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The Seven Deadly Investor Sins

Continued from page 1

Most don’t like thinking about taxes. Many investors distance themselves from the topic altogether as it can seem too ‘complicated’, ‘time consuming’, or ‘boring’. However, improper tax management can cost you more than 25 percent of your long-term return, severely limiting your spending power in retirement. The two most common tax missteps are not taking advantage of retirement plans and using tax inefficient investment vehicles, like mutual funds.

Retirement Plans. Almost all companies offer some form of tax advantaged retirement plan. It could be a 401k, a 403b, or a Roth 401k, among others. Individual Retirement Accounts (IRAs) are also available. While there are different rules surrounding contributions and withdrawals for each plan, a key similarity in all of them is tax-deferred growth. This is a major gift to investors, compliments of the US government. Why? The power of compounding. Investments grow unabated from taxes with dividends and income reinvested along the way. This significantly improves long-term return potential and the probability of reaching your most important financial goal: retirement. Moreover, most employers offer some form of matching contribution based on the amount you save into the plan. This is free money and only further improves your chances of success. So if you have the means to save, make sure to take advantage of any available retirement plans. You’d be surprised how many investors don’t.

Tax Efficient Vehicles. There are thousands of investment vehicles to choose from, and each can have radically different tax implications. Knowing which are most efficient (and which are inefficient) is a vital first step in reducing your tax bill—it also helps filter your choices to a smaller, more reasonable list.

Mutual Funds are notoriously bad from a tax perspective, and more than half of all American households own a mutual fund. High turnover often creates large annual tax bills. According to Morningstar.com, the ten largest mutual funds by assets had an average turnover ratio of almost 75%. Most of these are actively managed funds where managers attempt to outperform a benchmark by selling winners to lock in gains. The impact is clear. A 2010 study by Lipper (Taxes in the Mutual Funds Industry – 2010; Assessing the Impact of Taxes on Shareholder Return) showed owners of mutual funds in taxable accounts gave up an average of 0.98 percent to 2.08 percent in annual return to taxes over the last 10 years. This is significant. As seen in the figure below, a difference of 1% over 10 years results in over $17,000 less on a $100,000 portfolio.

Relative to mutual funds, Exchange traded funds (ETFs) are a step in the right direction. In fact, greater tax efficiency was the primary reason they were created. But the best way to mitigate taxes is to create a portfolio of individual securities, or a combination of individual securities and ETFs. This allows for tax management on multiple levels. With a wider set of options to meet cash flow needs, it’s easier to defer gains into future years. And if you have to sell low basis positions, you can harvest losses from poor performers to mitigate or neutralize the impact.

If you have taxable and tax-deferred accounts, you can also tax locate. This involves placing higher yielding securities in tax-deferred accounts to shield their income. Additionally, income from most REITs and bonds does not qualify for the same favorable tax rate as stock dividends. It is advantageous to strategically place these securities in tax-deferred accounts. Combined, these tactics help maximize total portfolio value and reduce your annual tax bill.

Deadly Investor Sin #5: Failure to Account for Inflation

Failure to account for inflation can be a costly mistake. Inflation eats into investment returns and can erode portfolio values over time. As such, excluding it from projections will cause investors to underestimate the level of growth required to generate income. This will likely lead to an asset allocation that is too conservative.

Let’s examine two scenarios. Both assume a starting portfolio value of $100,000 and starting annual withdrawal of $4,000. Inflation is set at 3%. In both scenarios, the $4,000 annual withdrawal needs to increase by inflation in order to accommodate the rising cost of living. The first investor properly accounts for this and builds a portfolio with a nominal projected return (before inflation) of 7%. The second investor fails to account for inflation and builds a portfolio with a nominal projected return of 4%, which he believes is sufficient to cover the $4,000 annual withdrawal (4% on a $100,000 portfolio). As seen in the figure below, the second investor’s portfolio is depleted by year 30. Throw in a few poor performing years and the portfolio could deplete much sooner.

Deadly Investor Sin #6: “Living off the Interest”

One of the most common misperceptions in investing concerns dividends and interest income. Put simply, many retired investors prefer higher yielding securities so they can “live off the interest”. But this is primarily a psychological bias rooted in arbitrary mental accounting practices. In reality, capital gains provide the exact same economic benefit as dividends and interest income.

How does this misperception hurt investors? It’s simple: it leads to less diversified portfolios.

In an attempt to generate more income, many investors build portfolios concentrated in high yield stocks. This can lead to unintentional economic sector bets. Telecommunications and utilities, for instance, tend to have a greater number of dividend paying companies. These sectors also happen to act very defensively—at least historically speaking. So while you’d likely be better positioned for down markets, you could miss significant upside returns during bull markets.

The pursuit of higher yields in the fixed income world poses an entirely different risk than stocks. Bond investors are typically compensated for risk through higher yields. This could be for default risk, interest rate risk, and/or inflation risk, to name a few. But regardless of the reason, higher yielding bonds typically carry higher risk. So investors looking to increase their level of interest income could unintentionally increase their portfolio’s risk profile. Moreover, investors need to be wary of taxes. Qualified stock dividends and capital gains are currently taxed at the same rate. Not true for bonds. Interest is taxed as ordinary income, so increasing your portfolio’s yield could also increase your tax bill.

Remember, there is no guarantee higher yielding investments will outperform their lower yielding counterparts over the long-term. Maintaining a diversified mix of both will shield your portfolio from unnecessary risk.

Deadly Investor Sin #7: Poor Debt Management

No financial picture is complete without first examining household debt—the most common forms being mortgages and credit cards. Managed properly, both can provide valuable benefits in the form of tax deductions and/or improved liquidity. But managed inappropriately, the impact to your financial health can be substantial. Two potentially costly mistakes are selecting the wrong mortgage and keeping high interest debt.

Mortgage. Selecting the right mortgage mostly refers to the fixed/variable decision. In other words, does it make more sense to take out a fixed or adjustable rate mortgage, also called an ARM. Both have benefits. A fixed rate, for instance, is just that—it’s fixed. This means regardless of what happens to prevailing interest rates, your mortgage payment will remain steady. Clearly this can be advantageous during periods of rising rates. In an ARM, however, your payments would change over time to reflect broader interest rate movements. While this would be hugely beneficial in a downward trending interest rate environment, it could be disastrous should rates rise.

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