Investment strategy in retirement

Selecting The Right Investment Strategy in Retirement

In my last article, “Creating Your Retirement Plan,” I discussed how to take the first steps towards developing your retirement plan by analyzing your cash flow and tax planning strategy. We start with those areas to establish a long-term income strategy for retirement. Certainly, circumstances change and unforeseen events will force you to make adjustments, but your short-term financial decisions need to be consistent with your long-term strategy. Now that you know how much income you need to withdraw in upcoming years, the next step is to develop an investment strategy that is consistent with your needs.

When you structure your investment portfolio, the assets that will generate your income for the next 3-5 years should be invested in bonds, which have lower volatility than stocks. Since you’ll need to draw these funds out in a fairly short time frame, they need to be invested in safer asset classes. The rest of your portfolio should be comprised of stocks, which exhibit more volatility and are riskier than bonds, but typically provide higher returns in the long run. This will cover the long-term growth component of your portfolio and provide a hedge against inflation, which has averaged 2.79% from 1998 through 2018.

Asset Allocation

Portfolio diversification involves holding a variety of different types of investments with different characteristics and relationships to one another. This is accomplished through a process called asset allocation. First, you’ll select the appropriate percentage of bonds vs. stocks in your portfolio, then select the proper percentage of each asset class to invest in. The primary asset classes are:

  • Large Cap U.S. Stocks
  • Mid Cap U.S. Stocks
  • Small Cap U.S. Stocks
  • International Stocks
  • Emerging Market Stocks
  • Real Estate Stocks
  • Fixed Income (Bonds)

In addition to these primary asset classes, there are many sub-asset classes such as global bonds, international small cap and TIPS, just to name a few. Each asset class has its own unique set of characteristics and risks, which causes them to move in different directions at different rates and times. We measure the relationship between each asset class using a statistical formula called correlation by comparing the degree of simultaneous movement between two securities. Bonds have the lowest correlation with stocks, which is why the asset allocation process begins with determining the percentage of bonds and stocks in your portfolio and then to different asset classes (and sub-classes) having different correlations to each other, which leads to further diversification.

Asset allocation is the most important aspect in obtaining the best risk-adjusted return over time. If you invest all your funds in one asset class you are statistically more likely to either do really well or really poorly as the market moves up and down. By diversifying you’re more likely to have slower, but steadier growth and less risk. It’s like the old saying goes,  “Don’t put all your eggs in one basket!”

Active or Passive

The next component of establishing the proper investment strategy is to determine what types of investment vehicles you will use. This decision begins by determining whether you want to pursue an active or passive investment philosophy. Active management is predicated on the belief that a fund manager has the ability to forecast and time markets in an effort to outperform a benchmark or market index. Higher fees typically accompany these types of funds to compensate the fund manager and fund analysts, and cover higher trading costs due to higher turnover within the fund. Most of these fees are expressed as a percentage called an expense ratio. It’s extremely important to pay attention to expense ratios since they can range anywhere from .05% to 2.0%! Lower fees are typical of passive fund management, which is founded on years of academic research. This style of management is based on the belief that there is no benefit to timing markets and that it’s better to own a variety of indexed-type funds to gain market exposure. The benefit is lower fees, since a passively managed fund is attempting to track an index so there is little turnover of the portfolio, which also results in better tax-efficiency. Once you have selected your underlying investment philosophy, you will then need to determine which fund family/families you will use as the engine to your portfolio growth. There are literally thousands of fund families to choose from between mutual funds, index funds and exchange-traded funds (ETF’s).

Portfolio Management

Once your asset allocation has been established, it will need ongoing management since all the asset classes in your portfolio will constantly fluctuate, making rebalancing your portfolio extremely important. There are many types of different rebalancing strategies, but the two most commonly used methods are calendar rebalancing, which simply seeks to rebalance the portfolio at predetermined time periods such as once a year and tolerance-band rebalancing, which assigns percentage weightings for each asset class along with upper and lower limits that would trigger a rebalance of that asset class. For example, if you have determined that your ideal small cap weighting is 10%, your lower limit may be 8% with your upper limit being 12%. If the small cap asset class declines to an 8% weighting in the portfolio, that means that other asset classes would in turn be overweight, which would prompt you to sell the overweight positions and then purchase enough small cap exposure to bring you back up to your originally intended target of 10%. Another major benefit of this strategy is that you are typically buying low and selling high in the long run through a disciplined strategy that helps take emotions out of the process.

If you own taxable accounts, it’s important to ensure that you are being as tax-efficient as possible when making any transactions. In my previous article, Creating Your Retirement Plan,” I explained how capital losses in your portfolio can be used to offset capital gains. Tax loss harvesting is a strategy where you sell positions in your portfolio that are down to “harvest” the loss that you can use to offset capital gains. For example, if you buy a U.S. Large Cap Fund for $50,000 and the position declines in value to $40,000, most investors will just avoid looking at their statements with the confidence that the position will recover to positive territory in the long run. In a taxable account, those investors are completely missing out on a great opportunity to sell the position when it’s down, realize the $10,000 loss and simultaneously purchase another U.S. Large Cap Fund so they can still benefit from the recovery. You have now created your own tax shelter in a sense, since this loss can be used to offset any other capital gains in the current year. If there are no capital gains in the current year, then $3,000 of the loss can be used to offset ordinary income and the remaining balance of $7,000 will be carried forward indefinitely to be used in future years. With the ability to match losses to gains in future years, you now have an extremely effective tool to control capital gain taxes when you begin creating income in retirement.

In addition to tax loss harvesting, another strategy that plays a big role in tax-efficient investing is asset location. I’ve written about why it’s so important to consider the tax treatment of the accounts you withdraw from in retirement. Asset location involves placing asset classes in the accounts to optimize tax-efficient growth. As an example, let’s assume you have monies in taxable, tax-deferred and tax-free accounts and have decided on a 50/50 stock and bond allocation. Your tax-free accounts should hold the asset classes that have the highest risk and the highest expected return since you want to maximize growth that is exempt from taxes. Taxable accounts should seek to utilize capital gains tax rates by avoiding short-term taxable gains and any type of security that pays taxable interest to avoid generating ordinary income. Long-term capital gains and dividends from stocks are taxed at a maximum rate of 20%, but 15% for most investors. Lastly, your tax-deferred accounts should hold any securities that pay taxable interest and that can have lower expected long-term returns, such as bonds. This is because distributions from tax-deferred accounts are treated as ordinary income and taxed at your marginal tax rate.  While the implementation and maintenance of this strategy can prove difficult for most investors, it is certainly an important aspect of tax optimization within your investment portfolio.

Hopefully, you can see by now that the best investment strategy is the one that is consistent with your income and tax circumstances. However, most investors and financial advisors do not perform enough analysis around these areas of planning and typically start the retirement planning process by finding an investment product to meet their needs. This typically leads to investments in vehicles that may have higher expenses and aren’t consistent your retirement needs. There aren’t really any shortcuts with investing in the markets. It’s all about obtaining diversification by establishing the proper asset allocation for your investment strategy. Choosing the right low-cost investment vehicles and implementing the proper portfolio management techniques like tax-loss harvesting will provide you with the returns you need throughout retirement. To ensure you are following every step in the proper sequence, download your Free Retirement Checklist.

Should I rebalance my portfolio?

How Often Should I Rebalance My Portfolio to Diversify My Investments?

Investors sometimes make the mistake of forgetting to rebalance their investment portfolio.  However, professional investors resist the temptation to “set it and forget it.” They understand that risk tolerance and asset allocations change with time.

Regular rebalancing of a diversified investment portfolio is different from “day trading” or “short-term investing.” As the market fluctuates, the value of your holdings will go up and down. This will knock your ratio of low-risk to higher-risk investments out of whack.

If you’re concerned about maintaining the sophisticated balance of your diversified investment accounts, you’re in the right place. In this article we’ll answer the following questions:

  • What does a diversified portfolio look like?
  • How often should investors reallocate a diversified investment portfolio?
  • What are the strategies you should consider when rebalancing your portfolio?
  • What are the common mistakes that savvy investors avoid when reallocating their portfolio?
  • Should I rebalance my portfolio?

What does it mean to have a diversified portfolio?

Think about where you are in life. Are you younger, with many years of potential earnings ahead of you? Are you approaching your target retirement age? Maybe you’re somewhere in between.

A diversified portfolio helps you manage risk. Your risk tolerance changes based on where you are in life.  

A qualified retirement advisor can help you determine your risk tolerance and craft an investment strategy to meet your needs. Generally, they will use a mix of stocks (higher-risk) and bonds (lower-risk).

Stocks can be more volatile and may carry more risk, but they have a higher earning potential. Bonds are usually considered safer investments because they provide a predictable, guaranteed return over time. But their rate of return is usually lower than a diversified collection portfolio of stocks over a long period of time.

Bonds can offer a hedge against the volatility of stocks, especially during times when the market is underperforming.

The number of stocks you choose to invest in can also help you create a diversified portfolio. Most investors avoid purchasing all of their stocks in the same sector. This helps to hedge against poor volatility in any one market sector.

It’s also important to pay attention to the underlying financial performance of the companies you’re holding in your account if you aren’t invest in professionally managed funds. Investors with a higher risk tolerance may choose to invest in high-growth funds. They are more volatile, but they can offer higher returns since these companies are still in their growth phase.

Investors with a lower risk tolerance may choose to hold stock in more established, stable companies. They are typically referred to as value stocks and while the growth potential may not be the same, these stocks typically pay higher dividends than growth stocks. Just keep in mind that past performance is not a guarantee of future results.

Balance your investment portfolio

How often should I reallocate to maintain a diversified investment account?

Generally speaking, stocks will outperform bonds over time. This can mean that the ratio of stocks to bonds in your account will change.

If the value of your stocks increase, they will naturally begin to represent a larger percentage of your portfolio. You will need to regularly reallocate the funds in your investment account in order to maintain your preferred blend of higher-risk to lower-risk investments.

There is one main type of risk that investors consider when reallocating funds:

Unsystematic Risk. These types of risks are specific to certain segments of the market. This could include poor management behavior, natural disasters in certain geographic areas or an industry-wide strike by a union.

It’s the job of every savvy investor to consider and learn about the threats that could impact their investment portfolio. As risk-profiles change, investors need to update their investment model to reduce risk through diversification.

Diversification is a powerful tool because it allows you to counter-balance risk across your portfolio. For example, if you’re invested in both aviation and railway stocks, an aviation mechanic strike would have a lower impact on the value of your investments. Some of the under-served airline transportation contracts may be transported by railway traffic. The spike in railway stocks can off-set your loss in the aviation sector. This is just one example.

Each investor has a unique blend of stocks, bonds and other securities in their retirement account portfolio. Your best bet is to consult a trained investment professional. The advice outlined here is simply meant as a guide to help you understand how diversification can help you reduce risk, as long as you maintain a sensible ratio of higher-risk to lower-risk investments.  

Strategies for Diversifying Your Retirement Portfolio

There are two popular strategies that investment professionals use to maintain diversification of their investment funds: Periodic Rebalancing and Risk Tolerance Based Rebalancing.

Periodic rebalancing involves reallocating the funds in a retirement account at regular intervals of time: monthly, quarterly or annually. Most investors should reallocate their investments at least once a year to maintain a comfortable level of risk.

The problem with periodic rebalancing is that some studies indicate it does little to reduce risk and results in higher transactional costs (trading fees, disbursement costs, etc.).

If you can constantly monitor the risk threshold of your investment account, it may make more sense to use risk tolerance-based rebalancing. This means that you’ll only rebalance your investments when the level of risk reaches a specific threshold.

This eliminates unnecessary transaction costs but can be dangerous if an investor or investment professional fails to carefully monitor risk.

Maintain Fund Diversity

Mistakes to Avoid When Reallocating to Maintain Fund Diversity

  1. Fintech apps that offer automated investing and portfolio management are becoming increasingly popular. But it’s hard to beat the subjective wisdom of a human fund manager. Don’t rely on algorithms alone to manage your account.
  2. Understand the types of investment vehicles are you are selecting when reallocating. Are the funds active or passive? Fees can vary significantly and have a big impact on portfolio returns.
  3. Don’t forget to calculate the tax implications of your reallocation. Unexpected capital gains taxes during tax return season are never fun.

Remember, your best move is to consult a qualified investment professional to discuss your specific needs.



What’s The Difference Between Passive And Active Management?

With the ultimate goal of achieving high returns, investors choose between active portfolio management and passive portfolio management.   While these terms may sound unfamiliar to you, they are broad concepts that are easy to understand. So what is the difference between passive and active management? Both active management and passive management are different approaches to how investors, account managers, and individuals make use of the investments in their individual portfolio.

Strategically speaking, passive and active management can achieve specific goals for investors. For example, active management helps to facilitate the goal of outperforming the market in contrast to previous degrees of performance.   While passive management encompasses the goal of mimicking “the investment holdings of a particular index.”

Newly minted investors often struggle with understanding the importance and difference between passive and active management, but more importantly, are concerned with how the strategies of each potentially impact their investment success.

Read on below to learn more about the key differences between active management and passive management.

Active Management Versus Passive Management Differences

Investors who make a move to implement an active management approach typically use fund managers or brokers for the buying and selling of stocks, with the ultimate goal of outperforming prior market benchmarks or specific indexes like the Standard & Poor 500 index.

Investment funds that are driven by an active management approach include a team of individuals such as a portfolio manager and the various co-managers involved in the decision-making process for the fund and its future.

Funds that are actively managed hinge upon the successful combination of accurate market forecasting, extensive research, and the degree of expertise held by the portfolio manager and the co-managers of the fund.

Portfolio managers of active attempt to identify proper times to buy and sell positions in their portfolios under the premise that they can forecast the markets. Their expertise comes from an attentive focus on the rises and falls exhibited in the market, as well as keeping abreast of political happenings and the ongoing contemporary factors that have the potential to greatly impact global companies and more.

The knowledge and expertise of a portfolio manager are used in conjunction with market data in an attempt to invest strategically at the right time and place to achieve optimal results.

Passive portfolio management stands in stark contrast to active portfolio management. Often referred to as index fund management, it is, as the name implies; a more passive approach to investing. It does not involve the heavy reliance of outperforming a specific index or past market benchmark like the more aggressive approach found in active management. It simply attempts to mimic the performance of an externally specified index by buying an index fund. When managers align their investments with specific indexes, it allows for good diversification and potentially lower turnover.

Passive management might not involve a team of key players collectively strategizing to outperform previous benchmarks and making group decisions. Instead, passive management portfolios are often headed by a single manager and are typically formed as unit investment trusts or mutual funds referred to as exchange-traded funds.

An easy way to remember the main difference between passive and active management is knowing that passive management’s goal is to match successful indexes, while active management strives to outperform an indexes previous results with hopes of seeing a major gain.

Key Points and Examples of Passive Portfolio Management

  • The passive management approach does not require a great deal of market expertise and industry knowledge because managers are not required to rely on their level of knowledge to strategize towards a result that excels to the point of outperforming previous benchmarks
  • Managers of passive portfolios shy away from high risk investing and do not employ a proactive approach geared towards achieving phenomenal results
  • Due to their passive nature, management fees for passive portfolio management are significantly lower than the fees involved with actively managed funds. Historically speaking, passively manage funds have generally outperformed actively managed funds.

There are a plethora of passive Income investment opportunities available today. Among the most popular tend to be the following:

  • Real Estate
  • Peer-to-Peer Lending
  • Dividend Stocks
  • Index Funds

Making the Decision Between Passive or Active Management

A truly personal decision, making a choice between these two investment strategies is largely dependent on whether you believe one can forecast and time markets, as well as your willingness to pay the significantly higher fees involved if you opt for active management.

Many investors opt for a diversified portfolio consisting of both active and passive management strategies to achieve a sense of balance regarding risk and cost.

Regardless of the approach you decide to take; active management, passive management, or a combination of both, always make it a point to remember that past performance is not always an indicator of future success and a strong outcome.