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.
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).
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.