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
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.
Source: Stocks, Bonds, Bills, and Inflation 1991 Yearbook, Ibbbotson Associates, Inc., Chicago
|Asset Class (Period: 1926-1990)
||Average Annual Return (%)
||Standard Deviation (%)
| Common Stocks
| Small-cap Stocks
| Long-term Corporate Bonds
| Long-term Government Bonds
| U.S. Treasury Bills
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.
hints at the kind of
gains and losses
occurred in those
years. In 1933, for
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
at the same time.
As you reallocate,
eliminate or reduce
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.
Uncle Sam: An Expensive Relative
||Notes on Tax and Volatility Ramifications
||Periodic interest payments are taxed at your highest personal rate.
||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.
||Real Estate Investment Trusts (REITs)
||REIT dividends do not generally qualify for reduced tax rates.
||Periodic interest payments are generally taxed at your highest personal rate, but volatility may also be high, sometimes higher than stocks.
||Most dividends may qualify for a lower tax rate.
||Due, in part, to exchange rate fluctuations. international assets may be volatile.
||These come with built-in tax advantages but are generally less volatile than most stocks and bonds.
||Non-Dividend Paying Stocks
||Without dividends, taxes are not due until the stock is sold.
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.