Watching a soccer match, it’s quickly apparent that key mid-match decisions include if and when to bring in substitutes. What’s the best strategy for the team, given the match situation? Is it better to keep or replace a player, given his strengths and performance thus far?
Now, suppose a team’s manager had little knowledge of how players were doing and didn’t even know the match’s score. How could such decisions be made?
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This scenario seems ludicrous (in any sport). But it can happen rather easily with your investment portfolio, especially when it’s divided across multiple accounts (brokerage, IRA, Roth) and if its manager lacks accountability to regularly report key measures. Since your portfolio is far more important than any game, here are six numbers to keep up-to-date on how things are going and how your portfolio’s manager is doing… even if that person is you.
1. Your asset allocation
What is your overall mix of stocks and bonds? It may be 75% stocks and 25% bonds (75/25) or 58/42 or 14/86. It’s also helpful to break your mix into its key subcategories since they often perform quite differently. There are seven “asset classes” for stocks (U.S. large value, U.S. large growth, U.S. small value, U.S. small growth, foreign developed, foreign emerging and other equities) and four for bonds (cash, short-term, intermediate/long-term and foreign). This matters when evaluating your performance. In 2017, large-growth stocks gained 28% while U.S. small-value rose just 12% (after gaining 24% in 2016). It’s also why broad-based holdings are often not your friend. If your portfolio is consolidated on a single financial statement, this information is usually provided.
2. Your portfolio expense ratio/percentage
All portfolios have expenses, whether you own index funds, individual stocks and bonds, annuities, exchange-traded funds (ETFs) or actively-managed mutual funds. This number is a weighted average of each holding’s annual expense ratio. Under 0.35% annually is good, especially if it includes active managers who you like working with. If you’re above this level, analyze whether higher-expense holdings are covering their costs based on performance. (More on this below.) Lowering this number much further usually involves eliminating active managers, even ones well-worth their cost.
3. Your portfolio’s overall rate of return
Remember, this is money to help fund key goals for you and your family. How much you need to accomplish them, how much you need to save, how much you can safely withdraw are all predicated on the return of your chosen investment mix. Are you on target? You can’t tell without this number. Calculate over one, three and five-year periods. It should reflect all expenses (#2) and advisory fees.
4. A benchmark return for your stock/bond mix
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You need one for stocks and one for bonds, weighting each by your overall mix (#1). For bonds, use a low-cost index fund like FSITX, SWAGX or VBTLX. For stocks, use VTHR (Russell 3000 index) if over 90% of your stocks are U.S. companies. Don’t use the S&P 500 (.SPX) as it excludes small-cap stocks. If you are more diversified with less than 75% in U.S. stocks, use VT (FTSE Global All-Cap index). Choosing the wrong benchmark is worse than having none at all.
Here’s how this works: If your portfolio’s allocation is 68/32 with 1/3 of its stocks overseas, use VT. For 2017, multiply VT’s return (+24.49%) by 0.68 and FSITX’s (+3.47%) by 0.32; add these to get 17.76%. This is your 2017 benchmark. For 2016, this 68/32 mix gained 6.56% and, so far in 2018 through June 30, it shows -0.60%. Compare these to your results (#3) by time frame; aim to be within 1% of them.
5. A comparison of each holding’s return to a benchmark for its asset class
This sounds harder than it is. Like sports substitutions, the goal is to decide which holdings should remain “in the game.” Except for balanced or “life-cycle” funds, most fit closely with a subcategory in #1. Sources like Morningstar, Fidelity, Schwab and Vanguard make this data readily available. You need a good reason to retain any holding that lags by more than 1% over the past three and five years.
6. The tax efficiency of your after-tax assets
This doesn’t apply to 401ks, IRAs or annuities, but after-tax assets generate taxable dividends and capital gains each year. Though they get better tax treatment than all but Roth IRAs, you still want to control when they are taxed. This number tells you the portion of total return that was taxable each year. Start by totaling the year’s dollar gain/loss for these assets. Then determine how much appeared on that year’s tax return as interest, dividends or capital gains. Divide the second number by the first to get a percentage. Over a three- to five-year period, you want this to be less than 30% (meaning you deferred 70% of these gains into the future) unless you are withdrawing money and need to sell some holdings each year.
Yes, there’s work involved to gain this knowledge about your portfolio. But knowledge is power. And it can help you make informed decisions that are in your best interest as well as those closest to you.
Jonathan Guyton is principal at Cornerstone Wealth Advisors Inc., a fee-only advisory firm in Minneapolis.
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