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Six Tips to Improve Your Nest Egg

June 20, 2012 | About:


Few markets have vexed investors more. Overseas bourses have tanked, as the world is riveted by a dysfunctional Greek economy: Will the Hellenic republic remain within the euro zone? Can it pursue policies austere enough to allow it to pay back its debts? And if a disorderly exit from the euro occurs, which southern European country will be next? Spain, whose national debt now yields over 7%? And how will a recession in Europe affect the United States and the rest of the world?

The emerging markets are, well, no longer emerging. The Chinese economy’s growth is slowing dramatically, while India’s debt ratings have been slashed to nearly junk.

The United States remains vulnerable to a double dip. May’s employment figures show the weakest job gains in a year and consumer sales are slowing dramatically.

While equities remain vulnerable, investors find little place to hide. Ten year bonds of safe haven countries like the United States, Germany, Switzerland and Japan all yield well less than 2%, a losing proposition after taxes and inflation. Meanwhile, money markets yield little and CDs are generally paying less than 1%

Despite all the uncertainty there are several simple strategies to improve your investments results now. Here are six of them.

1. Sidestep Taxes on Your Savings

Savers are constantly looking for the most interest on their money, frequently scouring the landscape for the best CD yields, bond rates, and money market interest. However, they often fail to heed the old saw: It’s not what you make but what you make after paying Uncle Sam.

The single most important step savers and other fixed income investors can make is to swap their taxable savings for tax exempt savings. By investing in the debt of state and local issuers, investors can avoid losing up to 35% of their income to Federal taxes and up to 10% or more for state taxes.

To calculate what a tax exempt interest rate could mean to you, divide the proposed tax exempt rate by one minus your marginal tax rate. So, a one percent tax exempt rate is equivalent to 1.54% for an investor in the 35% tax bracket.

Investors of more substantial means can invest in tax exempt bonds directly, but most will benefit from investing in tax exempt bond funds. Funds allow for investing small amounts, are highly diversified, and can be traded without cost, making them highly liquid.

You can also avoid state income taxes by investing in bonds or bond funds of issuers located within your state. Use short dated bonds or bond funds to reduce the risk of rising interest rates.

Consider Fidelity’s Intermediate Municipal Income Fund (FLTMX). It yields 1.52% and invests in bonds maturing in about five years. For a 35% tax bracket investor that’s the equivalent of 2.34%. That compares favorably to the average five year CD yield of just 1.11%. And FLTMX is completely liquid, although your sale price will fluctuate with changes in the interest rate environment.

2. Use Index Funds

Legendary investor Warren Buffett has repeatedly advised investors that if they are unable or unwilling to invest in individual stocks they are best advised to invest in low cost index funds.

What are index funds? These are mutual funds whose portfolios replicate an index, say the S&P 500, as opposed to actively managed mutual funds trying to beat the market by shuffling the portfolio. While hope springs eternal, the reality is, according to investment service Motley Fool, only ten of ten thousand actively managed mutual funds consistently beat the S&P 500 over a recent ten year period.

Why the underperformance? A lot is attributable to actively managed funds’ high fees. The average growth and income fund charges 1.29% annually, nearly twenty times as much as an index fund, and that doesn’t include various costs associated with actively managed funds’ increased trading. That can push total expenses to well over 2%.

Make no mistake – index funds have their drawbacks. For tax planning purposes we prefer individual stocks, in effect an unbundled portfolio, which gives greater flexibility to take losses and defer gains to minimize the tax bite. An index funds is also only as profitable as the underlying index; indexes are typically structured to give greater weight to pricier stocks, which violates the traditional investment principle of buying cheap and selling dear.

Nevertheless, the average investor relying on funds should use index ones.

3. Just Say No to ETFs

Exchange traded funds (ETFs) have skyrocketed in popularity. They’re akin to an index fund but offer more flexibility. These typically static portfolios funds can be traded all day long – unlike conventional mutual funds, which can only be bought or sold at 4 pm. Further, you can buy these funds on margin and sell them short.

So, why say no? These features are ones that index funds investors either don’t need or should avoid. Index fund investors don’t try to time the market, but rather take advantage of the long term historic upward trends in equity prices. To trade intraday, sell short, or leverage your bets is inconsistent with skepticism of short term market timing.

ETFs’ extra features make them more expensive. While trading conventional index funds is normally costless, ETF trades normally incur a commission, just like a stock. Even more important is the bid-ask spread you face – basically, an ETF buyer will pay more than the seller will receive. That difference goes into the market maker’s pocket and erodes your returns.

When you buy a conventional fund, you can be sure your shares are priced at the current value of the portfolio. Although ETFs try to keep their share prices in line with the underlying holdings, discrepancies of several percent or more are not at all unusual. That quickly defeats their highly touted low internal expenses.

Many ETFs are based on a highly specialized index representing a tiny slice of the market. That can make them quite volatile, and often unduly buffeted by the fate of just one or two stocks. For example, the Energy Select Sector Fund ETF (XLE) has over 35% of its assets in just two stocks, Exxon (XOM) and Chevron (CVX). If you like those stocks simply buy them and skip that ETF. And if you don’t like those stocks you won’t want to have an ETF with 35% of its assets in them.

Bottom line, indexing is a sound strategy, but is best pursued using conventional index funds, not ETFs.

4. Allocate Your Assets Efficiently

Your more conservative and income oriented assets (i.e., bonds and other fixed income) should be allocated to the extent possible to tax sheltered accounts (TSAs) like IRAs, 401Ks, 403Bs, etc. Here’s why: Preferential capital gains rates only apply in taxable accounts, so holding capital gain producing investments like stocks in the TSAs does not take advantage of those rates. Further, holding fixed income securities in the TSAs allows you to avoid present taxation on that income; the same income in taxable accounts would be taxed at the highest marginal rates. Stocks have a greater chance of loss, but if held in a taxable account the pain is mitigated because it can be set off against gains and up to $3,000 of regular income; any unused losses can be carried forward indefinitely. These can be used to shield future capital gains from any taxation. Taxable accounts can more easily be replenished if there is a loss; you are limited

in your ability to contribute to a TSA. Finally, only stocks held in taxable accounts can take advantage of the current 15% Federal tax rate on stock dividends.

To the extent consistent with your overall asset allocation plan and your short term liquidity needs, devote your taxable accounts to equities and allocate your fixed income to your TSAs.

Some investors note that if they need money and therefore have to access their investment accounts, they would first access a taxable account to avoid a TSA withdrawal. Their concern is, if equities were depressed, it would be painful to have to sell them in a taxable account to make the withdrawal. This concern is best addressed by realizing that you can always rebalance your TSAs into equities at the time you liquidate them in your taxable accounts.

5. Leave Predictions to the Stargazers

One of the greatest insights you can have as an investor is you cannot predict the overall market. Another is that neither can anyone else.

Why is that? There are just too many crosswinds, meaning influences on the markets. In the short term the direction is more about crowd psychology than any underlying fundamentals. If Greece defaults markets might go down, but they might go up if Germany decides to bail them out. Or they might go up if investors think Germany will bail them out, and then go down when Germany in fact bails them out, on the grounds that prices have risen and the hoped for good news is now passed.

Every trend in the market sets in motion the potential for a trend reversal. For example, gas prices may rise, but then there’s less driving and production is stimulated, driving prices down.

Examples of misguided expert prediction are legion: Treasury Secretary Paulsen said, in April, 2007 that: “I don’t see [subprime mortgage market problems] as imposing a serious problem. I think it’s going to be largely contained.” Former AIG derivatives head Joseph Cassano said, in August, 2007: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these [credit default swap] transactions.”

Bottom line, think long term and don’t believe that you or any pundit has a crystal ball.

6. Don’t Do What Everyone Else is Doing

Long term success in investing often depends on avoiding the big blunders. Those blunders often occur when chasing what the crowd is chasing – without regard to whether those fundamentals make any sense.

Back in 2000 investors threw money at all kinds of Internet companies, throwing caution to the wind by refusing to consider the underlying fundamentals like revenues, profits, and assets. New economy mania had set in. Within two years after the peak, $5 trillion in investment capita was wiped out and countless investors ruined.

A similar frenzy crested in 2006, when real estate investing took the nation by storm; buying and flipping condos in exotic locales like Miami sight unseen was not unusual. The public became convinced that a nationwide downturn in real estate could not occur, and ignored such warning signs as prices far outstripping rents and underlying affordability. After the crash real estate prices collapsed by 35% or more nationwide and many properties remain valued at less than their mortgages.

On the other side of the ledger was March, 2009, when media like USA Today trumpeted “Stock market recovery likely will be years in the making.” But, in less than three years the S&P 500 had doubled from its low then of 676.

Bottom line, heed Warren Buffett’s admonition: “Be fearful when others are greedy; be greedy when others are fearful.” Avoid chasing the herd.

About the author:

David G. Dietze, JD, CFA, CFP
David G. Dietze is President and Chief Investment Strategist of Point View Wealth Management, Inc., an SEC registered investment advisor, which he founded in 1993.

Visit David G. Dietze, JD, CFA, CFP's Website


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