3 Steps To Earn The Same Returns With Less Risk

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Forbes.com, Winter, 2018. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

If you’re skeptical about the headline, I completely understand.

In our everyday course of business we are constantly assessing investments, and we abide by the rule that if it sounds too good to be true, it probably is. That said, we believe there are three simple concepts you can employ to potentially earn the same return with lower risk.

Focus on what you keep as much as what you make

Taxes are one of the fastest ways to erode your returns. The benefit of high returns will be greatly impaired if you lose a substantial portion of those gains to Uncle Sam.

There are multiple ways to minimize taxation. Some of those options include:

– Limiting your ordinary income generation in taxable accounts and/or gearing your taxable account towards long-term capital gains

– Placing high-turnover strategies or ones that do pay large amounts of ordinary income (think preferred stocks) in tax-deferred or tax-free accounts

– Avoid purchasing certain mutual funds before annual gains/distributions occur

– Waiting an additional few weeks for short-term gains to become long-term gains, etc.

If your average investor, with a portfolio of 60% stocks and 40% bonds, were to employ a strategic approach to the taxation within their portfolio, and reduce their tax drag by what might appear to be a marginal amount by adding just 1/2 of a percent of return per year to their after-tax return, they could actually afford to reduce their equity allocation. The added benefits of reducing the equity allocation would mean the investor may experience a less volatile portfolio and yet have the same terminal portfolio value on an after-tax basis. In sum: Less risk for the same (or even higher) reward.

Be mindful of costs: You need to receive value for your fees

According to the Investment Company Institute (ICI), the average cost for an equity mutual fund in 2016 was 0.63%. While that figure is down significantly from 1.04% in 1996, the difference in cost from an index mutual fund is still a healthy 0.40%, based on the average index fund costing 0.23% in 2016.

If our average investor replaces their higher-cost, actively managed mutual funds with lower-cost index funds that have largely captured the same amount of return as their active brethren (per Morningstar’s Active/Passive Barometer), we could potentially target keeping another 0.4% of return per year. Once again because our hypothetical investor would pay less in fees for the potential same return, they could afford to reduce their equity allocation.

Diversification beyond stocks and bonds.

Diversification may be the most overused word in the investment industry and yet, you’d probably receive several hundred different descriptions of it if you spoke to 1,000 individual investment advisors.

In a nutshell, the two most common ways to depict diversification are to show a client a pie chart with several different colors or to highlight the amount of stocks and bonds an investor owns.

My team and I believe investors need to be diversified by more than a simple stock/bond mix. We advocate that a good portfolio is diversified based on risk factors such as company risk (too much in one company or overlapping bonds/stocks in the same company), interest rate risk (risks that arises for fixed income holdings when interest rates fluctuate), purchasing power risk (value of an asset suffers erosion from inflation) and manager skill risk (you have the right horse, i.e. area of the market, but the wrong jockey). In total, diversifying by risk leads to what we refer to as “effective diversification.”

Unfortunately, too many people at Lehman Brothers, Enron, Worldcom and Bear Stearns had a front row seat to the issues that arise when you have too much company risk. While it might be unfathomable for shareholders or employees of today’s darlings, such as Apple, Amazon, Facebook or Tesla, we would all do well to remember the damage endured by those that had too much exposure to one company in the past. Using effective diversification is one more step an investor can undertake to lower their portfolio’s equity allocation and volatility simultaneously.

If our average investor with a 60/40 portfolio were to employ these three strategies, and decide to reduce their equity allocation by 15%, to arrive at a 45/55 portfolio, when the next 30% stock market dip occurs–and there will be another 30% loss in the future– the equity portion of their portfolio would only fall by 13.5% instead of 18%.

There are certainly other ways to seek more return or equal returns with less risk. In my experience though, three methods that could potentially maximize risk-adjusted returns involve employing proper tax planning, being mindful of fees and allocating assets to achieve effective diversification.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing in stocks, mutual funds and index funds involves risk, including loss of principal. We suggest that you discuss your specific situation with a qualified tax or financial advisor.

Click here to see the article on Forbes.