Broker Check

Turbulent Times Series Part 2: The Impact of Investment Returns Can Be Controlled

by Darren L. Zagarola, CFP ® , CPA, PFS

As published in The Princeton Patch , July 23, 2012

Part 2 of 3 of the Turbulent Times Series

If I told you that I could help control the impact of returns of your financial investments, would you believe me? Especially during these turbulent times? While we all agree that no one can guarantee results nor a specific level of profitability on a particular investment, the impact of investment returns on your portfolio can be controlled.

No one controls the markets, but it's possible to impact the bigger picture in the long term by implementing an overall investment allocation plan. One's personal needs, combined with their risk tolerance, helps determine the investment allocation, or the mix of equity investments and fixed-income investments maintained in their portfolio. When considering diversification, ask the following: How much should be allocated to equities (higher risk, higher expected returns), fixed income (lower risk and lower expected returns), and within those two categories, how would you allocate among large-, mid- and small-cap investments, domestic versus international investments, and the many different types of fixed income investments?

It's worth noting that over the long term, the market does perform more predictably. When you look at the S&P 500 from 1926 - 2010 at 1-year rolling periods, 72 percent have been positive and 28 percent negative. When you look at 5-year rolling periods, 89 percent have been positive periods. This shows, as long as investors are not taking distributions from their portfolio, that 89 percent of the time investments would have increased.

The average growth in a 50 percent equity/50 percent fixed income portfolio over 20 years is 9 percent, while equities over a 20-year period average out to 10.9 percent. What this tells us is that the longer an investor's time horizon, the more predictable the market tends to be. And as it relates to short-term volatility, or the need to sell assets during turbulent times, we advise investors about the benefits of a bond ladder, which takes five years of cash needs and puts them in safe and secure municipal bonds, CDs or U.S. Treasuries. Having this money available alleviates the need to sell equities in a down market, thereby reducing the impact of market volatility on a portfolio. (In my June 21st column, I explained how to calculate for a person's cash needs.)

So, say a person is five years away from retirement. The fixed income portion of their portfolio will be diversified in mutual funds across the board (short-, long-, intermediate-term, high yield, international, emerging market, etc.). As retirement approaches, short-term bond funds will be turned into the bond ladder, and an allocation in higher risk fixed income products, like the emerging markets, will be reduced. With the bond ladder, the individual receives monthly payments, like a salary, from their portfolio to meet their needs. In order to combat inflation, a certain level of equity mutual funds will be needed in the portfolio, as equities historically perform better over the long term than fixed income products. The equity portion of their portfolio will also be diversified in mutual funds across the board (domestic, international, large cap, mid cap, small cap).

Another way to help control volatility in your investment returns is to control your emotions. Emotional decisions on when to buy or sell an investment can have a significant impact on your investment returns. For example, from January 1989 - December 2008, the average equity investor earned 1.8 percent annual return. This underperformed the S&P 500 Index by 6.5 points and inflation by 1 percent. This, unfortunately, illustrates that many people sell and buy when they shouldn't. I will dedicate a future piece on how emotions effect investment decisions.

Tax Efficiency
Taxes can have a significant impact on the erosion of an investment portfolio over time. Investors can control the impact of taxes on their portfolios based on whether they choose to take money from their retirement or nonretirement accounts. Retirement accounts, such as traditional IRAs and 401(k) plans are the least tax efficient (resulting in higher taxes paid) because distributions are taxed at ordinary income tax rates, which are usually higher than preferential income tax rates for qualified dividends and capital gains. Within the non-retirement account, investors can choose to take items that have a lower or higher cost basis (meaning the higher the cost basis, the less tax you pay when you have to convert those assets to cash). Distributions from a Roth IRA are not taxable at all.

Obviously, from a tax perspective, it's usually better to take the high cost basis assets first. Then look into retirement accounts, whether it's a traditional IRA or a Roth IRA. Proper planning of distributions to meet a person's needs can save them money in terms of overall income tax paid, which will allow their portfolio to continue to grow over time. In terms of the tax structure, investors need to be aware of the implications so that they draw money from the most tax-efficient financial bucket. For example, if a retiree with a portfolio of $800,000 (50 percent non-retirement and 50 percent traditional retirement accounts) needs $40,000 a year from her portfolio, her investment portfolio will last several years longer if it's taken from a cash ladder and then her IRA, which is considered more tax efficient, than if she withdrew from the IRA first.

As we all are aware, expected changes to tax law must be monitored to determine whether certain of these beneficial tax rates will continue to apply to personal situations (i.e. capital gain and qualified dividend tax rates).

Withdrawal Rates
In addition to identifying your needs in retirement and understanding the role that investments play in meeting those needs, a retiree's Withdrawal Rate needs to be determined. Simply put, the withdrawal rate is the amount of money needed from a portfolio to supplement a person's inflows in order to meet their outflows. This begins with understanding that just because you have $1 million in assets and plan to spend $100,000 annually it doesn't mean you're set for 10 years. Why is this? Inflation. Inflation plays a significant role in meeting your needs, especially given the fact that expenses usually increase at higher levels than Social Security and pensions.

Another thing we discuss with investors is the notion of the 4 percent withdrawal rate, meaning if they are taking 4 percent from their portfolio, research supports that they should be able to fund your retirement over the long term. However, that all depends on the individual's age. For example, for 60-year-olds, research shows 4 percent is probably okay. For 80-year-olds, more money can be withdrawn, while for someone wishing to retire at 50, a more conservative (less than 4 percent) approach will be necessary. The bottom line is this: Investors don't need to change their lifestyles in a bad year and, conversely, they shouldn't overspend in a good year.

The keys to providing control in a turbulent market are simple:

  1. Establish a long-term portfolio allocation based on one's individual risk tolerance.
  2. Provide for the next five years of cash needs with a bond ladder.
  3. Establish a tax-efficient plan to provide cash from the investment portfolio to meet one's needs.
  4. Determine the appropriate withdrawal rate from the investment portfolio.

By following these steps, one can gain a measure of control over how market volatility can impact one's investment portfolio. Better overall decisions, whether financial or life related, are made hen one is in control of one's environment. Success, however one defines the word, can be achieved as long as you remain proactive and arm yourself with this knowledge. It's when you're reactive that you lose money, and are most likely to sell at the wrong time. This kind of emotional response can cause your financial plan to fail.