Improving the Odds

Jonathan Clements

WE HEAR ABOUT highflying stocks and hotshot money managers, and it’s easy to imagine the streets of lower Manhattan are paved with gold. But the truth is a tad more mundane.

Want some reasonable assurance of investment success? We should shun the excitement of trying to pick winners and instead focus on more prosaic portfolio tweaks. The overriding goal: ensure the compounding of our investment dollars encounters as little friction as possible.

Minimizing this friction will, I believe, be especially important in the years ahead, because stock and bond returns will likely be below their historical averages. What to do? Many HumbleDollar readers are heavily invested in low-cost index funds, so they’re already well-positioned to capture the market’s return with minimal loss to investment costs. But don’t stop there. Here are five other steps that should speed your portfolio’s progress:

1. Cashing in. As brokerage commissions shrink, trading spreads tighten and investors flock to index funds, it’s become harder for brokerage firms to make money. But there remains one favorite way to milk customers: Pay them little or nothing on their cash balances.

Many brokerage firms offer money market mutual funds with reasonably high yields. Despite that, their designated cash sweep account—the place money goes if, say, we sell a stock—is often a bank account with a modest yield. To earn more, customers need to move cash out of this sweep account and into a higher-yielding money market fund.

Sound like work? This is a reason to invest at Fidelity Investments or Vanguard Group. Both use government money market funds with decent yields as their sweep account.

2. Taking risk. I realize this might sound odd, but if we’re worried that the stock market will deliver subpar returns in the decade ahead, arguably we should allocate more to stocks. Why? Even if stocks deliver modest returns, they should still outpace bonds and cash investments, so a heftier stock allocation ought to bolster our long-run performance.

But that suggestion comes with two caveats. First, there’s a grave risk of lousy short-run returns, given today’s lofty stock market valuations. My suggestion: If you decide to keep, say, 70% in stocks rather than 60%, make the shift slowly over 24 months, thereby reducing the risk that you buy heavily on Monday and get hit with a market downdraft on Tuesday.

3. Going global. That brings me to my second caveat: To ensure you capture the stock market’s return, use low-cost total market index funds—and be sure to diversify globally, because there’s no guarantee U.S. stocks will continue their recent dominance.

Not sure you can stomach investing abroad? Check out Vanguard Total World Stock ETF, which wraps together 56% U.S. stocks, 34% developed foreign markets and 10% emerging markets. The fund charges just 0.09% in annual expenses, equal to nine cents a year for every $100 invested.

Yes, if you buy Vanguard Total World Stock, you’ll end up owning foreign stocks—and, indeed, far more than most U.S. investors are comfortable with. But because you’ll have the world’s stock markets bundled together into a single fund, much of the daily carnage will be muffled by the fund’s broad diversification and that might make you less inclined to second-guess your international holdings.

Today, many indexers go for the three-fund portfolio: a total U.S. stock market index fund, a total international stock index fund and a total U.S. bond market fund. But if you buy Vanguard Total World Stock and couple it with a total U.S. bond market fund, you go one better—trimming your holdings to just two funds and yet still enjoying global diversification at a tiny cost.

4. Managing taxes. If you hold a two-fund portfolio—or, indeed, any portfolio that combines broad stock market index funds with taxable bond funds—aim to hold the taxable bond funds in a retirement account, so you can defer taxes on each year’s income distributions.

Meanwhile, broad stock market index funds are a great choice for a taxable account, because they shouldn’t generate big taxable gains each year—and any gains should be taxed at the favorable rate on qualified dividends and long-term capital gains. Keep in mind that, to have the precise asset allocation you want, you may end up with part of your stock fund holdings in a retirement account. Alternatively, if your retirement accounts are on the skimpy side, you might need to keep part of your bond holdings in your regular taxable account—at which point high-income earners may want to investigate tax-free municipal bonds.

As you work to improve your so-called asset location, also pay attention to whether you should fund tax-deductible or Roth retirement accounts—and whether this would be a good year to make a Roth conversion. Thanks to 2017’s tax law, folks currently have the chance to make relatively large conversions to a Roth IRA and pay federal income taxes on the sum converted at 24% or less.

5. Minimizing foolishness. Many investors—professional and amateur—tell me they take an occasional flier on a stock or two. Some even have a “fun money” account, where they allow themselves to trade with maybe 5% of their portfolio. The rationale: This fun money account offers both entertainment and an emotional outlet, so they’re less inclined to mess with the rest of their portfolio.

All that’s understandable. Still, in all likelihood, that fun money account will be a drag on a portfolio’s long-run return. Want to improve investment performance? Maybe we should find other, cheaper ways to entertain ourselves.

The above five steps should help speed our portfolio’s growth. But I’d be remiss if I didn’t mention the most obvious way to compensate for lower returns: save more. As I noted two weeks ago, perhaps half of our eventual retirement nest egg will reflect the actual dollars we sock away. How can we make our portfolios grow faster? Saving more is the most reliable strategy.

Of course, to save more, we’ll need to spend less. Try going through your check book and recent credit card statements, and question every expense. There may be automatic monthly charges that you don’t even realize you’re incurring, perhaps because you’ve forgotten about them or you neglected to cancel after the free trial period ended.

Meanwhile, there may be other costs that you simply take for granted, like the landline you never use or the premium cable package with channels you never watch. And what about that large storage locker that costs $200 a month? After a decade, you’ll be out $24,000, plus the investment gains that the money could have earned. Does anybody care about the stuff in the storage locker—or is it time to do yourself and your heirs a favor, toss everything and save $200 a month?

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include 50 Shades of RiskShow Me the Money and Timely Reminder. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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Peter Blanchette
Peter Blanchette
3 years ago

Going Global: A high % of the sales of companies in the S&P 500 have overseas exposure. What is the benefit of allocating specifically to an international fund or funds?

Cashing In: If someone is at Fidelity a better option is to utilize their 3 month bank CDs for cash swept into money market accounts.

Taking Risk: Before trying to reach for a higher return, determine what is your appropriate level of risk based on risk tolerance(feelings about risk and the need to take risk based on expected amount of assets needed and expected expenses).

Roboticus Aquarius
Roboticus Aquarius
3 years ago

Taking Risk: I’m relying somewhat on minimum volatility funds to help with this. If such funds reduce volatility by 15-30% (typical projections), then theoretically one can carry up to a 90/10 portfolio with roughly the same volatility risk as a 65/35, but more upside. Not all min vol/low vol funds are built the same however, and there are no guarantees of performance in a downturn. Given that min vol funds are relatively new, I’m hesitant to commit more than 30% of my AA. Still, even this allows me to carry 5-10% more equity than I otherwise would. I like the Vanguard offering a lot.

Costs. The big ticket items are usually 80% of the opportunity in most cases. While we’ve not had cable/satellite in 25 years, and we use OOMA for our landline, the house and cars are key. We refi’d down to 3.5%. We considered moving to a less expensive house, but the economics don’t work unless we move a long distance, which would impact quality of life for us. We sold our modestly expensive car and leased a less expensive car (for the flexibility). With college costs looming and the lease almost up, we are letting go the leased car for an old but well-cared for $5,500 car. I transitioned to working from home over the past couple years, so I rarely need a car (and could Lyft/Uber/Taxi in a pinch). Car payments were almost $1,050/month, soon to be $170/month on two cars.

Peter Blanchette
Peter Blanchette
3 years ago

Before you increase your risk level make sure need to take on more risk. It is foolish and possibly very costly to rely on a tool such as minimum volatility funds that you may not fully understand. For some reason many financial commentators tell people to take on more risk(or work longer) when taking on more risk is not always necessary. You should read this article:

Roboticus Aquarius
Roboticus Aquarius
3 years ago

Thanks for the link, but it doesn’t appear to work. I like Kitces too, were you trying to link to the ‘failed retirement planning/bankruptcy’ article?

I do my own investing, but your comment about risk is a good one. I think it’s important in defining one’s AA that the first step is to always understand risk and volatility as completely as possible. My worst case scenario planning always assumes that the min vol funds are no better on the downside than normal stocks.

With respect to actual income needed in retirement, my numbers keep going down the closer I look at them. Otoh, my pension is a tiny little thing, so yeah, there are tradeoffs to consider.

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