Many investors spend too much time thinking about what stocks to buy and if it’s a good time to be in the market. They ignore, at their peril, the small factors that add up over time. It’s understandable. An annual fee of 1% seems trivial when compared to a stock that may double over a year. But over the long term most investors end up with as many losers as winner in their stock (or mutual fund) portfolio. The few “home runs” don’t end up making nearly as much as an impact as other factors. Give some thought to these factors that can have a large impact over time.
Asset Allocation
You wont earn stock market returns if you’re not invested in stocks. But put too much in stocks, and you’ll get hit hard during stock market declines. What’s the right allocation? Whole books have been written in an attempt to answer this question. My starting point is 50% U.S. Stocks, 25% foreign stocks, and 25% bonds. I generally recommend increasing the bond allocation for older or risk-adverse investors.
Rebalancing
Over time your asset allocation will drift from its target as stocks and bonds perform differently. Rebalancing is simply the process of selling one type of investment (i.e. stocks) and buying another type (i.e. bonds) in order to bring your portfolio back to its target. Rebalancing results in selling stocks as they rise (relative to bonds) and buying them when they fall.
Mutual Fund Expense Ratios and/or Broker Fees
The best predictor of future mutual fund performance is not past performance, but fees. Funds with lower fees take less from investors. If you’re paying more than 0.50% fees in any of your mutual funds then you may want to look elsewhere.
Asset Location
Put investments that have the highest potential tax impact into tax sheltered accounts, such as a 401k or IRA, whenever possible. Generally this means stocks in IRA’s and bonds in taxable accounts, but not always. Do the math and find out what’s best. Similarly, when making withdraws choose the investments and accounts that are best for taxes.
Perseverance
Nothing is more important than choosing an asset allocation that you can stick with through ups and downs. Selling when the market declines and buying after it rises is the single largest factor affecting individual investor performance. Depending on the study, it costs between 1% and 3% annually on average. Choose an allocation, think about what it means if stocks drop 30% or more, and decide if you can stick with it. If not, then change your allocation. I run a 20 year simulation for my clients that makes it clear what kind of looses we’ll see over time. This is a good way to understand what you’re facing and determine if your allocation is reasonable for you.
In total, these “small factors” add up to 2% to 3% annually – a big number in the world of investing. They are, in fact, not small at all. In most portfolios these factors have a much larger impact than stock or mutual fund picks.