By David C. Brinkman, CFA, CFP®, CPA
Recent global headlines ranging from ongoing trade negotiations between the two largest global economies, the US and China, overall concerns of slowing global economic growth, unresolved BREXIT plans for the United Kingdom, and recent tensions in the Middle East are all fresh examples of activities that typically drive investor uncertainty and market volatility. In light of these near-term volatility inducing events, we encourage investors to focus their attention on long-term financial goals and objectives, appreciate the outsized impact of one’s asset allocation on long-term performance, and employ proactive portfolio construction considerations to improve one’s after-tax rate of return.
For those investors who are potentially skittish of near-term global uncertainties and eying potential investment portfolio adjustments, our first suggestion is to remember why people invest in the first place. For most individual investors, they choose to invest with the long-term goal of accumulating assets to provide future financial security and support for themselves and others. By focusing on the why, it should provide a longer-term perspective and allow one to more rationally conclude whether a portfolio adjustment is warranted. This should also help to ensure that the decision to make an investment adjustment is not a knee-jerk reaction to some near-term event, triggering additional associated trading and tax costs.
An asset allocation, or the percentage in which a portfolio is invested in fixed income, equities, and alternatives, will largely dictate how your investment portfolio performs over extended periods of time. Focusing on long-term allocation targets should position investors to retain better control of their emotions, the Achilles heel of most investors. A clear view of how one is invested, how a similarly constructed portfolio has performed in the past during up and down capital market cycles, and a realistic long-term return target for an investment portfolio are always good starting points for investors. A good understanding of the investment portfolio allocation should lead to more disciplined investing and position investors to take advantage of near-term volatility. The 2018 fourth quarter market pullback and the robust start to 2019 can test an investor’s investor discipline and their ability to attempt to buy low and sell high.
In addition, understanding how one’s investment portfolio is constructed, and its potential impact on future taxes and investment fees, are key for investors. Investment portfolio construction is the process of deciding which investments one holds in various investment accounts (i.e. traditional individual retirement account (IRA), Roth IRA, brokerage account, etc.). When working with clients and constructing financial portfolios, we are cognizant of how various investments will be taxed (i.e. ordinary income or qualified tax rates) with the goal of constructing a portfolio to maximize one’s after-tax rate of return.
Let’s assume an investor can own a corporate bond with a 5% interest rate in either their individual brokerage account or a tax-deferred account (i.e. an IRA or 401k). When analyzing the after-tax rate of return, the preference is to own this fixed income investment inside one’s tax-deferred account given the higher after-tax rate of return. This is just one example of understanding the tax ramifications of one’s investments, and structuring a portfolio accordingly, in order to maximize their after-tax rate of return.
Take a Roth IRA account for example. This is an account funded with after-tax dollars and generally does not have the same required minimum distribution constraints of a traditional IRA. The growth of the assets are never taxed if the 5-year holding period and age 59.5 rules are met. In this type of account, good construction would favor holding investments that over longer time periods have provided healthy capital appreciation to investors such a US mid-cap or US small-cap investments (with the upfront recognition that these investments during periods of increased market volatility are likely to be very volatile).
History shows that market swings and near-term uncertainties are always variables that investors have to overcome to be successful. But by focusing on the financial inputs directly within one’s control, such as asset allocation targets and investment portfolio construction, investors will be taking positive steps to help control near-term emotions and progress toward their long-term financial goals.
Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.
David C. Brinkman, CFA, CFP®, CPA is an Investment Relationship Manager with Schneider Downs Wealth Management Advisors, L.P. in Columbus, OH.