Two Opportunities to Decide if That's Light You See at the End of the Tunnel

Two Opportunities to Decide if That's Light You See at the End of the Tunnel The next few months will present two excellent opportunities to conduct a quick investment checkup. The first is when you receive your annual statements from mutual funds and brokers (and, hopefully, tally up those fat gains for the year). The second is when you finish preparing your tax return (and tally up those tax losses). On one or both of these occasions, do a quick review to decide if your portfolio is still on track. A little time and effort now could pay off in a more comfortable future. Here are a few criteria to keep in mind.

Let's Do Lunch
Economists are fond of saying that there is no such thing as a free lunch. If there was such a thing, however, it would be portfolio diversification. For a given level of expected return, diversifying across a variety of assets can significantly reduce portfolio volatility, or risk. So why put all your eggs in one basket when you can likely achieve similar results - and much less risk - by diversifying? Then when one asset experiences negative returns, another is probably in positive territory. Thus diversification helps keep a portfolio healthy should one security or asset class suffer a serious setback.

Business owners or employees sometimes have most of their investments tied up in their company or its stock. This is the exact opposite of diversification. Remember those Enron employees who held large amounts of company shares in their retirement plans? When Enron got into trouble, these same employees watched their jobs and their Enronladened portfolios go down the tubes.

To reduce the risk that you will suffer a significant investment loss, how can you tell if your portfolio is diversified? When you get those year-end statements, divide your holdings into asset classes. Your statement may already include a breakdown. Typical divisions are international stocks, U.S. stocks, international bonds, U.S. bonds, commodities, real estate, and cash equivalents. Add up the amount you have invested in each category, then divide that by the total amount of your investment portfolio to determine the percentage of your portfolio held in that asset class. If you don't know how to classify a holding, call your mutual fund, broker, or investment consultant and ask.

Several websites now offer to generate an overview of portfolio diversification. These are handy if you hold assets at more than one provider, as you will need to combine all results into a single overview.

Many factors must be considered to determine an appropriate portfolio asset allocation for your particular situation, including your goals and objectives. If you already have an asset allocation plan, perhaps one prepared by a financial advisor, compare your current allocation with the plan to decide if you need to get back on track. If you don't have a plan, you may want to develop one or see an investment consultant for help. But even without a plan, you should now be able to see what percentage of your portfolio is allocated to various asset classes.

If you find a very low percentage in any asset class, you will want to determine why. (A zero balance in cash equivalents might be acceptable, however, as some people prefer to fully invest in the remaining asset classes.)

Next, examine the holdings within each asset class for internal diversification. A portfolio might appear to be well diversified across asset classes, yet any single class may nevertheless suffer a lack of internal diversification. For example, if 30 percent of your total portfolio is in U.S. stocks, but the only U.S. stocks that you own are technology companies, then that asset class lacks internal diversification.

To Tilt or Not To Tilt?
Following this analysis, it is natural and appropriate to ask if these percentages are appropriate for the future. If you have an asset allocation plan, you may choose to stick to that plan, which could be a good long-term choice. Alternatively, you could tilt your allocation toward assets that appear to have a better chance for positive performance in the near term while tilting away from assets that are likely to struggle for positive returns. Don't go too far, however. Keep both feet on the floor and maintain some investment exposure to all asset classes.

Cascadia Investment Consultants is currently tending to tilt towards international stocks and bonds and away from U.S. stocks and bonds. Within bond categories, Cascadia favors shorter maturities and Treasury Inflation-Protected Securities, or TIPS, over longer maturity debt. Another attractive asset class Cascadia now favors is commodities. Our view is generally based on perceptions of how macroeconomic forces will affect worldwide financial markets and asset values. Your own perceptions or the perceptions of your investment consultant may differ, however. And Cascadia's views could quickly change without notice to reflect new circumstances and developments.

Asset Class (Period: 1926-1990) Average Annual Return (%) Standard Deviation (%)
Common Stocks 12.1 20.8
Small-cap Stocks 17.1 35.4
Long-term Corporate Bonds 5.5 8.4
Long-term Government Bonds 4.9 8.5
U.S. Treasury Bills 3.7 3.4
Inflation 3.2 4.7
Source: Stocks, Bonds, Bills, and Inflation 1991 Yearbook, Ibbbotson Associates, Inc., Chicago

Keep in mind that, in general, holdings with the highest potential returns also offer the highest risk of significant loss. A table on the next page shows how risk and return are correlated. Of asset classes shown, those with the highest annual returns between 1926 and 1990 had the highest standard deviation, or risk. Standard deviation, however, only hints at the kind of gains and losses that actually occurred in those years. In 1933, for example, small-cap stocks gained 143 percent. Then four years later, small-cap stocks lost 54 percent. As these data imply, then, high average annual returns come with a significant risk of painful loss.

Your personal risk tolerance is an important consideration. Remember the Internet Bubble and subsequent stock-market meltdown that occurred only a few years ago? If you got caught with postbubble investment losses, you may recall a feeling of deep disappointment. That feeling offers a good indication of your risk tolerance. Yes, a meltdown like that could happen again, and the more risk you bear in your investment portfolio, the more likely you will experience large losses in such a downturn. While diversification can significantly reduce risk, some always remains - even if you keep all your money under your mattress.

Running the Cost Gauntlet
Between the time your money leaves your hands, travels through the treacherous investment world, and returns to your pocket all fattened up (hopefully), that money negotiates a minefield of costs. The amount of fat your money accumulates during its arduous journey has much to do with how well it tiptoes around these land mines. Among costs that can nibble away at your returns are commissions, loads, operating expenses, 12b-1 fees, soft-dollar expenses, bid-ask spreads, and, yes, fees paid to advisors like Cascadia Investment Consultants. (Then after you get your money back, the accumulated fat is usually subject to more costs in the form of taxes, discussed next.) To enhance the investment returns of its clients, Cascadia not only keeps its own management fees low, but works diligently to eliminate or reduce all those other expenses as well. You should too.

If you choose to rebalance or reallocate your portfolio, evaluate the expenses associated with your investments at the same time. As you reallocate, eliminate or reduce costs where possible. If you invest through mutual funds, for example, insist on no-load funds. (You might also want to eliminate fund families that regulators recently charged with improprieties.) Of the remaining funds, gravitate towards those that boast lower expense ratios.

If you invest in individual securities, find out how much you are paying in brokerage commissions. Incredibly, some investors still pay fat commissions for a trade that could be executed elsewhere for a small fraction of that cost. Remember, too, another commission will be charged when the security is sold, potentially doubling the total commission paid.

A salient issue for those who invest in individual stocks and bonds is liquidity, which is one measure of how little transaction value is lost when a security is bought or sold. Some stocks are so illiquid that shares are traded only sporadically. A day or even a week may go by without a single share changing hands. Some bonds are even less liquid, with weeks between trades. These are illiquid and thus usually expensive securities to get into or out of. If you buy one, be sure you are on the right side of your bet.

Unfortunately, some brokerage firms sell illiquid shares without fully informing their clients of the ramifications of the trade. Later a client may pay another commission to the broker to get out of the position, then on top of that pay a high price for the security's lack of liquidity.

For greater tax efficiency, assets closer to the top of this list may warrant priority in tax-deferred accounts. There are notable exceptions, however. In addition, Roth IRA contributions and withdrawals are taxed differently than traditional tax-deferred account contributions and withdrawals. These guidelines do not adequately address that different tax treatment.

T V Asset Type Notes on Tax and Volatility Ramifications
1 6 Corporate Bonds Periodic interest payments are taxed at your highest personal rate.
2 7 Treasuries and Inflation-Protected Securities (TIPS) TIPS may be taxed on gains that are not actually received until years later when sold. To avoid such taxes, put these into a tax-deferred account.
3 5 Real Estate Investment Trusts (REITs) REIT dividends do not generally qualify for reduced tax rates.
4 4 International Bonds Periodic interest payments are generally taxed at your highest personal rate, but volatility may also be high, sometimes higher than stocks.
5 3 Dividend-Paying Stocks Most dividends may qualify for a lower tax rate.
6 1 International Stocks Due, in part, to exchange rate fluctuations. international assets may be volatile.
7 8 Municipal Bonds These come with built-in tax advantages but are generally less volatile than most stocks and bonds.
8 2 Non-Dividend Paying Stocks Without dividends, taxes are not due until the stock is sold.

Uncle Sam: An Expensive Relative
If your money somehow manages to survive this daunting cost gauntlet, gains are then subject to confiscation by the tax man. While taxes provide many valuable services to our communities and our nation, you probably don't want to pay more than legally required. Fortunately, there are many ways to reduce, or even eliminate, some taxes.

First, stash as much of your investment portfolio as possible into tax-deferred retirement plans. These are IRAs, 401(k)s, 403(b)s, and the like.

When deciding what type of assets have high priority for placement in tax-deferred accounts, three major tax-related characteristics should be weighed: the frequency of taxable distributions, the tax rate on those distributions, and the volatility of the asset. Assets that regularly generate taxable income (most bonds and REITs, for example) should get first priority in tax-deferred accounts where these "taxable" events may occur without immediate tax consequences. (Municipal bonds come with their own tax advantages, however, and therefore have low priority for tax-deferred accounts.)

Second, assets that are taxed at higher rates have priority for tax-deferred accounts. Again, bonds and REITs are normally taxed at a high rate, your personal income tax rate, when held outside of taxdeferred retirement accounts. In tax-deferred retirement accounts, however, you will pay zero tax on dividends, interest payments, and gains until these assets are later withdrawn.

Third, assets that exhibit a lot of volatility, or risk - like stocks - should get last priority in tax-deferred accounts. Highly volatile assets have a greater possibility of negative performance. Such a loss may be harvested to offset taxable capital gains and thus further reduce taxes. Furthermore, capital gains and most stock dividends are now taxed at a lower rate than distributions from bonds and REITs.

Refer to the nearby table for general guidelines. The "T" and "V" columns rank assets from 1 to 8, with 1 indicating the highest typical tax consequences or volatility. Fortunately, assets that generate frequent taxable income also tend to be less volatile - though there are notable exceptions to this ranking.

If you use an accountant or other tax preparer, ask him to be on the lookout for ways you might further reduce taxes on your investments. If you have an investment consultant, ask what she is doing to reduce your investment costs and tax liabilities. These strategies should help you refocus on that light at the end of the investment tunnel and keep your portfolio on track while reducing costs.