party time? Not likely. If rates of return in the future are less than the long-term average, managing your taxes and investment expenses becomes very important and it’s something you can control.
Let’s take a look at taxes. There’s a tax break with certain capital assets, which includes stocks, bonds and mutual funds. There’s a distinction between ordinary income and capital gains tax rates. Now, the highest federal income tax on ordinary income is 37%. For most long-term capital gains, the tax rate is 15%. Collectibles, real estate and so-called small business stock are taxed at different rates. For taxpayers in the lower two ordinary income tax brackets the capital gains tax is 5%. Higher income taxpayers pay a long-term capital gains tax rate of 20%. The key is to understand the holding period for long-term capital gains. Capital assets need to be held longer than a year to qualify as long-term. Most qualifying capital assets held longer than a year are only taxed at 15%, which is a good thing. Short-term capital gains, those held one year or less, are taxed as ordinary income. Between federal and state income taxes, taxpayers in the maximum tax bracket can easily be paying over 40% on short-term capital gains. So for those in higher income tax brackets, most long-term capital gains are taxed at less than half the short-term gains rate. The question is, which would you want, short-term or long-term capital gains? You don’t have to think too long (no pun intended), do you? Long-term capital gains tax rates are clearly preferable. Be cautious here. I’m just referencing the huge tax advantage long-term capital gains tax rates have over short-term gains. When deciding whether to sell a capital gain asset that has been held short-term, look at it strictly from an investment standpoint. Don’t think, “If I can hold on another six months, the gain will be long-term.” In other words, don’t let the tax tail wag the dog.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Thomas F. Scanlon, CPA, CFP® and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Tax preparation and accounting services are provided by Borgida & Company, P.C., not as a service of Raymond James. You should discuss tax or legal matters with the appropriate professional. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Examples discussed in this material are hypothetical and do not represent any actual investment. Asset allocation and re-balancing do not ensure profit or guarantee against a loss. Investing involves risk and investors may incur a loss regardless of the strategies employed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.