If you have been reading my blog for any length of time, you know how important asset allocation is to long term investment performance. Numerous academic articles and white papers have established that the manner in which funds are allocated into different asset classes is more important than any other factor which influences portfolio returns. Several sources suggest that as much as 90% of portfolio results are driven by asset allocation.
Today I would like to draw your attention to another factor which can significantly affect the returns you experience. I call it "asset location." It is the process of placing asset classes inside investment vehicles based on their tax characteristics.
Let's imagine an investor with a $1 million portfolio. This portfolio consists of three investment vehicles - $300,000 in a 401(k), $250,000 in an IRA and $450,000 in taxable account. Our investor earns $100,000. He's 50 years old and plans to retire in 10 years.
In this simplified scenario, the investor will have a portfolio consisting of 50% in equities and 50% in bonds. How should we allocate the $1 million across these two broad asset classes (equities and bonds) and across the three investment vehicles?
We know that bonds generally create income. Ordinary incomes taxes are 10%-35%. Our investor is in the 28% marginal tax bracket.
Equities can kick off dividends and capital gains. Qualified dividend income is taxed at 0%-15%. Our investor is in the 15% tax bracket. Short term capital gains are taxed as ordinary income. Long term capital gains are taxed at 0%-15%. Our investor is in the 15% tax bracket.
So, where do we place the $450,000 in bonds? These funds will go into either the 401(k) or the IRA. Why? Because the income coming from the bond funds we select will not be taxed inside these accounts. If we placed the bond funds in the taxable account, the income they create would be subject to a tax of 25%.
What about the equities? We should put these funds inside the taxable account. They may create some dividend income. If the dividends are qualified, the tax will be 15%. If the dividends are not qualified, the tax will be the ordinary income tax rate of 28%. Capital gains will be subject to tax at 15%. If we use exchange traded funds (ETFs), realized capital gains will not likely occur until the investor sells the ETFs.
Some investors might not think the asset location for tax efficiency makes much difference.
In this example, let's assume the equity return is 8% (2% dividends, 5.5% unrealized gain, 0% short term gains, and 0.5% long-term capital gains) and the return on the bonds is 3%. We'll assume the bonds are taxable, rather than municipal bonds.
If we locate the bonds in the non-taxable accounts (401(k) and IRA) and the equities into the taxable account (individual), in 20 years the investor will have $270,000 more than if we placed the bonds in the taxable account and the equities in the non-taxable accounts. This is an enormous difference and should serve to illustrate how important "asset location" is to Intelligent Investing.
Tuesday, April 26, 2011
Tuesday, April 19, 2011
A Distinction about Diversification
I was on a webinar today that included Jason Zweig, a journalist for The Wall Street Journal, on its panel. I respect Jason. He is a voice of reason for investors.
Jason made a comment about diversification that we should all bear in mind. He said, "Diversification works over time. It does not work all of the time."
This is an important distinction. Investors who believe diversification does not work should review the academic research on the role of diversification in investment performance. The data indicates that risk is lowered and returns are enhanced through proper diversification. Modern Portfolio Theory proves this to be true.
Investors have their own proof that diversification does not work at all times. During the market crash of late 2008 through the spring of 2009 investors saw that even a well diversified portfolio can suffer sign cant losses. In times of crisis, virtually all asset classes tend to move downward.
Many investors (and far too many advisors) have made the claim that "diversification is dead." This is not true.
Investors who remained invested through the full cycle of market crash to recovery have generally fully recovered their losses. The losses they experienced were temporary.
Investors who divested during the market crash converted what would have likely been a temporary loss of value into a permanent, realized loss.
I have recently read two books on market crises, bubbles, manias, depression, crashes, etc. We know that these market events happen fairly routinely. In fact, they tend to happen every 10 years or so. This has been true for about 400 years.
Intelligent Investors will not be surprised when the next market swoon occurs. They will buckle their seat belts and ride it out. For doing so, they will be rewarded on the other side.
Jason made a comment about diversification that we should all bear in mind. He said, "Diversification works over time. It does not work all of the time."
This is an important distinction. Investors who believe diversification does not work should review the academic research on the role of diversification in investment performance. The data indicates that risk is lowered and returns are enhanced through proper diversification. Modern Portfolio Theory proves this to be true.
Investors have their own proof that diversification does not work at all times. During the market crash of late 2008 through the spring of 2009 investors saw that even a well diversified portfolio can suffer sign cant losses. In times of crisis, virtually all asset classes tend to move downward.
Many investors (and far too many advisors) have made the claim that "diversification is dead." This is not true.
Investors who remained invested through the full cycle of market crash to recovery have generally fully recovered their losses. The losses they experienced were temporary.
Investors who divested during the market crash converted what would have likely been a temporary loss of value into a permanent, realized loss.
I have recently read two books on market crises, bubbles, manias, depression, crashes, etc. We know that these market events happen fairly routinely. In fact, they tend to happen every 10 years or so. This has been true for about 400 years.
Intelligent Investors will not be surprised when the next market swoon occurs. They will buckle their seat belts and ride it out. For doing so, they will be rewarded on the other side.
Friday, April 15, 2011
Let's Make a Plan
The CERTIFIED FINANCIAL PLANNER Board of Standards is rolling out a $37 million awareness campaign. Based on market research, the board found that consumers who represent the typical CFP's target audience are generally unaware of the credential or the benefits of working with a CFP. Further, when they learned about the value of comprehensive financial planning and the role of a CFP in that process, they were more likely to seek the services of a CFP.
The board commissioned a leading marketing agency, Arnold-DC, to place print ads (The Wall Street Journal’s Money & Investing section, SmartMoney, Kiplinger’s, Money and Barron’s), run commercials on cable news networks (CNN, MSNBC and the Fox News Channel)and lifestyle cable networks (The History Channel, HGTV and ESPN) and position banners on select web sites (LinkedIn, Morningstar.com, Bloomberg and Forbes). The campaign is called "Let's Make a Plan." The position statement is "If you need your whole financial life pulled together, a CFP professional is uniquely qualified to help.”
It is no wonder that the CFP credential is not well known. There are dozens of credentials in the financial services industry. A small industry creates credentials, develops curriculum for them and then markets them to insurance agents, stockbrokers, and financial advisors. It is literally a business with some of these mills producing several credentials in areas that range from life insurance to long term care insurance to mutual funds. Almost all of them can be obtained by satisfying very weak requirements.
The strongest credentials are Certified Public Account, Chartered Financial Analyst and CERTIFIED FINANCIAL PLANNER. The CPA, CFA and CFP are also held to a fiduciary level of care when working with clients.
I hope that the CFP Board's campaign is successful. But I suspect it will take regulatory action to actually clean up the industry and provide consumers more information about the true nature of the credentials that advisors use to promote themselves.
The board commissioned a leading marketing agency, Arnold-DC, to place print ads (The Wall Street Journal’s Money & Investing section, SmartMoney, Kiplinger’s, Money and Barron’s), run commercials on cable news networks (CNN, MSNBC and the Fox News Channel)and lifestyle cable networks (The History Channel, HGTV and ESPN) and position banners on select web sites (LinkedIn, Morningstar.com, Bloomberg and Forbes). The campaign is called "Let's Make a Plan." The position statement is "If you need your whole financial life pulled together, a CFP professional is uniquely qualified to help.”
It is no wonder that the CFP credential is not well known. There are dozens of credentials in the financial services industry. A small industry creates credentials, develops curriculum for them and then markets them to insurance agents, stockbrokers, and financial advisors. It is literally a business with some of these mills producing several credentials in areas that range from life insurance to long term care insurance to mutual funds. Almost all of them can be obtained by satisfying very weak requirements.
The strongest credentials are Certified Public Account, Chartered Financial Analyst and CERTIFIED FINANCIAL PLANNER. The CPA, CFA and CFP are also held to a fiduciary level of care when working with clients.
I hope that the CFP Board's campaign is successful. But I suspect it will take regulatory action to actually clean up the industry and provide consumers more information about the true nature of the credentials that advisors use to promote themselves.
Sunday, April 10, 2011
Relying on Social Security
The Associated Press and the LifeGoesStrong lifestyle website reported last week that nearly two thirds of Baby Boomers surveyed said Social Security will be either an "extremely" or "very" important source of income when they retire.
Most of those surveyed reported that their retirement accounts lost significant value during the economic crisis. Many indicated they plan to work longer than they anticipated. Few have saved nearly enough for retirement.
Social Security was never intended to be the primary, much less sole, source of income for retirees. It was conceived to complement the pension income employees receive through their employers and workers' savings.
Unfortunately, few employers offer formal defined benefit pension plans. Most companies have instead opted for a deferred compensation plan, such as a 401(k).
This would not be so bad if employees actually picked up the slack and saved more. However, they have generally not saved enough either through their plans at work or on their own.
The result is a generation that is headed toward retirement with very little in savings. While Social Security will surely remain a source of income for retirees, it will not provide nearly enough income to maintain the lifestyle that most Americans consider reasonable.
Most of those surveyed reported that their retirement accounts lost significant value during the economic crisis. Many indicated they plan to work longer than they anticipated. Few have saved nearly enough for retirement.
Social Security was never intended to be the primary, much less sole, source of income for retirees. It was conceived to complement the pension income employees receive through their employers and workers' savings.
Unfortunately, few employers offer formal defined benefit pension plans. Most companies have instead opted for a deferred compensation plan, such as a 401(k).
This would not be so bad if employees actually picked up the slack and saved more. However, they have generally not saved enough either through their plans at work or on their own.
The result is a generation that is headed toward retirement with very little in savings. While Social Security will surely remain a source of income for retirees, it will not provide nearly enough income to maintain the lifestyle that most Americans consider reasonable.
Sunday, April 3, 2011
The Important will soon become Urgent
Considerable research indicates that very few Americans are on track to save enough for retirement. Most are so far off course that they will likely face rather sobering choices when they reach the traditional age of retirement. Why is this?
Do Americans not care about their future? Surely this is not true. No one wants to spend the last decades of their life worrying about how to pay for basics like rent, food, and utilities.
Are Americans simply not able to save any money? We know that most American workers earn enough income to be able to save at least 10% of their gross income. There are many stories about how even those with low wage paying jobs are able to squirrel money away over their working lives.
Do Americans believe that Social Security will provide enough income to meet their needs? This is rather unlikely, given that it is common knowledge that Social Security is underfunded and will require significant revision to prevent it from collapse.
Are Americans relying on an inheritance to make up for what they have not saved? They had better not. Most Americans will receive no inheritance and those who do will rarely receive enough to make a significant difference in their financial condition.
My theory is that, while almost all Americans believe having sufficient savings in retirement is very important, is not an urgent matter. As we march through the decades of our lives, retirement is always far removed from reality. It is 40 years out, then 30 years out, then 20 years out.
We act upon that which is urgent. If your hand is cut, you stop the bleeding. If your house is on fire, you call the fire department. If the kettle is boiling, you pull it off the stove.
We may or may not act upon that which is important. If we feel it is important to brush our teeth, we do it. If we believe going to church is important, we go. If we feel getting an education is important, we go to school.
Then again most Americans would agree that exercise is important. But most Americans do not exercise. Most Americans feel it's important to maintain a balanced, nutritious diet. But most Americans do not. Most Americans believe charity is important. However, very few Americans give much of their time or money.
Americans know planning for retirement is important. But it's not urgent. So, they put it off. Only when it becomes urgent do most Americans act. Unfortunately, at this point, it is very difficult to do much to improve their prospects for comfortable retirement.
Do Americans not care about their future? Surely this is not true. No one wants to spend the last decades of their life worrying about how to pay for basics like rent, food, and utilities.
Are Americans simply not able to save any money? We know that most American workers earn enough income to be able to save at least 10% of their gross income. There are many stories about how even those with low wage paying jobs are able to squirrel money away over their working lives.
Do Americans believe that Social Security will provide enough income to meet their needs? This is rather unlikely, given that it is common knowledge that Social Security is underfunded and will require significant revision to prevent it from collapse.
Are Americans relying on an inheritance to make up for what they have not saved? They had better not. Most Americans will receive no inheritance and those who do will rarely receive enough to make a significant difference in their financial condition.
My theory is that, while almost all Americans believe having sufficient savings in retirement is very important, is not an urgent matter. As we march through the decades of our lives, retirement is always far removed from reality. It is 40 years out, then 30 years out, then 20 years out.
We act upon that which is urgent. If your hand is cut, you stop the bleeding. If your house is on fire, you call the fire department. If the kettle is boiling, you pull it off the stove.
We may or may not act upon that which is important. If we feel it is important to brush our teeth, we do it. If we believe going to church is important, we go. If we feel getting an education is important, we go to school.
Then again most Americans would agree that exercise is important. But most Americans do not exercise. Most Americans feel it's important to maintain a balanced, nutritious diet. But most Americans do not. Most Americans believe charity is important. However, very few Americans give much of their time or money.
Americans know planning for retirement is important. But it's not urgent. So, they put it off. Only when it becomes urgent do most Americans act. Unfortunately, at this point, it is very difficult to do much to improve their prospects for comfortable retirement.
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